Contract theory in economics involves communication between an agent and principal to ensure a clear understanding of needs and abilities. It is used to ensure adequate rewards for the agent. Asymmetric information and moral hazard are also factors. Contracts can be complete or incomplete.
Within the realm of economics, contract theory has to do with understanding how the balance between expertise and rewards is achieved. In essence, contract theory implies the need for communication between an agent and a principal, so that there is a clear understanding of both the principal’s needs and the agent’s ability to meet those needs competently. Once this state is established, contract theory is then employed to ensure that the agent receives adequate rewards for his efforts.
One of the easiest ways to understand contract theory is to apply the principle to hiring people to work in the workplace. Essentially, a prospective employee will provide information about their ability to meet the requirements of a particular position. In turn, the employer will need to be able to verify the accuracy of the information provided. When the employer is unable to do so, the condition is considered asymmetrical. Asymmetric information is not necessarily incorrect or false information. However, it presents an obstacle to the employer being able to adequately evaluate the potential employee.
Contract theory is also intertwined with the concept of moral hazard. In essence, both the agent and the principal show some degree of trust. The agent, or prospective employee, trusts that the working conditions, rate of pay, job responsibilities and additional benefits are those presented by the employer. In turn, the employer or principal trusts that the credentials presented by the agent are valid and complete enough to merit the creation of an employment contract. When all economic actors in the process operate with a high level of expertise, the resulting agreement is likely to be mutually satisfactory.
Contractual agreements within the contract theory process can take the form of complete contracts. In this type of contractual agreement, every possible situation covered by the local law is included in the terms of the agreement. The second format is referred to as an incomplete contract and can be somewhat broader and less specific on some points.
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