Posted in Finance, Accounting and Economics Terms, Total Reads: 444
Definition: Contract Theory
It is a study of how economic actors, individuals or business, develop and construct legal agreements in presence of asymmetric information. It analyse the behavior of decision makers under uncertain conditions. It has a link with both the agency and its incentive banking on the fact that agents/ agency have different intention and motives to perform or not perform an action.
Contract theory is based on the premise that contract will delineate the expectation of the Principal. Along with that it also provide a clear understanding of how will the agent benefit if the expectation of Principal are met and includes an implied trust between the parties.
It is closely related to game theory because in both we analyze the decision making process of individuals and businesses. The spirit of the model lies in promoting a certain outcome by finding the motive and thus making the agent to take an appropriate action. Incentivizing the agent to promote an outcome can also lead to moral hazards stemming from degree of asymmetry of information.