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Definition

contract theory

Contributor(s): Ivy Wigmore

Contract theory is the study of how people and organizations develop legal agreements in situations with uncertain conditions, unknown factors and information asymmetry. Contract theory applies to both multi-party negotiations between a principal and one or more agents and contracts created by a single individual or organization to specify details of multi-party agreements, such as employee contracts.

Ideally, a contract specifies the responsibilities and requirements of both parties so meticulously that there can be no room for dispute or misunderstanding. However, that ideal may never be achieved, for various reasons. Moral hazard, one model within contract theory, is the risk that one party to a transaction is not acting in good faith.  For example, that party may have withheld important  information or provided misleading information or may have undisclosed motivation driving elements of an agreement that are being negotiated. Moral hazard often involves the assumption of risks that disadvantage the party with less information. Other models within contract theory include adverse selection, in which the principal party is not fully informed of the agent’s risk factors, and signaling, in which the agent reliably conveys information about itself to the principal, for example, a job applicant listing qualifications that match the hirer’s list of requirements.

Contract theory is a special application of game theory, which is the study of mathematical models of negotiation, conflict and cooperation between individuals, organizations and governments. Central questions of game/contract theory include why an individual makes a particular decision and how the decisions made by one individual affect others.

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This was last updated in June 2016

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