Contract Theory Definition
Contract theory is a theory that seeks to understand how contractual arrangements such as legal agreements are made. This theory examines the existence of a contract and how it was constructed or developed. Contract theory entails an analysis of what both parties in a contract stand to gain, and their conflicting interests. Through the theory, a clear understanding of the formation of both formal and informal contracts is achieved.
In economics, contract theory examines the behavior of parties in a contract, their interests and performances. How incentives are formulated as well as the make up of obligations of both parties in the contract is considered.
A Little More on What is a Contract Theory
Positions, agreements, obligations and expectations in a contract are made clear through the contract theory. This theory examines the existence of a contract, the duties and interests of the parties. Kenneth Arrow was the first researcher and economists to carry out a formal research on contract theory, this was done in the 1960s. This theory falls with the tenets of economics and law and covers issues such as implied trusts between parties, incentives and valid representations in the contract.
Another set of economists that contributed to the development of contract theory are Oliver Hart and Bengt Holmström. Their contributions were recognized when they won the Nobel Memorial Prize in Economic Sciences in 2016.
How the principal or decision maker in a contract behaves, his expectations and structures of contracts are examined by the contract theory.
Three Models of Contract Theory
There are three frameworks of models of the contract theory, these models outline actions that parties can take under specific circumstances and structures in the contract. These models are:
- The adverse selection model: this reflects the principal of a contract as an individual with more information than the other party. Through the better knowledge he has, he is able to influence our distort the market process. Such individuals are often insured by insurance which serves as a protection for the level of information they hold.
- A moral hazard model: in this model, a principal is liable to take on risks which are absorbed by the other party in the contract. This model entails the presence of information asymmetry and a contract structure that empowers the other party to alter the risky behaviors of the principal
- The signaling model: this model features a party who is knowledgeable and possesses qualities he clearly conveys to the principal. In most cases, the Knowledge is transferred or signaled to another party for mutual understanding and satisfaction in the contract.