Loopholes and the Evolution of Contract Form∗

We explore a simple overlapping-generations model of the evolution via “loopholes” of incentive systems such as contracts, organizations, or regulatory regimes. Young principals, who are uncertain about what actions will be feasible for their agents, get limited observations of earlier agents’ behavior, and rationally update their beliefs about feasible actions. When old, they offer contracts that deter only the harmful actions they deem sufficiently likely to exist; their agents then cheat if it is both feasible and undeterred by the contract, i.e., if there is a loophole. In a loophole equilibrium, principals who observe cheating close loopholes when they offer contracts. But loophole-free contracts deter all cheating, thereby conveying little information about feasible actions to the next generation of principals; they rationally update in favor of the view that cheating is unlikely or infeasible and may therefore offer contracts with loopholes. The result is cycling of contract types that alternately deter and encourage undesired behavior, yielding heterogeneity across principals. There are also “bureaucratic” equilibria in which contracts deter behavior that is actually infeasible. Depending on whether principals sample concurrently or historically, population dynamics in a loophole equilibrium may display aggregate cycling or convergence to a stationary, nondegenerate distribution of contracts or rules.