Contribution to JEL Classification K12 The New Palgrave Dictionary of Economics and the Law Contracts Steven Shavell Abstract The private and the social functions of contracts and of contract law are examined in this entry In section 1 on the basic theory of contracts the topics considered include contract formation why contract enforcement is valuable the incompleteness of contracts the interpretation of contracts remedies for breach renegotiation of contracts and judicial overriding of contracts In section 2 the economic literature on production contracts is reviewed and in section 3 other types of contract are discussed 2 Contracts The private and social functions of contracts and of contract law are examined here In section 1 the basic theory of contracts is considered in section 2 production contracts are analyzed and in section 3 several other types of contract are discussed 1 Basic Theory 1 1 Definitions and framework of analysis A contract is a specification of the actions that named parties are supposed to take at various times as a function of the conditions that then obtain The actions usually comprise delivery of goods performance of services and payments of money and the conditions include uncertain contingencies past actions of parties and messages sent by them A contract is said to be complete if the list of conditions on which the actions are based is exhaustive that is if the contract provides explicitly for all possible conditions Otherwise a contract will be referred to as incomplete Typically incomplete contracts do not include conditions which were they easy to include would allow both parties to be made better off in an expected sense It should be noted that an incomplete contract may well not have literal gaps For example although a contract stating merely that a specified price is to be paid for a quantity of wheat that is to be delivered is incomplete it does not mention many contingencies that might affect the buyer or the seller of wheat the contract has no gaps for it stipulates what the parties are to do pay a price deliver wheat in all circumstances A contract in some relevant class of feasible contracts is called Pareto efficient if the contract is impossible to modify within the class of contracts so as to raise the expected utility 3 of both of the parties to it such a contract will sometimes be referred to simply as efficient or as mutually beneficial Often below efficiency will connote the efficient terms in the class of complete contracts that is efficiency will refer to a first best contract this will be clear from context and should cause no confusion Contracts are assumed to be enforced by a tribunal which will usually be interpreted to be a state authorized court but it could also be another entity such as an arbitrator or the decisionmaking body of a trade association or a religious group Reputation and other non legal factors may also serve to enforce contracts but will not be discussed here on such mechanisms of enforcement see for example Bernstein 1992 and Charny 1990 Enforcement refers to actions taken by the tribunal when parties to the contract decide to come before it Tribunals may impose money sanctions so called damages for breach of contract or insist on specific performance of a contract require parties to do what a contract specifies for example convey land Tribunals may also fill gaps settle ambiguities and override terms in contracts 1 2 Contract formation The formation of contracts is of interest in several respects Search effort Parties expend effort in finding contracting partners and it is apparent that their search effort will not generally be socially optimal On one hand they might not search enough because the surplus gained when one party locates a contract partner would ordinarily be divided between them in bargaining the private return to search may be less than the social return On the other hand parties might search more than is socially desirable because of a negative common pool externality associated with discovery of a contract partner when one party finds and contracts with a second other parties are thereby prevented from contracting with that party Both of these externalities arise in Diamond and Maskin 1979 who examine a 4 specific model of search and contracting Although policies to promote or to discourage search might be desirable one wonders whether social authorities could obtain the information needed to determine the nature of problems with search effort Mutual assent and legal recognition of contracts A basic question that a tribunal must answer is at what stage of interactions between parties does a contract become legally recognized that is become enforceable The general legal rule is that contracts are recognized if and only if both parties give a reasonably clear indication of assent such as signing their names on a document This rule obviously allows parties to make enforceable contracts when they so desire Moreover bec