From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties.
From an economic perspective, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of information asymmetry. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as law and economics. One prominent application of it is the design of optimal schemes of managerial compensation. In the field of economics, the first formal treatment of this topic was given by Kenneth Arrow in the 1960s. In 2016, Oliver Hart and Bengt R. Holmström both received the Nobel Memorial Prize in Economic Sciences for their work on contract theory, covering many topics from CEO pay to privatizations. Holmström focused more on the connection between incentives and risk, while Hart on the unpredictability of the future that creates holes in contracts.
A standard practice in the microeconomics of contract theory is to represent the behaviour of a decision maker under certain numerical utility structures, and then apply an optimization algorithm to identify optimal decisions. Such a procedure has been used in the contract theory framework to several typical situations, labeled moral hazard, adverse selection and signalling. The spirit of these models lies in finding theoretical ways to motivate agents to take appropriate actions, even under an insurance contract. The main results achieved through this family of models involve: mathematical properties of the utility structure of the principal and the agent, relaxation of assumptions, and variations of the time structure of the contract relationship, among others. It is customary to model people as maximizers of some von Neumann–Morgenstern utility functions, as stated by expected utility theory.
Contract theory in economics began with 1991 Nobel Laureate Ronald H.
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In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge. A common way to visualise information asymmetry is with a scale, with one side being the seller and the other the buyer.
The principal–agent problem refers to the conflict in interests and priorities that arises when one person or entity (the "agent") takes actions on behalf of another person or entity (the "principal"). The problem worsens when there is a greater discrepancy of interests and information between the principal and agent, as well as when the principal lacks the means to punish the agent. The deviation from the principal's interest by the agent is called "agency costs".
A contract is an agreement that specifies certain legally enforceable rights and obligations pertaining to two or more mutually agreeing parties. A contract typically involves the transfer of goods, services, money, or a promise to transfer any of those at a future date. In the event of a breach of contract, the injured party may seek judicial remedies such as damages or rescission. A binding agreement between actors in international law is known as a treaty.
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ELSEVIER SCIENCE SA2020
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