Contract Theory

Contract Theory is a framework that explores how parties create legally binding agreements for the exchange of goods or services and encompasses key elements of law and economics. It focuses on two primary objectives: determining the types of agreements that can be enforced and outlining the consequences of any breaches. Central to Contract Theory are two foundational theories: Benefit-Detriment Theory, which considers the benefits and losses to the parties involved, and Bargaining Theory, which emphasizes the conditions under which a promise becomes legally enforceable through offer, acceptance, and consideration.

Game Theory also plays a significant role by analyzing how cooperation can transform noncooperative interactions into mutually beneficial agreements. However, there are critiques of Bargaining Theory, including its inability to differentiate between fair and unfair bargains and potential issues of incomplete contracts, which arise when unforeseen circumstances complicate the fulfillment of contractual obligations. Scholars like Richard Posner have contributed significantly to the intersection of law and economics, advocating for the efficiency of common law, though this view has not remained unchallenged. Overall, Contract Theory provides essential insights into the dynamics of agreements and the implications of legal frameworks in economic interactions.

Published in: 2021

By: Gould, Marie

Subject Terms

Contract Theory

Abstract

This article focuses on how law and economics contribute to the concept of contract theory, especially regarding bargain theory. There is an exploration of how Game Theory provides an example of cooperation within contract theory. Pertinent scholars, such as Richard Posner, are introduced. Finally, there is a review of the concept of incomplete contracts.

Overview

Contract Law. Contracts entail the consideration of two main objectives. First, one must consider what types of agreements are to be made and enforced as a result of a contract. Second, one must consider what the consequences will be if any of the signing parties break the promises of the contract.

With this in mind, Cooter and Ulen (2000) created a list of purposes for contract law. Items on their list include:

Enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions. Cooperation is seen as the best way to be efficient. It is believed that payoffs are higher when all parties cooperate with one another.
Encourage the efficient disclosure of information within the contractual relationship. The parties involved should create an environment where breach of contract isn't a viable option. It is in all parties' best interest if mediation is not required to get any of the parties to adhere to their agreement and promise.
Secure optimal commitment to performance.
Secure optimal reliance.

Benefit-Detriment Theory vs. Bargaining Theory. The foundation upon which contract law rests can be attributed to two main theories: Benefit-Detriment Theory and Bargaining Theory. Within Benefit-Detriment Theory, it is assumed that the promisor will benefit or that the promisee will be at a loss. While the Benefit-Detriment Theory is sometimes used today, Bargain Theory has become dominant within Contract Law.

Bargain Theory was developed in the late 1800s and early 1900s. During this period, it was believed that a promise was legally enforceable if it was a part of a bargain. In order for a bargain to be considered legal, it had to meet three conditions:

Offer;
Acceptance;
Consideration.

The offer and acceptance are very clear and create a reciprocal transaction (i.e. Person A approaches Person B and extends an offer for a product or service; Person B either accepts or rejects the offer). Both parties are required to give something to make the agreement a mutual transaction. Consideration refers to the actual object of the bargaining process (i.e. The payment of $100 for concert tickets would be the consideration). The promise (contract) becomes binding once the consideration has been completed.

Criticisms. Some have criticized bargain theory for a number of reasons. Some of the reasons include:

Bargain Theory does not distinguish between fair and unfair bargains.
Consideration could be absent for justifiable reasons.

Despite its criticisms, it can be said that bargaining attains economic efficiency if both the promisor and promisee agree to enforceability at the time the agreement is made. In this scenario, Pareto's efficiency is realized. Pareto's efficiency is described as a situation in which no changes can be made to improve an individual's status without harming another individual—or, the situation in which there is the most efficient use of resources.

Scholars in the Field. Contract theory is connected to the disciplines of law and economics; Richard Posner is a key pioneer of this academic combination. His contributions are based on his views of common law. "Common law is the expression of a core of common judicial principles applied to an accretion of individual cases and not simply an averaging of unrelated, empirically derived opinions" ( Lowry, 1976, p. 10). It is the responsibility of the courts to ensure that bargain and contract transactions/agreements (i.e. enforcing transfer of titles) are honored. During the 1970s, Posner (1992) claimed that common law was efficient. He believed the legal system was operating appropriately and addressed the issues that arose. Overall, he did not believe there were any flaws in the system. In addition, he was credited for the treatment of law and economics as a field of study as opposed to an opinion of individual scholars.

