Contract Theory

What is contract Theory

Contract theory is the study of how individuals and businesses construct and develop legal agreements. It analyzes how parties with opposing interests build formal and informal contracts. The theory explores the formation of contracts in the presence of asymmetric information. Contract theory is based on the principles of financial and economic behavior as different parties have different incentives to perform or not perform certain actions.

Breaking the contract theory

According to the theory of contracts, there are contracts to see what the principal expects happened and what will happen. It provides a clear and specific understanding and agreement of the positions and responsibilities of stakeholders. Contract theory also includes an implied trust between the parties, and that all built views are valid and will be complied with. One of the most famous applications of the theory of contracts how to design the optimum employee benefits.

During the 1960s, Kenneth arrow has conducted the first official study on this topic in Economics. Because contract theory includes both the behavioral incentives of principal and agent, it falls under the field known as law and Economics.This area of research is also called Economic analysis of law.

In 2016, the economists Oliver HART and Bengt Holmström was the winner of the Nobel prize in Economics for their contribution in this area. According to a press release, “through their initial contributions, HART and Holmström launched contract theory as a fertile area for basic research. Over the past few decades, they have also explored many of its applications.”

Contract theory examines the behavior of decision-makers, for a specific structure. Within these structures, contract theory is directed to the input of the algorithm, which will optimize the decisions of the individual.

Three models of contract theory

Practice divides the theory of contract in three models and types of frames. These models specify ways for the parties to take appropriate measures under certain circumstances specified in the contract.

  • Moral model the risk is a major who has an incentive to engage in risky behaviour because the associated costs are absorbed by the other Contracting Party. For non-pecuniary damage, to be present, there must be asymmetric information and the contract provides for the possibility for parties to change their behavior. To counter moral hazard, some companies provide contracts that depend on observable and verifiable actions as incentives for parties to act in accordance with their interests of the principal.

  • Negative selection model reflects the main who have more and better information than the other Party and, therefore, distorts the market process. Adverse selection is common in the insurance industry. Some insurers provide coverage for policyholders who holds valuable information in the process of filing for protection. Without asymmetric information, the insurers will likely not be the insured or the insured at an unfavourable price.
  • The signaling model, when one side is adequately conveys knowledge and features about main. In Economics, signaling involves the transmission of information from one side to the other. The goal of the program is to achieve mutual satisfaction of a specific contract or agreement.

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