Contract Theory

What is a 'Contract Theory'

Contract theory is the study of the way individuals and businesses construct and develop legal agreements. It analyzes how different parties make decisions to create a contract with particular terms in case uncertain conditions happen, and it also covers how individuals and businesses make contracts with asymmetric information. Contract theory draws upon principles of financial and economic behavior as different parties have different incentives to perform or not perform particular actions.

BREAKING DOWN 'Contract Theory'

The first formal research on this topic in the field of economics was done in the 1960s by Kenneth Arrow. Since contract theory covers both behavioral incentives of a principal and an agent, it falls under a field known as law and economics, also known as the economic analysis of law. One of the most prominent applications of contract theory is being able to find the optimum design for employee benefits.

In 2016, economists Oliver Hart and Bengt Holmström won the Nobel Memorial Prize in Economic Sciences for their contributions to this field. According to the press release, "Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications."

Contract theory analyzes a decision maker’s behavior under specific structures. Under these structures, contract theory aims to input an algorithm that will optimize the individual’s decisions. Such practice divided contract theory into three types of frameworks: moral hazard, adverse selection, and signaling. These models find ways for parties to take appropriate actions under certain circumstances stated in the contract.

According to contract theory, contracts exist to put a line between what the principal expects to happen and what will happen. It provides a clear and specific understanding and agreement of how both parties stand and how they should perform. It also covers the implied trust between both parties that all of the constructed representations are valid and will be followed.

Moral Hazard

Moral hazard models include information asymmetry wherein the principal is unable to observe and/or authenticate the other party’s action. Contracts made for employee performance depend on observable and confirmable actions that may become incentives for parties to act according to the principal’s interest.

Adverse Selection

Adverse selection models portray a principal who is not informed about particular characteristics of the other party during the time the contract was constructed. For example, one of the risks insurers carry is how some buyers may not reveal some of their present illnesses at the time of the application for a medical-related policy.

Signaling

In signaling models, one party effectively conveys information and characteristics about itself to the principal. In economics, signaling greatly covers the transfer of information from one party to another. The purpose of this transfer is to achieve mutual satisfaction for a specific contract or agreement.