Contractual incompleteness as a signal of trust

This paper shows how the fear of signaling distrust can endogenously lead to incomplete contractual agreements. According to standard results in contract theory an optimal incentive contract should be conditional on all verifiable information containing statistical information about an agent’s action or type. Most real world contracts, however, condition only on few contingencies and often no explicit contract is signed at all. This paper argues that the proposal of a sophisticated complete contract including fines for misbehavior and other explicit incentives signals distrust to the partner. A trustworthy partner would choose the desired action anyway. Insisting on explicit contractual incentives thus means that the partner’s trustworthiness is called into question. Thus if it is important for the relation that an agent believes to be trusted, a principal may prefer to propose an incomplete contract rather than to signal her distrust by proposing a complete contract. Asymmetric information about how much one partner trusts the other one leads thus endogenously to contractual incompleteness for strategic reasons. JEL-Classification: C7, C9,