What is Contract Theory? Definition, How It Works, and Types

What Is Contract Theory?

Contract theory is the study of how people and organizations construct and develop legal agreements. It analyzes how parties with conflicting interests build formal and informal contracts, even tenancy. Contract theory draws upon principles of financial and economic behavior as different parties have different incentives to perform or not perform particular actions.

It is also useful for understanding forward contracts, and other legal contracts and their provisions. It also includes an understanding of letters of intent and memorandums of understanding.

How Contract Theory Works

In an ideal world, contracts should provide a clear and specific understanding of responsibilities and requirements, eliminating the risk of disputes or misunderstandings occurring later. However, that does not always happen.

Contract theory covers the implied trust between the different parties and investigates the formation of contracts in the presence of asymmetric information, which occurs when one party to an economic transaction possesses greater material knowledge than the other party. 

One of the most prominent applications of contract theory is how to design employee benefits optimally. Contract theory examines 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. 

Types of Contract Theory

Practice divides contract theory into three models or types of frameworks. These models define the ways for the parties to take appropriate actions under certain circumstances stated in the contract.

Moral Hazard

A moral hazard model portrays a principal who has an incentive to engage in risky behaviors because the associated costs are absorbed by the other contracting party.

For moral hazard to be present, there must be information asymmetry and a contract that provides an opportunity for a party to alter their behavior. To counter moral hazards, some companies create employee performance contracts, which depend on observable and confirmable actions to serve as incentives for parties to act according to the principal’s interest.

Adverse Selection

An adverse selection model portrays a principal who has more or better information than the other contracting party and therefore distorts the market process.

Adverse selection is common in the insurance industry. Some insurers provide coverage for policyholders who withhold valuable information during the application process to obtain protection. Without asymmetric information, these policyholders would likely not be insured or would be insured at unfavorable rates.

Signaling

The signaling model is when one party adequately conveys knowledge and characteristics about itself to the principal. In economics, signaling includes 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.

History of Contract Theory

Kenneth Arrow conducted the first formal research on this topic in the field of economics in the 1960s. Since contract theory incorporates both behavioral incentives of a principal and an agent, it falls under a field known as law and economics. This field of study is also called the economic analysis of law.

In 2016, economists Oliver Hart and Bengt Holmström won the Nobel Memorial Prize in Economic Sciences for their contributions to contract theory. The two were applauded for exploring “many of its applications” and launching “contract theory as a fertile field of basic research."