Lost in Translation: Honest Misunderstandings and Ex Post Disputes

We give a formal treatment of optimal risk sharing contracts in the face of ambiguity. The central idea is that boundedly rational individuals do not have access to a language sufficiently rich to describe all possible states of nature. The ambiguity in a contract arises from contractual clauses that are interpreted by the parties in different ways. The cost of ambiguity is represented in terms of dispute costs. Taking the potential for dispute into account, we find that risk averse agents may forgo potential gains from risk sharing and choose incomplete contracts instead.