Contract Theory and Incentive Compatibility

What is a contract? In essence, it is a mutual agreement between people to act in some specified way. A common example is an agreement to pay a sum of money on the occurrence of some event that may or may not be controlled by one of the parties. You may place a bet with a bookmaker to receive a specified pay-off if a particular horse wins a race. Whether or not that horse wins is not (or, at least, is not supposed to be) controlled by either of you. An insurance company may agree to pay you a specified sum if your house burns down. Whether or not it does is at least partly under your control. An employer may offer you a job at a specified salary provided that you graduate. Whether or not you do depends not only on how hard you work but also on how clever you are and you may know that better than your prospective employer. All these are examples of contracts.