Contracts and Control: A Theoretical Treatment

Abstract

The article constructs a theoretical model of contracts and their monitoring within a principal-agent relationship. An unambiguous contract is perfect, meaning that the principal’s intention becomes executed as such. However, the agent may gain economic or other benefits from deception in execution, which implies that the spirit of the contract turns biasedly into practice. The deviation of realization from intention of the contract causes agency costs to the principal. In the model, execution can be enhanced by control, which is also costly due to its diminishing marginal product. That makes the amount of control an optimization problem. In the optimum, the principal-agent relationship gets tightened, but the realization of the principal’s intention remains imperfect. The outcome is a second-best optimum constrained by the problem of asymmetric information common in contractual relationships.