Contract Theory: Moral Hazard, Adverse Selection, and Incentive Design

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

Assumptions

IRON LAW: The optimal contract balances risk-sharing against incentive
provision — full insurance destroys incentives, full incentives impose
unbearable risk. There is no contract that achieves first-best when
information is asymmetric.

• The principal is risk-neutral; the agent is risk-averse (standard setup)
• The agent's action (effort) or type is private information
• Output is a noisy signal of the agent's effort: x = f(e) + epsilon
• Both parties are rational and can commit to the contract terms
• Courts can verify output but not effort (contractibility constraint)

Methodology

Step 1 — Classify the Information Problem Determine whether the core issue is moral hazard (hidden action after contracting), adverse selection (hidden type before contracting), or both. Identify who is the principal and who is the agent.

Step 2 — Specify Constraints