Transaction cost theory

Transaction cost theory focuses on the modalities of economic agents that seek to understand their commitment constraints which are made to guarantee the returns of specific investments. This theory relies on safety measures to ensure protection of each party from the potential for behavior that is opportunistic and offers incentives to perform the transaction. In other words it places more effort on manipulation of the costs of breaking the contract.

Another plus for this theory is that is focuses on private conflict resolution measures. This is because commitments are specific and open-ended therefore resolution of conflict cannot be handled by outside authorities. It is such conditions which force the parties in the contract to agree beforehand on mechanisms of resolving disagreements.

Transaction cost theory offers agents a standard set of co-ordination rules which in turn free them from invention or reinvention within their relationships in the contracts. Another essential role played by this theory is that it provides reliability to sanctions thus providing an assurance on contractual obligations.

2.2 Incentive theory

Incentive theory is inspired by the hypothesis of Walrasian economic theory. The general assumption is that economic agents are equipped with contract knowledge which makes them sure of the structural pattern of the issues being confronted in the contract. These agents have access to information that is complete and tailored to the set preference. To make it easier for the agents there exist an incentive scheme which based on an institutional framework.[1] The said framework is benevolent and competent thus ensuring that principal adheres to his commitment.

This theory begins from a canonical angle where a principal who is the under-informed party puts measures comprising of an incentive scheme to coerce the agent who is the informed party to provide information or implement behavior that is in line with the interests of the principal.

[1] Crocker, K.J. and Masten, S.E. “Mitigating Contractual Hazard: Unilateral Options and Contract Length”, (1988) Rand Journal of Economics, 19(3): 327–43