A Complete Guide to All Your Queries about Contract Theory

Since centuries and millenniums, contracts have a significant role to play in the workings of the economy. As technology improved and organisations evolved, the theory and practice of contract have only increased in importance. But not all contracts are complete. So, how do you deal with incomplete contracts? The answer to this lies in contract theory. Oliver Hart and Bengt Holmström coined the term. It fetched them the Nobel Memorial Prize in the field of Economic Science back in 2016. Keep reading this write-up to know all about the contract theory.

What is the Contract Theory?

Contract theory is more than the study of legally binding contracts. In law and economics, contract theory studies how in the presence of asymmetric information, economic players like government and business owners can construct contractual arrangements. The fundamentals of a contract theory study the behavior of the person or an organisation initiating the contract (i.e. the government or the business owner) under specific numerical utility structures. These numerical structures are applied in an optimum algorithm that further helps in identifying optimal decisions.

Contract theory studies the design of both formal and informal agreements that help people come to a resolution by taking mutually beneficial actions to resolve their conflicting interests. It also guides us in creating a written bond between companies and their suppliers, shareholders, chief executives, employers and employees. At the end of the day, contract theory is all about giving each of the parties the motivation and the right incentives to work together effectively.

Benefits of the Contract Theory to the Employees

Most of the time employees find a loophole in a contract due to informational gaps and incomplete clauses. Based on the research paper presented by Hart’s and Holmström, the issue of incomplete contracts was brought into light. As a solution to these problems, Hart and Holmström came up with the modern contract theory.

The informational problem that both the economists traced in legal contracts was the inconsistency in one party (mainly the employer) not observing what the other (the employees) was doing. There was a visible disparity in the delivery of promises of the employer, which seemed unfair to the employees. To remove this discrepancy, the modern contract theory was brought into force in which the employer was binding to the employee too, unlike in previous contracts where the employees had to comply with a set of guidelines. This helped to bring in more transparency in the job environment on the employer’s part.

Another aspect that was overlooked before the implementation of contract theory was the aspect of moral and quality hazard that employees had to face. For example, let us consider the issue of motivating an employee to work harder. Generally, an employer monitors the employees and rewards them if they work well and fulfill their duties, and penalises them if they shirk it off.

According to Hart and Holmström, the basis of such monitoring is often unrealistic. In most cases, employers base rewards on the outcome of the employee’s work. But that may not always be the right parameters to measure the performance of an employee. In Holmström’s paper “Moral Hazard and Observability” he shows how an employer should link employee rewards to performance outcomes. This benefitted employees in winning rewards on the right grounds. Employees felt motivated, which led to an increase in productivity. Hart, on the other hand, tried to address the issue of an incomplete contract. With the modern contract theory, she worked to achieve a contract that covers every relevant future contingency.

Three Models of the Contract Theory

On the basis of implementation, the concept of contract theory is divided into three types of frameworks. Each of these models has a different way of approach in taking the appropriate actions to counter certain circumstances that are stated in the contract.

Moral hazard

This model showcases a principal who enjoys an incentive to engage in risky behaviors because of the other party in the contract who absorbs the costs of it. To establish the grounds of moral hazard, information asymmetry is a must. Moreover, the contract should be alterable, i.e. it should provide an opportunity for one of the parties to alter their behavior. To curb the issue of moral hazards, companies often create employee performance contracts so that parties act according to the principal’s interest.

Adverse selection

This model portrays the principal party who has more information than the other party in the contract and therefore uses it to distort the market process. This is a recurring issue in the insurance industry. When a policy-holder withholds information from an insurer to obtain insurance protection. The insurer is given the power to nullify an insurance contract or provide protection at unfavorable rates.

Signaling Model

Under this model of contract theory, one party conveys all the information about itself to the principal. In the law of economics, signaling refers to the transfer of data from one party to another. The purpose of such transfer is to achieve mutual satisfaction between both the principal as well as the contracting party for a specific agreement.

What is the Theory of Incomplete Contracts?

In the theory of law of economics, contract theory can be subdivided into complete contracts and incomplete contracts. Oliver D. Hart, Sanford J. Grossman, pioneered the paradigm of incomplete contracts and John H. Moore. They argued that in reality no contract is specific about possible contingencies in the near future. They explained that future contingencies might not even be defined at the time of structuring the contract. Moreover, they considered that no party could commit themselves not to “engage in a mutually beneficial renegotiation later on in their relationship“. Therefore, to counter the two problems of an incomplete contract – that is unaddressed future contingencies and the nullification of a contract due to further renegotiation – the theory of contract theory was developed.

Even today, the approach of incomplete contracting has been a subject of an ongoing discussion in contract theory. Authors such as Tirole and Maskin have presented the argument that the problem of hold-up can be solved with the use of complex contracts. But Hart pointed out that however complex and detailed a contractual solution is, it will not work unless the factor of renegotiation is ruled out. In a more recent study conducted by Hart and Moore in 2008, the economists have argued that “Contracts may serve as reference points.”

As of now, the theory of incomplete contracts has been applied in contexts like international trade, privatisation, management of research & development, allocation of formal and real authority, and many others.

There is more to the Contract theory, and these are just the foundations of the study. Once you are done with the fundamental concepts of the subject, it becomes a lot easier to comprehend the more complex parts of it and complete your assignment on contract theory. And if some of the concepts are still unclear to you, we suggest you take expert help from professionals for better educational insights.

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