What contract theory seeks out to do is analyze and explain how and why economic actors use contracts when interacting with one another. A contract can be defined as an agreement, a set of promises, between two or more actors.
The importance of contracts is increasingly recognized and they are likely to become more important in the years to come. As customers get pickier they force firms to become more efficient and with globalization global commerce is ever increasing. It can be important for actors, who trade, to reach an agreement before money and products switch hands. One can not always rely on good intentions of the person you are doing business with. This is especially important for actors who are in international trade. Business practices are obviously not the same from one country to the next.
Contracts can be extremely important when businesses do long term contracts, for example when a company rents an office space. Companies must be sure that their workforce can actually come into their office when they are supposed to. The bottom line is this, economic actors use contracts to protect their own interests.
There are virtually no limits to the topics of contracts or who can take part in forming one. Countries do both formal and informal agreements, businesses of all sizes and types enter into contracts as do individuals. Contracts bring more efficiency to the economy as they seek to make it easier for economic actors to plan into the future. They can also allow actors to work together, specialize in certain fields and therefore both save time and money.
Kinds of Contracts
At the beginning, we have to define the term „contract“. A contract is a written or an oral setting of transaction between two parties and, if the two or more parties are making a contract, they want to be sure that the agreements of both sides are keeping within the conditions (Groenewegen, Spithoven, & Van den Berg, 2010). The contract laws build frameworks to provide a basis which ensures both parties that they can trust in the compliance of the contracts. Caused by the freedom of contracts (which is set in the laws , e. g. In Germany out of Art. 2 I GG (Professor Christian Tomuschat, 2010)) contracts can appear in different categories.
First, there is the division between the complete and the incomplete contract which is the most important one in contract theory. The difference between them is lying in the flexibility to future changes (Groenewegen, Spithoven, & Van den Berg, 2010). While the complete contract foresees that there can be different situations in the future and is able to keep the framework of itself alive within the perfect market and full information, the incomplete contract has to be changed caused by missing information. In the incomplete contract there is a necessity after some time to adjust it to the present situations. In conclusion, the incomplete contract is the most common form of contract because of the rarity of foreseeing the future changes in the reality of imperfect markets.
Second, we can divide between the informal and formal contracts (Groenewegen, Spithoven, & Van den Berg, 2010). The formal ones are those, who can be enforced by laws and are described through them. Otherwise, informal contracts are totally free in settings and the compliance is in society regarded as naturally. Some do call those two self-enforcing and legally enforceable agreements, too.
Recurring and non-recurring transactions are also part of the feature to describe contracts. It means simply that we can define contracts as a only once happening transaction or if there are more transactions through time. If there are transactions that are coming to get proceeded with the same participants more than once, we speak about the recurring transaction and if it´s just a so-called spot-transaction, we are talking about the recurring transaction.
The last pair of attributes is the simultaneous and non-simultaneous contracts which divide in time preferences. The simultaneous contract can be fulfilled at a certain time which is set. With this, the need for a write – down is very low. On the other hand, if there‘s a contract about something which cannot be fulfilled immediately or within a predictable space of time, we have a non-simultaneous one (Groenewegen, Spithoven, & Van den Berg, 2010). The need to have a written contract is in this situation higher and probably there´s a higher need for a framework set by law, too.
So, for every contract which is made, there can be several attributes. As a conclusion, we could describe a contract for example as a formal, incomplete and at the same time simultaneous and non-recurring contract which might be the contract you are making when you are buying a house. But, the main problem is the hidden information that does in reality cause that there are mostly incomplete contracts.
Agency theory
When a contract is signed, there are always at least two subjects that stay in relation to each other and study of this relationship is the essence of the agency theory (known as well as the agent-principal theory). One of the subjects (principal) contracts the other (agent) to act on its behalf.
We can observe examples of such a relationship all around us, as for instance relation between a buyer and a seller, an employee and an employer, politicians and the society, a manager and a team, even within a group during the team work. Those contracts can of course be described with different attributes, as mentioned before, but every contract claims existence of an agent and a principal.
The point of going into this relation for both sides is to gain profits and get the most efficient outcome, but there are some problems and uncertainties born on the way. Interests, motivations and attitude towards risk (risk-neutral, when one has diversified and has more options to choose from; risk-averse, when a person puts all his eggs in one basket) of the actors are usually incompatible.
Hence the contract is signed to align and protect interests of both sides and to insure them against the risks. The contract should therefore be designed in such a way that it contains incentives for both sides not to cheat on each other and not to behave in an opportunistic manner. To put it in other words, the construction of the contract should provide conditions in which neither of the parties would have inducements to exploit all the information asymmetries to maximize its own interests at the expense of the other.
