A contract curve is one of several different economic curves used to illustrate the point at which the possibility of buyers and sellers to both consider a transaction to be beneficial is exceeded, and the motivation for continuing to pursue the transaction no longer exists. Considered part of the Pareto efficient allocations, the projection of this curve can aid in determining when there is still a valid reason to pursue the transaction, and when both parties should simply move on to other opportunities.
One of the easiest ways to understand the concept behind the contract curve is to consider a trade arrangement that exists between two entities known as Trader A and Trader B. The former has an interest in the goods offered by the latter and vice versa. As a result, the two parties will enter into negotiations to arrange some sort of exchange that will be mutually beneficial to both parties, attempting to come to terms on matters such as the number of units each party will purchase, and the unit prices that will apply to both sets of goods.
Assuming that the two parties can reach a working agreement or contract that makes it possible for each one to make volume purchases at certain price levels for the period of one calendar year, the relationship serves both parties well. Each gains some type of benefit from the arrangement, in terms of selling goods and also buying goods that are considered desirable. Once that contract is complete, if Trader A wants to reduce the volume purchased from Trader B while still retaining the unit price associated with the former volume commitment, there is a good chance that Trader B will no longer consider the arrangement to be beneficial and will seek a new arrangement with a different trader. It is at this point that the contract curve is reached in the history between the two traders, and continuing to pursue the working relationship becomes fruitless.
The general concept of the contract curve can be applied to a number of different financial scenarios. With investing, both buyer and seller must find a price range for a number of shares that is mutually beneficial to both parties before the deal can be completed. If it is not possible to agree on a price, then both parties can seek opportunities elsewhere. Even in terms of making everyday purchases of goods and services, the price and volume of a transaction must represent an acceptable level of benefit to both buyer and seller, or the deal leaves at least one party unfulfilled. The only way to avoid entering the contract curve is for both parties to identify enough benefit from doing business that the transaction makes sense and both will be happy with the result.
