grad-contract-theory
Contract Theory: Moral Hazard, Adverse Selection, and Incentive Design
Overview
Contract theory studies how economic actors construct contractual arrangements in the presence of asymmetric information. The two canonical problems are moral hazard (hidden action — the agent's effort is unobservable) and adverse selection (hidden type — the agent's characteristics are private). The optimal contract balances the principal's desire for risk-sharing against the need to incentivize effort or truthful revelation. Hart and Holmstrom's contributions on incomplete contracts and incentive design form the modern foundation.
When to Use
- Designing compensation, bonus, or commission structures for employees or contractors
- Evaluating insurance contracts for moral hazard (deductibles, copays) or adverse selection (screening)
- Structuring partnerships, franchise agreements, or procurement contracts with unobservable quality
- Analyzing incomplete contracts where not all states of the world can be specified
When NOT to Use
- Both parties have symmetric information and trust is established (no incentive problem)
- The relationship is a one-shot anonymous transaction with no contractual enforcement
- Behavioral factors (reciprocity, intrinsic motivation) dominate monetary incentives
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