What are the Features of the Contract Theory?

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Contract theory deals with striking a balance between levels of competency and the proportional rewards in the field of economics. The agent and principal are the major participants of the contract theory where the agent has to understand and fulfill the necessities of the principal in an effective manner. Once this is done the contract theory ensures due rewards to the agent for his efforts. Contract theory is closely associated with law and economics as they basically involve the agency and incentives. Agency problems include moral hazards where the principal is unable to verify information provided by the agent and leads to information asymmetry. Adverse selection happens when the agent does not divulge certain facts to the principal.

What are the features of Contract Theory?

Contract theory examines the process of decision-making and developing legal agreements by individuals as well as businesses. Contract theory studies how the concerned parties of the contract have to take decisions under conditions which may not always be certain and may lead to asymmetric information. Agents and principals are the basis of any economic behavior and are driven by different incentives to take certain decisions. Contracts may contain suitable terms to arrive at a particular outcome but at the same time may prove to be morally hazardous due to the distance between the agent and the principal.

What is the Example of Contract Theory?

The principle of contract theory can be understood better with respect to hiring people in the workforce. A prospective employee generally provides adequate information about his qualification and skills to fulfill the demands of the particular position. It is then the responsibility of the employer to verify the truth of the data provided by the prospective employee. An asymmetric condition arises when the employer cannot accurately verify facts. Asymmetric information doesn’t imply false or incorrect facts but it acts as an impediment as the employer is not able to satisfactorily test the prospective employee.

What are the underlying standards of Contract Theory?

Contract theory functions on the requirement of certain moral standards between the agent and principal. Both the principal and agent work, expecting to trust each other. In the case of the prospective employee, the agent believes the employer’s terms relating to salary, work conditions and responsibilities. Likewise the principal or employer trusts that the information provided by the agent are genuine and worthy of creating a contract of employment. When the participants function with credibility and competency then the entire process becomes satisfying and successful.

What are the different agreements in Contract Theory?

Contract theory may encompass various forms of contractual arrangements including complete contracts where the terms of agreement cover every situation coming under local law. Incomplete contracts may refer to a format of contractual agreement which is quite broad and does not include any specific points on many issues. For example in contracts relating to relationship- specific dealings, the parties involved are unable to write a contingent contract in totality. Many a times there are default rules provided by the law which fill the gaps visible in the agreement.

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