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CONTRACT THEORY

Prepared by: Mr. AvinashMs. Rashmi

Department. Of Agril. Economics, CSKHPKV PALAMPUR10-11-2016

Contract Theory : 合同理論是在某些數值效用結構下代表決策者的行為 ????

What is contract ?

• A contract is a voluntary arrangement between two or more parties that is enforceable at law as a binding legal agreement.

• Contract is a branch of the law of obligations in jurisdictions of the civil law tradition.

• As Hart said , "Contracts are just an incredibly

powerful way of thinking about parts of economics. ... Both sides have an incentive to construct the transaction [so that] it generates the greatest value."

Contract theory

•contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of

asymmetric information.

• In the field of economics, the first formal treatment of this topic was given by Kenneth Arrow in the 1960s.

Kenneth Arrow• Kenneth Joseph "Ken"

Arrow (born August 23, 1921) is an American economist, writer, and political theorist. He is the joint winner of the Nobel Memorial Prize in Economics with John Hicks in 1972. To date, he is the youngest person to have received this award, at 51.

•A standard practice in the microeconomics of contract theory is to represent the behavior of a decision maker under certain numerical utility structures, and then apply an optimization algorithm to identify optimal decisions.

•The spirit of these models lies in finding theoretical ways to motivate agents to take appropriate actions.

Contract theoryContract theory

Main models of agency problems

Moral hazard

In moral hazard models, the information asymmetry is the principal's inability to observe and/or verify the agent's action. Performance-based contracts that depend on observable and verifiable output can often be employed to create incentives for the agent to act in the principal's interest.

Adverse selection

In adverse selection models, the principal is not informed about a certain characteristic of the agent at the time the contract is written. The characteristic is called the agent's "type".

For example, health insurance is more likely to be purchased by people who are more likely to get sick. In this case, the agent's type is his or her health status, which is privately known by the agent.

Another prominent example is public procurement contracting: The government agency (the principal) does not know the private firm's cost. In this case, the private firm is the agent and the agent's type is the cost level.

Incomplete contracts

Contract theory also utilizes the notion of a complete contract, which is thought of as a contract that specifies the legal consequences of every possible state of the world.

More recent developments known as the theory of incomplete contracts, pioneered by Oliver Hart and his coauthors, study the incentive effects of parties' inability to write complete contingent contracts, e.g. concerning relationship-specific investments

Implications for the real world

Contract theory identifies a variety of obstacles to cooperation and suggests which contracts are best suited to overcome them.

It offers explanations for contracts that are commonly written and for finding suitable contractual solutions to new problems.

Applying contract theory to property rights helps us understand the costs and benefits of privatisation and public versus private ownership.

Perhaps the greatest application of the subject is in corporate finance where contracts are designed in a manner to ensure that entrepreneurs and managers act in the interests of investors.

Understanding contracts does not only have implications in the financial domain for understanding bankruptcy reforms and investor rights, but has wider implications for governance.

In a typical employment transaction, the employer offers a wage and the employee agrees to accept the employer's directions in return.

Conclusion….

Contract theory provides us with a general means of understanding contract design.

One of the theory’s goals is to explain why contracts have various forms and designs.

Another goal is to help us work out how to draw up better contracts, thereby shaping better institutions in society.

Should providers of public services, such as schools, hospitals, or prisons, be publicly or privately owned?

Should teachers, healthcare workers, and prison guards be paid fixed salaries or should their pay be performance-based?

To what extent should managers be paid through bonus programmes or stock options?

Contract theory does not necessarily provide definitive or unique answers to these questions. However, the power of the theory is that it enables us to think clearly about the issues involved and help us understand the potential pitfalls when designing new contracts.

The theory determines how a worker-employer or customer-company contract can best be mutually beneficial, avoiding conflicts and negative consequences.

Through their initial contributions, Hart and Holmstrom launched contract theory as a fertile field of basic research.

The Royal Swedish Academy said. "Over the last few decades, they have also explored many of its

applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions."