Contract Theory in New Age Economics|Vamsi Karedla

Vamsi Karedla

On 10th October the Nobel prize for Economics was announced. Mr. Oliver Hart a Harvard man, an American of British origin, & Bengt Holmström professor at MIT, of Finland  were given the award. The awards were given in recognition of their outstanding contribution in the field of Contract Theory. In a nutshell, contract theory tries to address issues involved in drawing up of contracts. Drawing up of a contract is a complicated process and achieving an efficient outcome is even more difficult owing to the multiple factors that need to be kept in mind.

In today’s globalized world involving complex transactions, drawing up efficient contracts is a critical part for smooth functioning of business.

Insights into drawing up efficient contracts are extremely valuable. The contract theory is as relevant today as Amartya Sen’s welfare economics theory was at the beginning of the millennium.

Contracts govern transactions and market activities like never before and it is in this context that the contract theory assumes great importance. Contract theory is essentially the determination of how contracts should be drawn up to ensure that there are efficient outcomes resulting from the agreement. For the layman it would seem that contracts are agreements, where an outcome which is beneficial to both the parties will be drawn up. This is a fair understanding, but in a world where transactions are becoming complex and the parties in the contract are expected to perform multiple roles, it becomes difficult to draw up efficient contracts without a clear understanding of the dynamics involved, principles and guidelines. This is where contract theory has contributed most to contemporary understanding of what is the best strategy that firms, individuals, companies and partnerships should adhere to ensure efficient outcomes from contracts.

At the heart of it, contract theory is trying to achieve a delicate balance between two opposing forces in a contract. According to Holmström, there has to be a balance between risks and incentives. Consider an employment contract, which typically consists of two competing forces, one being the risk exposure that an employee has to face, the responsibilities that the employee is burdened with and the remuneration for the same. Many a times, we find that employees are in a position where their risk exposure is very low but their remuneration is assured at the end of every month leading to gross underperformance.

If the principle of maintaining a balance is applied to the same, then the solution to the same becomes clear. The solution is to reduce the gap between the risks, responsibilities and the incentives.

An interesting analogy can be drawn to the civil services in India. The civil servant in India has a contract with the government which provides job security and a higher level of immunity, when compared with other jobs in the private sector. If we apply the principles of contract theory as espoused by laureates, it would be right to say that the payment and incentive to the civil servant should be based on performance rather than providing the assurance of a fixed salary.

For a long time, the privatisation of railways in India was contemplated. It was thought that opening up of the railways to private parties would promote healthy competition which in turn would increase the quality of service. This seems like a compelling argument for privatisation. However, Hart and Holmström theorise that this quality based enhancement would only last for a short period of time. After this initial phase, running costs will begin to rise and at the same time increased competition will lead to cost cutting measures. A situation that has come to prevail in the Airline industry today.

Hart, in an 1997 article affirmed this by saying that the incentive for the private company to indulge in cost cutting activities was too strong, especially in a globalised economy where a large number of companies are competing for a tiny market space.

Ever wondered why companies offer bonuses? It may seem to the employee that the company is being generous by giving him an extra piece of the pie. The catch is that it is exactly what the company wants the employee to think. By giving the employee an initial signing bonus, the company wants the employee to commit to the company. By putting in the extra hours, the employee is constantly trying to increase his chances of securing another bonus for himself. This is how the firm gains the maximum out of the employee.

We often see front page news saying that “X student from an IIT institution secured a 1 crore package”. Read between the lines and you will see that the high package contract involves a signing bonus, stock options and health insurance. This is an efficient outcome that has been achieved by the company by cutting down on employment costs and at the same time ensuring maximum output.

In today’s complex activities, it becomes increasingly hard for the employer to observe the level of performance by the employee. In this context, an efficient way to resolve this is to link the same with performance.

However this model has not always worked, because the idea of performance is not always equated with payment by the employee. Many a times, the employee may not link performance with payment, but better job satisfaction. This is what I call the ‘the workaholic paradox’.

Many a times, parties to a contract are put in a place where they are not in a position to completely determine or predict the manner in which the contract will pan out , this is what is known as an incomplete contract and the same is reflected in the manner in which the terms of the contract have been drawn up. Under such circumstances, it is wise to take an alternative approach to ensure that there is efficiency in the outcome. Here, since the outcome is not clearly known to the parties involved, it is more efficient if a different class of incentives are offered instead of payment for performance, because the question as to whether there will be complete performance of the same is unclear in this situation. The ideal alternative is to evaluate, the risk exposure of the parties. The party who is exposed to more risk should be given higher decision making powers.

In the world of finance, profits can be fluctuating quarter to quarter and year to year. In such circumstances, if the terms of the contract remain at status quo, then an inefficient outcome is inevitable. Here, contract theory states that there should be shifting of the powers and the incentives of the parties as circumstances change. Consider a contract between an entrepreneur and his investors. It is theorised here that when the venture is registering profits the power to decide and run the company is to be vested with the entrepreneur, and when the venture is registering losses, the power to decide and run the company should be kept in the hands of the investors. This aspect of contract theory focuses on keeping the subject matter static, while at the same time changing the position of the parties to ensure that there is a fair outcome always.

The contract theorists have been one of the foremost contributors to our understanding of contracts and contractual policy. Hart and Holmström’s work has given us new ways of thinking about how contracts should be designed to ensure efficient outcomes, coupled with maximum benefit both in private markets as well as in the sphere of public policy.

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