A contract is an agreement containing legal obligations that are agreed upon by two or more parties. In economics, contracts are a necessary part of the interaction between two economic agents because they provide the terms for agreement. The purpose of such an agreement is to engage in some sort of productive action or for mutual advantage. A contract may be implemented if one party wants to trade their resources for another party’s resources.
Contract law comes into play when contracts are broken between one or more of the parties and/or if there is a party member who does not agree with the contract. Contract law is necessary for free exchange to exist in a market. Without it, voluntary agreements and exchanges in markets would not be able to occur because there would be no guidelines to govern disagreements and problems within the agreement.
The goal of contract law is to minimize the costs of writing contracts and the costs that are caused by inadmissible behaviour from one or more of the parties. Contract theory studies the way economic agents form contractual agreements. Contracts and contract theory are a large component of law and economics because they deal with legal bindings and incentives.
The topic of contracts typically looks at incentives, incomplete contracts, and transaction costs. In microeconomics, contract theory looks at the behaviour of the decision maker and the actions they take to making optimal decisions. In a way, contract agreements are based on the costs and benefits from the perspective of each party.