Overcoming contractual incompleteness: the role of guiding principles

Abstract

Transactions of any complexity between buyers and sellers are supported by long-term contracts and these contracts are inevitably incomplete. We propose an approach for overcoming contractual incompleteness based on the idea that most people are inclined to follow widely accepted social norms, such as being fair-minded and acting with integrity. We suggest that this tendency can be reinforced if these social norms are incorporated into a formal contract in the form of guiding principles. We develop a model in which guiding principles reduce shading behavior and discuss cases where the approach has been successfully applied in practice (JEL D23, D86, K12).