What is Contract Theory

Contract theory is the study of the way people and organizations construct and develop legal agreements. It analyzes how parties with conflicting interests build formal and informal contracts. The theory investigates the formation of contracts in the presence of 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

According to contract theory, contracts exist to distinguish what the principal expects to happen and what will happen. It provides a clear and specific understanding and agreement of the positions and duties of the interested parties. Contract theory also covers the implied trust between the parties, and that all the constructed representations are valid and will be followed. One of the most prominent applications of contract theory is how to design employee benefits optimally.

During the 1960s, Kenneth Arrow conducted the first formal research on this topic in the field of economics. 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 this field. According to the Royal Swedish Academy of Science's 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 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. 

Three Models 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.

  • 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.
  • 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.
  • 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.