AØKA08055U Contract Theory and the Economics of Organization

Volume 2013/2014
MSc in Economics

The course provides an introduction to contract theory. Contract theory examines the characteristics of optimal contracts when one party has certain relevant knowledge that the other party does not have.

The course consists of two parts. In the first part, some of the basic ideas in contract theory are presented. We will, in particular, look at optimal contracts when one party has hidden information (adverse selection) or can take a hidden action (moral hazard). In the second part of the course we apply the insights obtained to a number of specific economic questions, studying some original journal articles.

In the first part we will study selected sections of chapters 2-5 of the textbook by Laffont and Martimort. Chapter 2 explains the basic idea and insights of adverse selection. Chapter 3 studies some important extensions of the basic adverse selection model: for example, environments where the agent may be of more than two “types”, which may lead to “bunching” (i.e., several types being offered the same contract).

Chapter 4 explains the basic idea and insights of moral hazard, using a very stylized model with two effort levels and two possible outcomes. Chapter 5 extends this model in some interesting ways, for example: environments with a continuous effort variable, leading to a discussion of the so-called first-order approach.

The journal articles that we will study are about the political economy of industrial economics, and managerial incentives and product market competition.

Learning Outcome
The primary aim of the course is to introduce students to central results and insights in contract theory. An additional aim is to familiarize students with some selected examples of how contract theory can be used to study economic questions. A broader aim is that students who take the course will, by working extensively with theoretical models, acquire analytical skills that are transferable to other kinds of intellectual problems.

After having successfully completed the course the students will be able to formulate and solve contract theory models. The students will also be able to read professional journal articles that apply contract theory and to use this broad analytical approach when analyzing and thinking about questions where incentives play a role.

In order to pass the course, the student must demonstrate familiarity with and understanding of the approach of contract theory. Moreover, the student must show ability to solve and work with models used in contract theory and ability to understand the logic behind the results. The very good should at the end of the course be able to demonstrate full or almost full capability of using and understanding the techniques of analysis taught in the course.



Laffont, Jean-Jacques, and David Martimort (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

  • The Introduction (pages 1-6).
  • Sections 2.1-2.6, 2.9, 2.10 (except 2.10.2 and 2.10.3), and 2.15.2.
  • Sections 3.1 and 3.7.
  • Introduction to Ch. 4 (pages 145-148), Sections 4.1-4.4 up until and including Proposition 4.5 on page 161.
  • Section 4.5 (pages 163-167) – however, the formal model with a risk-averse agent is excluded although the discussion on page 167 is included.
  • Section 5.1.2. Also the discussion related to the first-order approach in Sections 5.1.1 and 5.1.3 (hence not the formal models).
  • Sections 5.2.1 and 5.2.2.

Journal Articles / Book Chapters

Vital Anderhub, Simon Gächter, and Manfred Königstein. Efficient contracting and fair play in a simple principal-agent experiment. Experimental Economics, 5(1):5—27, 2002.

  • The whole paper. But the most important questions for you to keep in mind when reading are: (i) What do they do (i.e., what is their experimental design). (ii) What are their results?

Inderst, Roman, and Marco Ottaviani. “Misselling through agents.” American Economic Review, 99: 883—908, (2009).

  • The introduction (pages 883-886) and Appendix A (pages 903-904, which describes and solves a "toy version" of Inderst and Ottaviani's main model). In addition, Appendix A uses some notation etc that is not explained there but must be looked up in Section II (pages 887-889) of the paper.

Laffont, Jean-Jacques, and Jean Tirole (1993), A Theory of Incentives in Procurement and Regulation, MIT Press.

  • The first few pages of Chapter 1, namely, pages 53-59.

Schmidt, Klaus M. “Managerial Incentives and Product Market Competition,” The Review of Economic Studies, 64 (2):191—213 (1997).

  • Pages 191-203 and 209-213 (i.e., we exclude the end of sub-section 4.1, the whole of sub-section 4.2 and the whole of Section 5).

Vickers, John. “Concepts of competition.” Oxford Economic Papers, 47 (1):1—23 (1995).

  • Section 6 only (i.e., pages 7-12), but we exclude the discussion and modelling of the so-called ratchet effect in section 6.3.
  • To solve the models described and discussed on these pages one must make use of four results about expectations and conditional expectations of normally distributed stochastic variables. Being able to derive these results or to know them by heart is not included in the course requirements. Exactly which four results this statement refers to is specified in “Appendix to Lecture 10”, which is uploaded on the Absalon course page.
No graduate courses are required, but a certain proficiency in solving game-theoretic models is helpful.
3 hours of lectures per week for 14 weeks.
  • Category
  • Hours
  • Exam
  • 3
  • Lectures
  • 42
  • Theory exercises
  • 161
  • Total
  • 206
7,5 ECTS
Type of assessment
Written examination, 3 hours under invigilation
3 hours written exam taking place at Peter Bangs Vej 36.
Without aids
Marking scale
7-point grading scale
Censorship form
External censorship
100 % censurship
Exam period
Will be updated before the start of the semester
Same as ordinary. But if only a few students have registered for the re-exam, the exam might change to an oral exams with a synopsis to be handed in. This means that the examination date also will change.
Criteria for exam assesment
The Student must in a satisfactory way demonstrate that he/she has mastered the learning outcome of the course.