Contract Theory

                                       

 Two professors and economists—Oliver Hart and Bengt Holmström—received the Nobel Prize in Economic Sciences Monday for their insights into the modern contract theory- specifically how businesses and organizations can better understand and design contracts in the “real world,” with all of its complexities and uncertainties.

                                            

What is contract theory?

Human beings, knowingly or not, are surrounded by contracts. Our lives are intertwined with different types of contracts. But what are contracts? Contracts are legally binding agreements governing who will do something in exchange for something under some circumstances. Simply put, contracts are predefined agreements which define the actions to be taken in the future.

As humans, we come across conflict of interests. This conflict is mitigated, if not completely resolved, through contract theory. Well-designed contracts enable contracting parties to exploit the prospective gains from cooperation. Contract theory creates the prospect of establishing a symbiotic relationship.

For example, labour contracts include pay and promotion conditions that are designed to retain and motivate employees; insurance contracts combine the sharing of risk with deductibles and co-payments to encourage clients to exercise caution; credit contracts specify payments and decision rights aimed at protecting the lender, while encouraging sound decisions by borrowers.

Principal-Agent Model:

Employment contracts are best seen in the context of principal-agent problems. “A principal engages an agent to take certain actions on the principal’s behalf. However, the principal cannot directly observe the agent’s actions, which creates a problem of moral hazard: the agent may take actions that increase his own payoff but reduce the overall surplus of the relationship. To be specific, suppose the principal is the main shareholder of a company and the agent is the company’s manager.

As Adam Smith noted, “the separation of ownership and control in a company might cause the manager to make decisions contrary to the interests of shareholders.” To alleviate this moral-hazard problem, the principal may offer a compensation package which ties the manager’s income to some reliable performance measure. We refer to this as paying for performance. The company’s profit or stock-market values are frequently used performance measures, but they have well-known drawbacks. So, the principal might use other indicators like measuring the firm’s performance relative to other firms in the same industry. In this, we observe that there can be competing incentives for both the agent and the principal, which makes it difficult to design an ideal contract.”
For instance, shareholders of a bank (the owners, or principal) employ bankers (agents) to run the bank. Shareholders are interested in returns.

 However, it is the banker who is responsible for the day-to-day decisions like deposits, corporate lending, and investment banking etc. that generate those returns. In turn, the banker is to be compensated for his or her services.
Typically, the principal cannot observe the agent’s effort. If agents are offered a fixed salary regardless of effort, there is not much incentive for hard work. We see this in government jobs. Thus, in many industries, including banking, we instead see performance-based pay, where better outcomes for the shareholder (greater returns) are to be rewarded with better compensation for the banker.

Bad news with a Silver Lining:

Professors Hart and Holmstrom established that there can be no perfect contract. However, their large body of work showed ways to improve outcomes.
In other work, Prof. Holmstrom studied the trade-off between complete insurance contracts and the resulting moral hazard. A car owner who knows that she will receive a full payout in case of damage might not be as careful as she would be if she hadn’t entered into the contract. Socially optimal contracts ensure that the car owners too have a stake in the game, as it were, by being made to pay a part of the cost.

Incomplete Contracts:

Another application is that of Prof. Hart’s theory of incomplete contracts. Not all elements of a contract can be specified. This makes certain contracts “incomplete”. Therefore there is a question about what should happen if an unexpected event occurs which has not been specified in the agreement. Here comes the role of the party that has an upper hand at taking decisions, i.e. who has higher decision rights. Whoever has the right to make a decision on the unspecified elements of the contract consequently has more bargaining power.

An example of incomplete contracts: The lack of specified elements in contracts could encourage greater integration within a production chain with an individual instead of scattered responsibilities. For instance, the researcher in a company could have the most unspecified contract. That is to say you won’t know the R&D innovation before you see it, hence it’s inherently unspecified. One solution to this contract problem is to give the researcher decision rights and ownership of the complete production chain. This will obviate the need for an entire process of delegation of power and authority.

Final questions which Contract Theory raises:
Prof. Hart’s work suggested that the private sector might focus too much on cost reduction, but proper contracts can provide incentives for quality as well. The public sector, on the other hand, has little incentive to do either. This gives rise to the question whether providers of public services, such as schools, hospitals, and prisons, should be privately owned or not.
Several of Prof. Hart and Prof. Holmstrom’s insights have indeed found their way into modern contracts. But the example of Wall Street suggests that regulators must pay more attention to their findings, particularly in high-risk industries.
Even in case of financial crises in the first decade of the 21st century, the public got to know that bankers were paid exorbitantly when the bubble was at peak. They were remunerated in the form of huge bonuses and stock options.

The question that rises here is “Why did the companies enter into such kinds of contracts? Why did they throw money at bankers who led to crashes like the 2008 crisis? Why didn’t the government authorities look into the matter?”
This leads to our final question: What is an optimal contract for a regulator? If we are lucky, we won’t have to wait until the next crisis to find out.

-Vineet Narang & Rishabh Mittal