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Characteristics And Applications Of Contract Theory

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Contracts have a long history and contracts as a field of study has its roots in the 1700’s. Adam Smith argued that sharecropping contracts does not give sufficient incentives for tenants to improve the land. The theory was further developed in the 1930s by American business executive Chester Barnard who studied ways to motivate employees in big corporations. People have different interests which is an obstacle to cooperation among them. Conflicts of interest are mitigated by contractual agreements. One important reason for drawing up a contract is to regulate future actions. For e.g. Labour contracts include pay and promotion conditions designed to motivate and engage employees and employment contracts can stipulate rewards for good performance and conditions for dismissal. Contracts often have other purposes too, such as sharing risk among the parties to the contract.

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Contracts play a critical role in the operation of the modern economy. They set out terms and conditions on who is allowed to do what with the land they own and the people they employ. They underpin nearly all of the banking and insurance sectors. Contracts also play a role in shaping public policy and the agreements between government and private parties in delivering public services. Individuals are self-interested, but to take advantage of economic opportunity people must often work together and find ways to align their interests (or minimize conflicts of interest).

Contract theory not only includes the study of legally binding contracts, but the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions. Contract theory also explores the kind of incentives that must be given for both parties to work efficiently. Incomplete contracts: It is impossible to predict all future uncertainties that might arise and include it in the contract, hence it is vital to specify who has the right to take decisions when the parties cannot agree or when there are uncertainties and ambiguities in the future. The critical question that arises with an incomplete contract is, who has the right to decide about the missing things? This is called the residual rights of control or decision rights. The party with this decision-making power will have more bargaining power and get a better deal in the output. Regarding ownership, Hart in his 1986 paper with Sanford Grossman proposes a Theory of Vertical and Lateral Integration which studies incomplete contracting in which various parties invest to increase the productivity of an asset. In case of unforeseen contingencies, the bargaining power should be with the party whose investment is the most important i.e. the owners of the asset. Hart in his 1990 paper with John Moore, build upon his 1986 paper to study ownership of multiple assets. It shows that assets whose values are improved when used together should be owned by a single party rather than multiple parties. This concentrates the bargaining power in the hands of one party rather than multiple parties and makes a strong case for large integrated firms where all the assets are owned by a single corporate entity. Holmstrom’s informativeness principle introduced in 1979, a contribution to the Principal-Agent problem states that any available measure of performance by the agent should be factored into the level of compensation in the contract. As the principal-agent problem arises out of information asymmetry and incentives, to counter against a situation of an agent acting out of self-interest is to be very clear and intentional about the language of the contract and the kind of incentive being given. The paper shows how employers should optimally link employee rewards to performance outcomes.

Another paper published in 1982 extends this to a team of employees contributing individual efforts towards a collective output, in which problems of equal profit-sharing creates a free-rider problem. He shows that the free-rider problem can be addressed by introducing a third party such as a venture capitalist who assigns rewards and penalties to team members and keeps what is left for him/herself. Holmstrom’s 1991 paper with Paul Milgrom considers situations in which the employee divides his/her effort amongst multiple tasks. If certain tasks which can be measured easily are incentivised, the employee with devote undue time and attention to that task. Applications of contract theory:

Insurance and incentives: Giving full insurance to people in cases of accidents invites a moral hazard- people might be more careless if they know they will be fully reimbursed. This invites the concept of co-pay, premiums and deductibles in the insurance contracts. The tension between insurance and incentives is due to a combination of two factors. The first is a conflict of interests: If we were all equally careful, regardless of whether or not we bore the full consequences of our behaviour, full insurance would be not problematic. The second factor is measurement: not all our actions can be perfectly observed.

Paying for performance: Another area is the problem of providing incentives to employees for performance. Bengt Holmström in 1979 published a paper suggesting that is that an optimal contract should link payment to all outcomes that provides information about actions that have been taken- informativeness principle. It suggests linking manager pay to the performance of the firm relative to other firms rather than just the stock price, which could be due to factors in the economy beyond the control of the manager.

Strong incentives vs Balanced incentives: it suggests rewarding current performance with higher future earnings. Employees tend to focus on tasks where performance can be measured easily, so it would be more ideal to offer weaker overall incentives for such tasks. For eg: teachers and test scores. If teachers are paid incentives only on the test scores of the students, they will tend to focus only on them, hindering the development of creativity and independent thinking among students.

Team Work: Holmström in his 1982 article also showed that when the firm’s entire income is divided among team members (worker owned firms), effort will generally be too low. An outside owner for the firm can boost individual incentives because compensation can be more flexible and the total compensation for the team members no longer needs to add up to the total income they generate.

Private Prisons: Hart argues that contracts between the government and private prison companies are significantly incomplete with respect to two important factors: the use of force by guards and the quality of personnel. As a result of this incompleteness a private contractor can use its residual rights of control to save money by hiring cheap, unqualified guards. These guards may not have the skill to respond to violent situations effectively. Here, the supplier is choosing an action permitted by the contract that saves money at the expense of quality.

Hart et al. (1997) concludes that the case for private provision is weak in maximum security prisons but can make sense in youth correctional facilities, garbage collection and can be tested out in schools and hospitals. It also has applications in corporate finance, in finance and governance of entrepreneurial firms, venture capital financing, bankruptcy reform and investor rights. The work of Oliver Hart and Bengt Holmstrom focuses attention on the necessity of trade-offs in setting the contract terms and explores the imperfections in markets. It lays an intellectual foundation for the design of various policies and institutions. It will have an effect on a number of policy implications to governments worldwide. It also recognizes that when people want to work together, individual self-interest must be kept under control.

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