Initially contracts have been considered as a mechanism to save on transaction costs. However, over time they have come to be regarded a result of the need to share risks. Risks can be either exogenous to the contracting parties or generated by them (endogenous). In particular, information asymmetry creates adverse selection and exogenous randomness while endogenous randomness is due to moral hazard. The principal agent models essentially contain a formal characterization of risk sharing in contracts towards its efficiency. There is an acknowledgement that such sharing results in a propensity to take up more risky transactions and spread them to more individuals in various forms. Mature individuals are expected to regulate their activities and contain risks within acceptable bounds. Individual greed may however lead to systemic risks which are beyond their control. Efficient regulation must be conceptualized to move the system back to stability.
KeywordsRisk Aversion Moral Hazard Agency Cost Adverse Selection Risk Sharing
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