However, it should be noted that Posner's assertion was not entirely supported by other scholars in the field. For example, during this period of time, scholars, such as George Priest, reconsidered their position and rejected the concept of common law as efficient. "Meanwhile, most scholars who applied economic analysis confined their analysis to the effects of particular legal rules, so those scholars had no reason to express an opinion as to whether they thought an entire field of law (much less the entire common law) was efficient" (Craswell, 2003, p. 904).

Scholar S. Todd Lowry (1976) observed how many in the economic and legal fields failed to connect social arrangements and the economic and liability issues that came with them. In his work, he reflected on how there is a social and economic interaction among bargain, contract and administrative decisions. "By failing to recognize the relational threshold as a precondition for bargain, the distinction between bargain (transaction) and contract (relation) has been obscured in some discussions of legal and economic process" (Lowry, 1976, p. 9-10).

Application

Game Theory—Cooperation & Contract. As mentioned above, one of the purposes for contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions. It is believed that payoffs are higher when all parties cooperate with one another. A study conducted by Sacconi and Faillo investigates the environment within which players will cooperate.

The 2005 study set out to determine at what point players who have contributed to the choice of a norm actually comply with the norm; especially when the norm does not align with the individual motivation of the players. In essence, under what conditions will a player desert the characteristics of a person adhering to the self-interest based model? How does one get the players to create cooperative solutions that would be a win-win situation for everyone? What type of agreement (promise) can they support?

The study was based on an experiment called the Exclusion Game. The participants were asked to choose how to play the game once they had agreed to play according specific rules. The experiment was conducted at the Computable and Experimental Economics Laboratory of the University of Trento. There was a total of 150 participants. Fifteen participants were active in each session, and there was a total of ten sessions.

The participants were divided into groups of three individuals. Two of the participants were active players and one player did not have an active role. This one player, the "dummy player," had to rely on the decisions of the active players and his/her rewards were determined by the decisions made by the active players. For example, there was a sum of money provided in this game. The two active players were given three options as to how to get the money. The three choices were to:

Ask for half of the money;
Ask for one third of the money;
Ask for one fourth of the money.

The agreement was that if both of the players asked for half of the money, the dummy player would not receive anything. However, if both active players asked for one third of the money, the pot would be split equally among the three players.

The experiment was divided into three phases. The first phase was the process of the players engaging in the Exclusion Game two times. In the second phase, the participants were assigned to a new three-person group without knowing the results of the previous games. At this point, the new team had to agree on how the money would be divided among the players in the new group. The researchers provided the new group with two alternatives.

There were two guiding principles. One principle stated that every player should share the pot (i.e. if both players asked for one third of the money, each player received am equal share of the pot). The second principle asserted that active players are entitled to a larger amount from the pot (i.e. since the dummy player is not active, this player should not receive any money from the pot). Based on the principles of the game, one can assume that if players are motivated to get the most money, they would choose the second principle, which does not require sharing with the dummy player.

If the players were able to select a principle, they were allowed to move to phase three and play the game again. Saconi and Faillo (2005) found that:

About 85 percent of the players chose the second principle at least once in the first phase.
Considering the players in phase one who chose the second principle at least once, and in phase two chose the first principle (approximately 60 percent of the players), those who expected that the other active players would select the first principle agreed to support this decision
Choosing a principle induced a change in the behavior of a significant number of the players (p. 103).

The researchers were able to take an environment, which encouraged the participants to agree to the terms of a game as well as what the payoff would be. Thus, instead of working individually, all players agreed to work together and created a contract of acceptable behavior. The contract consisted of guidelines for their actions (behavior).

Viewpoint

Incomplete Contracts. Moral hazards occur when one of the parties of a contract does not have the opportunity to validate a person's action. When this type of situation occurs, there is potential for legal consequences. Incomplete contracts are arranged when there are a number of complex issues, which make it difficult to honor and abide by a standard contact. Therefore, the law provides rules that allow the parties to insert an arrangement in the actual contract between the parties involved. Maskin (2001) believes that the contract is incomplete when "it is not as fully contingent on the 'state of the world' (the resolution of uncertainty about the future) as the parties to the contract might like it to be" (p. 1). In other words, Maskin is attempting to explain how some contracts cannot be resolved because the parties involved (i.e. the promisor and promisee) may not be able to reach consensus due to situations being beyond their control.

