Contract theory
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Contract theory comprises many different theories and various interpretations of the various body of rules and subrules that define contract law.
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[edit] Classical contract theory
Classical contract theory is the set of ideas and assumptions that underpinned the development of contract law in England and the United States during the 19th century. During this period, the prevailing liberal individualist philosophy of laissez faire elevated contract to a position of central importance in the law.
Classical contract theory was organised around the will theory of contract, which held that a contract represents an expression of the will of the contracting parties, and for that reason should be respected and enforced by the courts. The principles of modern contract law were founded on the concepts of individualism and free will over government intervention. They were encapsulated in a political theory labelled "contractualism" by Morris Cohen.
This approach had two principal effects. Firstly, the courts were reluctant to recognise the existence of non-contractual obligations. Since the law of tort and restitution was still largely undeveloped, the courts tended to perceive social relations in contractual terms. The principles of contract law were seen as objective and neutral, and based on a respect for voluntary choices.
[edit] Criticism of classical theory
The will theory and classical approach to contract have been comprehensively criticised by the legal realism movement. Legal realists demonstrated that contracts did not necessarily represent the will of the parties. The classical notion of individuals freely entering into contracts fails to take account of the complexities of social behaviour and the unequal distribution of economic power.
Another deficiency in the will theory is that many problems that contract law must deal with arise as a result of what parties have not expressly agreed upon, rather than what they have agreed upon. A contract could arise on the basis of an objective interpretation of the parties agreement, even if that was inconsistent with the true will of one of the parties.
[edit] Why are contracts enforced?
The central problem for contract theory is the question, Why are contracts enforced? One prominent answer to this question focuses on the economic benefits of enforcing bargains. This first approach could be said to offer a utilitarian theory of contracts.
A second approach to the question emphasizes the role of promise and draws on deontological moral theory. This second view is associated with Charles Fried, who articulated the promise theory of contract in his book Contract as Promise.
Fried makes the point that a person who makes a promise is morally bound to keep it because that person has "intentionally invoked a convention whose function it is to give grounds - moral grounds - for another to expect the promised performance." Fried's theory fits comfortably with the classical will theory of contract. His endorsement of the ideology of laissez faire underlies his view that judges shouldn't interfere with contracts in order to redistribute wealth. However, Fried does reject some of the extremes of the classical approach and allows that there are aspects of contract law that do not rest on the promise principle. For example, when a contract is frustrated by subsequent events, the courts must fill the gap by applying non-promissory principles of fairness.
[edit] Default Rules and Complete Contracts
Contract theory also utilizes the notion of a complete contract, which is thought of as a contract that specifies the legal consequences of every possible state of the world. Because it would be impossible and costly for the parties to an agreement to make their contract complete, the law provides default rules which fill in the gaps in the actual agreement of the parties.
[edit] Economics
In economics, the theory of contracts is part of information economics and describes how economic actors use particular contractual arrangements to deal with information asymmetries.
Where the principal is not informed about a certain characteristic of the agent, an adverse selection problem may arise, e.g. in the case of health insurance which is more likely to be taken out by people who are likely to get sick. One of the pioneers of this branch of economics was George Akerlof, who described adverse selection in the market for used cars. In certain models, such as Michael Spence's job-market model, the agent can signal his type to the principal which may help to resolve the problem.
In moral hazard models, information asymmetries result from the principal's inability to observe the agent's action. Thus, performance-based contracts will be employed to create incentives for the agent to act in the principal's interest, such as in the case of managerial compensation.
The more recent development known as the theory of incomplete contracts, pioneered by Oliver Hart and his coauthors, points out the incentive effects the party's inability to write complete contingent contracts, e.g. concerning relationship-specific investments.
During the last 20 years, much effort has gone into the analysis of dynamic contracts. Important early contributors to this literature include, among others, Edward J. Green, Stephen Spear, and Sanjay Srivastava.
Literature:
- Salanié, Bernard: "The Economics of Contracts" (MIT Press, Cambridge, Mass. & London, England, 1997).
- Laffont, J.J. and Martimort, D.: The Theory of incentives" (Princeton University Press, 2002)
- Bolton, Patrick and Dewatripont, Mathias: "Contract Theory" (MIT press, 2005)
