Imagine you were looking to buy a car. You don't want to spend much money on the car, so you buy a second-hand car. After searching and asking around, you discover that one of your friends is selling a car. You like the car, and you decide to buy it. After some time, you find out that the car had problems your friend didn't tell you about. That's when contract theory comes into play. Contract theory studies how contracts are formed when one party has more information than the other party. Why don't you read on to find out all there is about contract theory and who benefits and loses under such contracts?
Contract Theory Definition
The contract theory definition refers to legally binding agreements between individuals and organizations under asymmetric information.
Contract theory analyzes how individuals and organizations form an agreement when there is asymmetric information.
Contract theory includes individuals, organizations as well as multiparty legally binding agreements.
An ideal world would entail legal contracts that are transparent, and both parties have all the available information which is relevant and important to the agreement. A contract would detail the obligations and duties of both parties with such a high level of specificity that there would be no opportunity for disagreement or confusion. The available information would deliver full transparency on both parties' stakes when they enter into a contract.
For example, an ideal contract would clearly state the risks, requirements, and benefits to both parties. However, both parties don't always have equal and complete information. As a result of asymmetric information, most contracts lead to only one side benefiting from them.
Contract theory aims to analyze how these contracts are drawn in the presence of asymmetric information, where one party has more information than the other to prevent one party from benefiting disproportionately.
Moral hazard is a part of most contracts covered by contract theory.
A moral hazard occurs when a party enters an agreement with another party, knowing in advance that they won't bear any loss in case the contract goes wrong.
A moral hazard would occur if there is asymmetric information between two parties, meaning that one party is unaware that the other party might engage in damaging behavior after the contract is finalized.
For instance, that party may have hidden vital information, offered false information, or may have secret reasons for promoting components of an agreement of which the damaged party is unaware.
Think about someone who smokes cigarettes and does not disclose this information to the health insurance provider. As a result, the health insurance provider faces higher medical bills after the contract is finalized.
Check out our article on moral hazard for a more detailed explanation of it!
In addition to moral hazard, contract theory also includes contracts subject to adverse selection.
Contract Theory in Economics
Contract theory in economics studies how contracts are developed in the presence of asymmetric information.
Asymmetric information occurs when one party in the agreement has more information than the other party.
One of the most common examples of asymmetric information is when a car owner wants to sell their car. The car owner is in possession of far more information about the car than the person who is looking to buy the car. Contract theory studies how such contracts are formed.
We have a detailed explanation of asymmetric information.
Feel free to check it out and refresh your knowledge of it!
Asymmetric information leads to moral hazard and adverse selection as seen in Figure 1 below.
A moral hazard occurs when one party engages in risky behavior that causes harm to the other party after the contract is made.
Moral hazard is common in the insurance industry. When an individual enters a legal agreement with the insurance company, they have the incentive to engage in risky behavior that is damaging to the insurance company. That's because the individual knows that they won't bear the cost of their behavior.
For example, an individual who gets health insurance from a company may increase the number of cigarettes they smoke daily. This would cause harm to their overall health, which would increase potential future medical bills. These medical bills are not a liability for the individual, but they are a liability for the health insurer.
Another extreme example of moral hazard occurs with fire insurance. An individual buys fire insurance and burns the house down to get back the money. The insurance company has no idea that the buyer bought it intending to burn down the house to make a profit.
For a more detailed explanation of moral hazard, check out our article!
Adverse selection occurs in contracts between two parties, where one party has more information than the other. This information leads to a loss, which the other party incurs.
An example of adverse selection occurs when you decide to buy a car from an acquaintance. As the acquaintance has been driving the car for quite some time, they have way more information on the state of the car than you have.
The acquaintance is not incentivized to disclose all the information about the car. Or better put, their incentive to sell the vehicle is greater than their having all the information about the car told. You proceed with the transaction and find out that the car had some problems, which cost $2,000 to fix them. That cost will have to be paid by you rather than the acquaintance.
We have an entire explanation covering adverse selection in great detail. Feel free to check it out!
Contract theory shows how these contracts are built and the loss and benefit to each party involved in the transaction.
Like in the example of buying the car, the seller's incentive to sell the car is greater than their incentive to disclose information. This leads to a contract where only one party benefits while the other incurs a loss.
Contract Theory Examples
Contract theory examples include examples of all contracts that are made when one party is more informed than another party.
Imagine a new tech startup that develops software products that are capable of analyzing multiple stocks at the same time. The founder of the startup needs funding to help grow the startup.
After going to some venture capital firms, the startup founder manages to find an investor willing to invest. However, the software product has a bug that the tech team still cannot solve. Such information is not disclosed during the funding process.
The agreement is made such that 10 million dollars are invested in exchange for a 20% stake in the startup. This values the startup at 50 million dollars.
A year after the funding goes through, everyone learns about the bug, causing the startup to fail.
Due to asymmetric information, all the investor's money in such a case is lost.
The startup did not disclose the bug issue hoping it would be solved, and the investor jumped in, unaware of the bug.
Importance of Contract Theory
The importance of contract theory is that it enables understanding legally binding agreements between parties under the influence of adverse selection. In other words, contract theory helps explain how economic agents behave and conduct transactions under the influence of asymmetric information.
Asymmetric information is part of the majority of transactions in an economy. Contract theory helps to provide solutions to asymmetric information problems.
Some of the most common solutions to contracts built under the influence of asymmetric information include signaling and screening, as seen in Figure 2.
Signaling occurs when one party is willing to reveal information about themselves to reduce asymmetric information.
The main purpose of signaling is to enable both parties mutually benefit from a transaction.
An example of signaling is when an individual sends a resume when applying for a job. This way, they "signal" to the company that they match the requirements for the job position. Otherwise, the contract would be subject to asymmetric information, and the company could hire someone who doesn't know how to do the job.
We have a detailed explanation that covers signaling too!
Screening occurs when the uninformed party requires the informed party to reveal information before entering a contract.
For example, when someone buys a new car, they may request that an independent auto mechanic check it. The auto mechanic can reveal further information on the state of the car, which would ultimately impact the agreed price.
For a more detailed screening explanation, take a look at our article!
Contract Theory in Behavioral Economics
Contract theory in behavioral economics studies how economic agents behave in the presence of external factors when entering into a contract with another party.
According to the contract theory in behavioral economics, an economic agent is influenced by the beliefs and moral standards that they have. In contrast to the classical approach, an individual is not purely driven by self-interest.1
Behavioral contract theory suggests that individuals are concerned about how the payoffs of a contract they enter with another party impact the people around them.
For example, research has shown that certain individuals refused to enter a contract whose outcome was characterized by large inequalities. The contract was rejected even when the individual experienced a forgone income due to not entering a contract that delivered a high payoff for them but an unequal payoff for others.1
Contract Theory - Key takeaways
- Contract theory refers to the study of how individuals form contracts when there is asymmetric information.
- Asymmetric information occurs when one party in the agreement has more information than the other party.
- A moral hazard occurs when a party enters an agreement with another party, knowing in advance that they won't bear any loss in case the contract goes wrong.
- Adverse selection occurs in contracts between two parties, where one party has more information than the other. This information leads to a loss, which the other party incurs after signing the contract.
References
- Harvey Upton, Essays in Behavioural Contract Theory, https://core.ac.uk/download/pdf/222793057.pdf
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