Contract theory

This article is about the economic analysis of contracts. For legal definitions and contract law, see Contract.

For a less technical discussion of this topic, see Principal-agent problem.

In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Contract theory is closely connected to the field of law and economics. One prominent field of application is managerial compensation.

Standard Setups

Moral Hazard

In moral hazard models, the information asymmetry is the principal's inability to observe and/or verify the agent's action. Performance-based contracts that depend on observable and verifiable output can often be employed to create incentives for the agent to act in the principal's interest. When agents are risk-averse, however, such contracts are generally only second-best because incentivization precludes full insurance.

The typical moral hazard model is formulated as follows. The principal solves:

$max_{w(\cdot )}E(y({\hat {e}})-w(y({\hat {e}})))$

subject to the agent's "individual rationality (IR)" constraint,

$E(w(y(e))-c(e))\geq {\bar {u}}$

and the agent's "incentive compatibility (IC)" constraint,

${\hat {e}}=argmax_{e}E(w(y(e))-c(e))\geq {\bar {u}}$

Adverse Selection

In adverse selection models, the principal is not informed about a certain characteristic of the agent. For example, health insurance is more likely to be purchased by people who are more likely to get sick.

Incomplete contracts

Contract theory also utilizes the notion of a complete contract, which is thought of as a contract that specifies the legal consequences of every possible state of the world. More recent developments known as the theory of incomplete contracts, pioneered by Oliver Hart and his coauthors, study the incentive effects of parties' inability to write complete contingent contracts, e.g. concerning relationship-specific investments.

Because it would be impossible and costly for the parties to an agreement to make their contract complete, the law provides default rules which fill in the gaps in the actual agreement of the parties.

During the last 20 years, much effort has gone into the analysis of dynamic contracts. Important early contributors to this literature include, among others, Edward J. Green, Stephen Spear, and Sanjay Srivastava.

Examples

• Free Legal Advice/Legal Discussion Board
• George Akerlof described adverse selection in the market for used cars.
• In certain models, such as Michael Spence's job-market model, the agent can signal his type to the principal which may help to resolve the problem.

See also

• Default rule
• Complete contract
• Contract

References

• Salanié, Bernard: "The Economics of Contracts" (MIT Press, Cambridge, Mass. & London, England, 1997).
• Laffont, J.J. and Martimort, D.: The Theory of incentives" (Princeton University Press, 2002)
• Bolton, Patrick and Dewatripont, Mathias: "Contract Theory" (MIT press, 2005)