Contract Theory

In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics. One prominent application of it is the design of optimal schemes of managerial compensation. In the field of economics, the first formal treatment of this topic was given by Kenneth Arrow in the 1960s.

A standard practice in the microeconomics of contract theory is to represent the behaviour of a decision maker under certain numerical utility structures, and then apply an optimization algorithm to identify optimal decisions. Such a procedure has been used in the contract theory framework to several typical situations, labeled moral hazard, adverse selection and signalling. The spirit of these models lies in finding theoretical ways to motivate agents to take appropriate actions, even under an insurance contract. The main results achieved through this family of models involve: mathematical properties of the utility structure of the principal and the agent, relaxation of assumptions, and variations of the time structure of the contract relationship, among others. It is customary to model people as maximizers of some von Neumann–Morgenstern utility functions, as stated by expected utility theory.

Read more about Contract Theory:  Incomplete Contracts, Examples

Famous quotes containing the words contract and/or theory:

    Smoking ... is downright dangerous. Most people who smoke will eventually contract a fatal disease and die. But they don’t brag about it, do they? Most people who ski, play professional football or drive race cars, will not die—at least not in the act—and yet they are the ones with the glamorous images, the expensive equipment and the mythic proportions. Why this should be I cannot say, unless it is simply that the average American does not know a daredevil when he sees one.
    Fran Lebowitz (b. 1950)

    Won’t this whole instinct matter bear revision?
    Won’t almost any theory bear revision?
    To err is human, not to, animal.
    Robert Frost (1874–1963)