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Lectures on Contract Theory
(Preliminary notes. Please do not distribute without permission.)
The contours of contract theory as a field are difficult to define. Many would argue that
contract theory is a subset of Game Theory which is defined by the notion that one party
to the game (typically called the principal) is given all of the bargaining power and so can
make a take-it-or-leave-it offer to the other party or parties (i.e., the agent(s)). In fact, the
techniques for screening contracts were largely developed by pure game theorists to study
allocation mechanisms and game design. But then again, carefully defined, everything is a
subset of game theory.
Others would argue that contract theory is an extension of price theory in the following
sense. Price theory studies how actors interact where the actors are allowed to choose prices,
wages, quantities, etc. and studies partial or general equilibrium outcomes. Contract theory
extends the choice spaces of the actors to include richer strategies (i.e. contracts) rather
than simple one-dimensional choice variables. Hence, a firm can offer a nonlinear price
menu to its customers (i.e., a screening contract) rather than a simple uniform price and an
employer can offer its employee a wage schedule for differing levels of stochastic performance
(i.e., an incentives contract) rather than a simple wage.
Finally, one could group contract theory together by the substantive questions it asks.
How should contracts be developed between principals and their agents to provide correct
incentives for communication of information and actions. Thus, contract theory seeks to
understand organizations, institutions, and relationships between productive individuals
when there are differences in personal objectives (e.g., effort, information revelation, etc.).
It is this later classification that probably best defines contract theory as a eld, although
many interesting questions such as the optimal design of auctions and resource allocation
do not t this description very well but comprise an important part of contract theory
nonetheless.
The notes provided are meant to cover the rough contours of contract theory. Much of
their substance is borrowed heavily from the lectures and notes of Mathias Dewatripont,
Bob Gibbons, Oliver Hart, Serge Moresi, Klaus Schmidt, Jean Tirole, and Je Zwiebel. In
addition, helpful, detailed comments and suggestions were provided by Rohan Ptichford,
Adriano Rampini, David Roth, Jennifer Wu and especially by Daivd Martimort. I have
relied on many outside published sources for guidance and have tried to indicate the relevant
contributions in the notes where they occur. Financial support for compiling these notes
into their present form was provided by a National Science Foundation Presidential Faculty
Fellowship and a Sloan Foundation Fellowship. I see the purpose of these notes as (i) to
standardize the notation and approaches across the many papers in the eld, (ii), to present
the results of later papers building upon the theorems of earlier papers, and (iii) in a few
cases present my own intuition and alternative approaches when I think it adds something
to the presentation of the original author(s) and di ers from the standard paradigm. Please
feel free to distribute these notes in their entirety if you wish to do so.
c 1996, Lars A. Stole. | 
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