Inflexible Rules in Incentive Problems

Abstract

In practice, contracts involve "standard terms" or "rules," allowing for variations only under "exceptional" circumstances. We develop a simple model in which optimal contracts display this feature, even in the absence of transactions costs. Rules arise when an agent has "countervailing incentives" to misrepresent private information. These incentives are created by endowing the agent with a critical factor of production ex ante. Applications in regulatory, labor, and legal settings are developed.