Contract Theory

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DEFINITION of 'Contract Theory'

The study of how individuals and businesses construct and develop legal agreements. Contract theory analyzes how parties to a contract make decisions under uncertain conditions, and when there is asymmetric information. It draws upon principles of financial and economic behavior, as principles and agents often have different incentives to perform or not perform actions.

BREAKING DOWN 'Contract Theory'

Contract theory is closely related to game theory, which looks at the decision-making process followed by individuals and businesses. Contracts can be incentivized in order to promote certain outcomes, but can also contain a level of moral hazard stemming from the distance between the principle and agent.

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