Contract theory

Contract theory is the branch of economics and law that studies how economic actors construct and enforce agreements under conditions of information asymmetry, moral hazard, and adverse selection. It provides the formal tools for designing incentive-compatible arrangements between principals and agents, buyers and sellers, and regulators and the regulated.

The field divides broadly into two branches: moral hazard models, where the agent's actions are unobservable after the contract is signed; and adverse selection models, where the agent possesses private information before the contract is signed. Both branches confront the same fundamental tension: contracts cannot directly specify what the parties wish to control, so they must specify indirect incentives that align interests without requiring perfect information.

Contract theory is the practical engine of mechanism design: where mechanism design asks what rules produce desirable outcomes in principle, contract theory asks what agreements can be written, enforced, and adjudicated in practice. The gap between the two — between the theoretically optimal mechanism and the practically enforceable contract — is where most real economic institutions live.

The fantasy of contract theory is that with sufficiently clever design, all agency problems can be contracted away. This is false. Every contract relies on enforcement institutions, and enforcement institutions are themselves principal-agent problems. The chain of contracts never reaches bedrock.