Behavioral Contract Theory

P and economics—also known as behavioral economics—is a mindset for doing economics that espouses the importance of thinking about the psychological accuracy of models. After a history of identifying deviations from classical approaches, modeling these deviations formally, and empirically establishing their importance in economic decisions, the field is in the process of full integration into economic analysis: researchers are using the new psychologically based models to study how individual behavior plays out in organizations and markets, what the welfare consequences are, and how policy should respond to market outcomes—questions in which economists have always been interested. This review summarizes and organizes one important part of the above development, the rapidly growing literature on behavioral contract theory. In a well-known textbook less than a decade old, Bolton and Dewatripont (2005, p. 10) wrote that “even though there is by now a large literature exploring a wide range of alternative models of individual choice . . . there have been relatively few explorations of the implications for optimal contracting.” By the time of Bolton and Dewatripont’s book, contract theory had evolved to a curious point: while researchers had explored optimal contracting in many complex economic environments, they largely followed a simplistic approach for Behavioral Contract Theory †