When should workers be paid a bonus based on performance? What’s the best way to structure the contract specifying the terms for paying a bonus? Should managers have stock options as part of their contracts, or is some other arrangement preferable? When should insurance companies require co-payments, and what’s the best co-pay schedule?
Here’s a way to think about contract theory. People often find themselves in situations in which they must trust that someone else will act in their best interest, so contracts are a way of creating incentives that avoid conflicts of interest and specify how to share any risks inherent in the contractual relationship.