Inflexible Rules in Incentive Problems.

In practice, contracts generally involve "standard terms" or "rules," allowing for variations only under "exceptional" circumstances. The authors develop a simple model in which optimal contracts display this feature, even in the absence of transactions costs and bounded rationality. Rules arise when an agent has "countervailing incentives" to misrepresent his private information. These incentives are optimally created by endowing the agent with a critical factor of production ex ante. The implications of the findings are examined in three different settings: (1) regulating the activities of a firm that also participates in unregulated markets; (2) labor contracting involving mobility restrictions; and (3) legal contracting with provisions for renegotiation. Copyright 1989 by American Economic Association.