What type of situation causes an incomplete contract to occur? For example, there are two people who intend to trade. Before the transaction can transpire, the "selling" party must disclose information about the product or service. There will be times that this type of information is still unavailable at the time that the transaction is to take place. Therefore, arrangements are often made without full disclosure or agreement.

Maskin (2001) suggests that literature on Contract Theory describes three main reasons for contractual incompleteness. These reasons are:

Some aspects of the state of the world may not be common knowledge or commonly observable; in particular, whoever is responsible for enforcing the contract (e.g., the court) may not be able to ascertain these aspects (in which case, we say that the aspects are "unverifiable");
Some aspects of the state may be unforeseen or indescribable by the parties in advance (perhaps because there is simply too vast a range of possibilities to think about); and
Even if certain aspects are foreseen, writing them into a contract may be too costly (p. 3).

Conclusion

This article has provided an overview of Contract Theory through a focus on Contract Law and its relation to the theories of Benefit-Detriment and Bargaining. A discussion of scholar Richard Posner and his contributions to the study of law and economics and its application to common law and Contract Theory is also provided. A view into a 2005 behavioral study conducted by Saconi and Faillo provides the reader with some insight on the evolution of Contract Theory as supported by behavioral evidence. Finally, a discussion of the issue of incomplete contracts and their implication is included to illustrate the importance of careful execution of agreements.

Terms & Concepts

Bargain Theory: Theory which highlights promises that are legally binding. The agreement has to meet three conditions—offer, acceptance and consideration.

Benefit-Detriment Theory: Assumption that within an exchange situation, either the promisor will benefit or that the promisee will be at a loss.

Contract Theory: A theory that discusses how two parties arrive at a legally binding agreement for a service or product.

Economic Analysis: Systematic approach to determine how to best utilize resources for optimum usage.

Game Theory: A mechanism for resolving conflicts of interest.

Incomplete Contracts: Occurs when some contracts cannot be resolved because the parties involved (i.e. the promisor and promisee) may not be able to reach consensus due to situations being beyond their control.

Pareto Efficiency: Occurs when there are optimum conditions for an agreement where it can be shown that one person benefits without the other party suffering as a result of the transaction.

Richard Posner: Seen as one of the pioneers for supporting the combination of law and economics as a discipline.

Bibliography

Christensen, H. B., Nikolaev, V. V., & Wittenberg-Moerman, R. (2016). Accounting information in financial contracting: The incomplete contract theory perspective. Journal of Accounting Research, 54(2), 397–435. Retrieved January 4, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=114640046&site=ehost-live&scope=site

Cooter, R., & Ulen, R. (2000). Law and economics, 3rd edition. Addison Wesley Publishing Company.

Craswell, R. (2003). In that case, what is the question? Economics and the demands of contract theory. The Yale Law Journal, 112, 903–924.

Grossman, S., & Hart, O. (1986). The costs and benefits of ownership: A theory of vertical and lateral integration. Journal of Political Economy, 94, 691–719.

Hart, O. (1995). Firms, contracts and financial structure. Oxford: Clarendon Press.

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Hoppe, E.I., & Schmitz, P.W. (2013). Contracting under incomplete information and social preferences: An experimental study. Review of Economic Studies, 80, 1516–1544. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91593683&site=ehost-live

Lowry, S. (1976). Bargain and contract theory in law and economics. Journal of Economic Issues, 10, 1–22. Retrieved April 1, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4673815&site=ehost-live

Maskin, E. (2001, September). On indescribable contingencies and incomplete contracts. Retrieved March 29, 2009, from Institute of Advanced Study and Princeton University. http://www.sss.ias.edu/publications/papers/econpapereight.pdf

Pacala, A. (2012). The theories of incomplete contracts in analyzing the company. Annals of the University of Oradea, Economic Science Series, 21, 554–561. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86068787&site=ehost-live

Posner, R. (1992). Economic analysis of law (4th edition). Boston: Little, Brown and Company.

Sacconi, L., & Faillo, M. (2005, June 20). Conformity and reciprocity in the Exclusion Game: An experimental investigation. University of Trento Economics Working Paper No. 12. Retrieved April 1, 2009, from Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract%5fid=755745

Schepel, H. (2013). Freedom of contract in free movement law: Balancing rights and principles in european public and private law. European Review of Private Law, 21(5/6), 1211–1229. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91751563&site=ehost-live

Contract Theory

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Subject Terms

Contract Theory

Abstract

Overview

Application

Viewpoint

Conclusion

Terms & Concepts

Bibliography

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