What is Contract Theory?

Within the realm of economics, contract theory has to do with understanding how the balance between competency and rewards is achieved. Essentially, contract theory involves the need for communication between an agent and a principal, so that there is a clear understanding of both the needs of the principal and the ability of the agent to meet those needs in a competent manner. Once this state is established, contract theory is then employed to ensure that the agent receives adequate rewards for his or her efforts.

One of the easiest ways to understand contract theory is to apply the principle to hiring persons to labor in the workplace. Essentially, a prospective employee will provide information about his or her ability to meet the requirements of a given position. In turn, the employer will need to be in a position to verify the accuracy of the information provided. When the employer is unable to do so, the condition is understood to be asymmetric. Asymmetric information is not necessarily incorrect or false information. However, it does present a roadblock to the employer being able to adequately evaluate the prospective employee.

Contract theory is also interwoven with the concept of moral hazard. Essentially, both the agent and the principal are exhibiting a certain degree of trust. The agent, or prospective employee, is trusting that the working conditions, rate of pay, job responsibilities, and additional benefits are as presented by the employer. In turn, the employer or principal is trusting that the credentials presented by the agent are valid and sufficiently complete to merit the creation of a contract of employment. When all economic actors in the process function with a high level of competency, the resulting arrangement is likely to be mutually satisfying.

Contractual arrangements within the process of contract theory may take the form of complete contracts. In this type of contractual agreement, every possible situation that is covered by local law is included in the terms of the agreement. The second format is referred to as an incomplete contract, and may be somewhat broader and less specific on certain points.