Economics

What Is Contract Theory?

When multiple entities enter into a contractual agreement, one or more of them often has information the others don't.

What Is Contract Theory?

Contract theory is an economic theory that entails how parties can develop a legal agreement in a situation that involves asymmetric information. Asymmetric information is a situation where one party possesses more information that than the other party. Contract theory analyzes how stakeholders in an agreement make decisions and agree on particular terms in case of the unforeseen occurs. Contract theory applies the principles of economic and financial behaviors as the parties involved are motivated by different incentives to undertake on not to undertake a particular action. The first significant development in the field was by Kenneth Arrow in the 1960s. In essence, contract theory provides the parties involved with the appropriate incentives and motivations to work together; it is therefore considered under the economic analysis of law. Contract theory is commonly used by employers and employees seeking optimum employees benefits. In 2016, Oliver Hart and Bengt R. Holmström were awarded Nobel Memorial Prize in Economic Sciences for their contribution to contract theory. A standard practice in the application of contract theory is to represent the behavior of a decision maker under uncertainty and then provide optimization algorithm that will guide the decision make to make an optimal decision. Three models have been developed to explain the theoretical ways of motivating decision makers to reach a decision under uncertainty; they are; moral hazard, adverse selection, and signaling. The model has been tested severally by endogenizing the information structure to allow the parties involved gather enough information about the other party.

Moral Hazard

In the Moral hazard model, the information asymmetry involves one party inability to observe and verify the action of the other party. The moral hazard model is applied when performance-based contracts are agreed upon by employers and employees. The agreement depends on actions of the employee that are observable and confirmable. The model was pioneered by Steven Shavell, Oliver Hart, and Sanford Grossmann. It is difficult to test the model since there is difficulty in measuring unobservable data, but the general assumption that incentives matter in has been successfully tested.

Adverse selection

The adverse model involves a situation where one party withholds certain information from the other party at the time the contract is agreed upon. The information is known as the agents “type.” For example, people who frequently get sick are more likely to purchase health insurance and is less likely to inform the insurer that they frequently get sick. The model was pioneered by Eric Maskin and Rodger Myerson.

Signaling

The signaling presents a situation where one party presents all the necessary information to the other party. The purpose is to achieve a mutual satisfaction for the agreement to occur. Signaling is applied to the Michael Spence’s job job-market signaling model where employees inform their employers on their ability to handle a job through academic and experience credentials.

Incomplete Contracts

Contract theory is built around the notion of complete contacts. Recently, Oliver Hart has pioneered the theory of incomplete contracts that analyze the effects of incentives of parties that are unable to agree on a contract. The theory is applied in the theory of the firm; a theory developed by Oliver Hart. Because of the complexity in completing contracts, the theory provides guidelines that caters for the gaps in the contract.

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