Because of its connections with both agency and incentives, contract theory is often categorized within a field known as law and economics.
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.
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.
Contract theory in economics began with 1991 Nobel Laureate Ronald H. Coase's 1937 article "The Nature of the Firm".
Coase notes that "the longer the duration of a contract regarding the supply of goods or services due to the difficulty of forecasting, then the less likely and less appropriate it is for the buyer to specify what the other party should do.
Principals and agents are able to foresee all future scenarios and develop optimal risk sharing and revenue transfer mechanisms to achieve sub-optimal efficiency under constraints.
[8] In moral hazard models, the information asymmetry is the principal's inability to observe and/or verify the agent's action.
Performance-based contracts that depend on observable and verifiable output can often be employed to create incentives for the agent to act in the principal's interest.
When agents are risk-averse, however, such contracts are generally only second-best because incentivization precludes full insurance.
The agent is then a "residual claimant" and will maximize the expected total surplus minus the fixed payment.
The moral hazard model with risk aversion was pioneered by Steven Shavell, Sanford J. Grossman, Oliver D. Hart, and others in the 1970s and 1980s.
[11][12] The moral hazard model with risk-neutral but wealth-constrained agents has also been extended to settings with repeated interaction and multiple tasks.
[16] In adverse selection models, the principal is not informed about a certain characteristic of the agent at the time the contract is written.
Another prominent example is public procurement contracting: The government agency (the principal) does not know the private firm's cost.
A leading application of the incomplete contracting paradigm is the Grossman-Hart-Moore property rights approach to the theory of the firm (see Hart, 1995).
Hence why principals need to form contracts with agents in the presence of information asymmetry to more clearly understand each party's motives and benefits.
Source:[29] Considering absolute performance-related compensation is a popular way for employers to design contracts for more than one employee at a time, and one of the most widely accepted methods in practical economics.
But one drawback of this method is that some people will fish in troubled waters while others are working hard, so that they will be rewarded together with the rest of the group.