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.

Contact theory analyzes a decision maker’s behavior under specific structures. Under these structures, contact 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.


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.

  1. Continuous Contract

    A reinsurance contract that does not have a fixed contract end ...
  2. Implied Contract

    A legal substitute for a contract. An implied contract is an ...
  3. Bilateral Contract

    A bilateral contract is a reciprocal arrangement between two ...
  4. Revealed Preference

    An economic theory of consumption behavior which asserts that ...
  5. Decision Theory

    An interdisciplinary approach to determine how decisions are ...
  6. Mechanism Design Theory

    An economic theory that seeks to determine the situations in ...
Related Articles
  1. Trading

    Modern Portfolio Theory vs. Behavioral Finance

    Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...
  2. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  3. Trading

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  4. Investing

    What is a Forward Contract?

    A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
  5. Trading

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  6. Trading

    Dow Theory: Current Relevance

    By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.comThere is little doubt that Dow theory is of major importance in the history of technical analysis. Many of its tenets and ...
  7. Investing

    Moral Hazards: A Bump In The Contract Road

    Learn how this phenomenon can cause a party in an agreement to behave differently than expected.
  8. Trading

    Stock Futures vs Stock Options

    A full analysis of when is it better to trade stock futures vs when is it better to trade options on a particular stock. A quick overview of how each of them works and why would a trader, investor, ...
  9. Investing

    5 Nobel Prize-Winning Economic Theories You Should Know About

    Here are 5 prize-winning economic theories that you’ll want to be familiar with.
  10. Entrepreneurship & Small Business

    Master The Art Of Negotiation

    Learn the strategies that will help you to come out on top in any negotiation.
  1. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  2. How does agency theory propose to deal with the agency problem?

    Learn more about agency theory and how businesses may use it to understand employee-employer relations. Find out more about ... Read Answer >>
  3. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  4. How do modern corporations deal with agency problems?

    Learn about ways that capitalist investment markets regulate the principal-agent problems that arise with corporate management ... Read Answer >>
  5. What is a forward contract against an export?

    Understand forward exchange contracts in exporting, and learn the purpose of using a forward contract and its advantages ... Read Answer >>
  6. How are forward contracts regulated in the United States?

    Read about the risks of forward contracts and why they are not readily subject to regulation, including what happens when ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center