Information asymmetries can cause problems that lead to efficiency losses both before and after contract’s conclusion. A problem connected to the parties’ inequality in possessed information that occurs before signing the contract is a problem of adverse selection, the one that may appear after signing the contract is called moral hazard.
Information asymmetry
Information asymmetry is an important issue in economics. This refers to a situation where two parties that are involved in a transaction (a buyer and a seller) do not have the same information at hand. This can lead to a situation called adverse selection, and another one, called a moral hazard (Investopedia ULC, 2012).
A good example of adverse selection can be read about in George Akerlof´s article called “The market for lemons”. There Akerloff describes the market for new and used cars (a lemon is a common US term for a car that is not well built) as it is a good example of the problems that arise. He describes the following. A person in the market for a new car does not know in advance if his car will be well built or of poor quality. But if he buys a particular car, he will have a pretty good idea in a short while. He will know this much better than before the original purchase. Now a certain asymmetry has developed, as the owner has better information about the car than prospective buyers. But the poor and good cars still sell for the same price as there is no way of knowing which car is of good quality and which ones are lemons. It is also apparent that a used car can´t be of the same value as a new car because then the owner of lemons could trade their cars in for new models that have a higher probability of being of good quality. For that reason the owners of the good cars are locked in, in the sense that they can´t receive the true value of the cars. This also means that the bad cars will drive the good cars out of the market (Akerloff, 1970).
But let´s look at another (hypothetical) situation that involves adverse selection. An employer will not have as good of a picture of a given candidate when he is looking for new employees. The person applying for the job will have an incentive to exploit this information asymmetry by pretending to be a better match for the job description than he really is, in order to get the job. This is in fact a very similar situation to the one Akerloff talks about regarding cars. What will happen is that employers will offer an average pay which will drive out the good candidate and increase the supply of bad candidates. this is not an adverse selection problem since after the deal is done employers can know the quality of the employees So just like the bad cars (lemons) in the car markets drive out the good ones from the market. So a similar thing happens on the job market where asymmetries in information often stand in the way of mutually beneficial exchange in the market for high-quality goods
In the beginning of this essay we also mentioned a thing called a moral hazard. This is another kind of a situation that can happen in instances of information asymmetries. Akerloff points out in his essay that people over the age of 65 have a hard time of buying health insurance because of these moral hazards. The person that will try and purchase insurance over the age of 65 are the ones that are sure they need it. This means that the average condition of the person applying for insurance will deteriorate and the price level will get ever higher. Ultimately no insurance will be provided at all to people in this age group (Akerloff, 1970).
Let´s look at another hypothetical situation from the workplace to see how a moral hazard can affect people. A person that is running a business will not be able to fully monitor every single person that he employs (as it is too expensive). The people working for him will know this and as they will probably not work quite as hard as when the boss is watching. This will cause losses for the owner.
Moral hazards and adverse selection are both examples of how information asymmetry impacts contracts. This has been an important venue for economics research, as can be seen by the fact that the Royal Swedish Academy of Sciences awarded Akerloff, along with two other noted economists the Nobel prize for their research in this area (Nobelprize.org, 2012).
References
Akerloff, G. (1970). The market for “lemons”: Uncertainty and the market mechanism. The quarterly journal of economics, 84(3).
Furubotn, E., & Richter, R. (2005). Institutions and Economic Theory: The Contribution of the New Institutional Economics. University of Michigan Press.
Groenewegen, J., Spithoven, A., & Van den Berg, A. (2010). Contract theories. Í J. Groenewegen, A. Spithoven, & A. Van den Berg,Instiutional Economics – An Introduction (bls. 106-119). Palgrave.
Investopedia ULC. (2012). Investopedia. Retrieved 3 19, 2012, from Investopedia: http://www.investopedia.com/terms/a/asymmetricinformation.asp#axzz1pTeUfWk0
Nobelprize.org. (2012, 3 19). Nobelprize.org. Retrieved 3 19, 2012, from Nobelprize.org: http://www.nobelprize.org/nobel_prizes/economics/laureates/2001/press.html
Professor Christian Tomuschat, P. D. (October 2010). Basic Law for the Federal Republic of Germany. Sótt 16. 03 2012 frá Deutscher Bundestag: https://www.btg-bestellservice.de/pdf/80201000.pdf
Shapiro, S. (2005). Agency Theory. Sótt frá Technische Universität Dresden: http://tu-dresden.de/die_tu_dresden/fakultaeten/philosophische_fakultaet/is/makro/lehre/download/rntexte/shapiro.pdf
Slangen, L., Loucks, L., & Slangen, A. (2008). Institutional Economics and Economic Organisation Theory: An Integrated Approach. Wageningen Academic Publishers.
Anna, Ingi, Sabrina, Sigurgeir
New Institutional Economics 