Contract theory is the body of legal thought that investigates normative and conceptual problems in contract law.

Why Are Contracts Enforced

The central problem for contract theory is the question, Why are contracts enforced? One prominent answer to this question focuses on the economic benefits of enforcing bargains. This first approach could be said to offer a utilitarian theory of contracts. A second approach to the question emphasizes the role of promise and draws on deontological moral theory. This second view is associated with Charles Fried, who articulated the promise theory of contract in his book Contract as Promise.

Default Rules and Complete 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. Because it would be impossible and costly for the parties to an agreement to make their contract complete, the law provides default rules which fill in the gaps in the actual agreement of the parties.

Economics

In economics, the theory of contracts is part of information economics and descibes how economic actors use particular contractual arrangements to deal with information asymmetries.

Where the principal is not informed about a certain characteristic of the agent, an adverse selection problem may arise, e.g. in the case of health insurance which is more likely to be taken out by people who are likely to get sick. One of the pioneers of this branch of economics was George Akerlof, who described adverse selection in the market for used cars. In certain models, such as Michael Spence's job-market model, the agent can signal his type to the principal which may help to resolve the problem.

In moral hazard models, information asymmetries result from the principal's inability to oberserve the agent's action. Thus, performance-based contracts will be employed to create incentives for the agent to act in the principal's interest, such as in the case of managerial compensation .

The more recent development known as the theory of incomplete contracts , pioneered by Oliver Hart and his coauthors, points out the incentive effects the party's inability to write complete contingent contracts, e.g. concerning relationship-specific investments.

During the last 20 years, much effort has gone into the analysis of dynamic contracts. Important early contributors to this literature include, among others, Edward J. Green, Stephen Spear, and Sanjay Srivastava.

Literature:

• Salanié, Bernard: "The Economics of Contracts" (MIT Press, Cambridge, Mass. & London, England, 1997).

See also

• Default rule
• Complete contract
• Contract