India Economy

How the deal is drawn up is key

S A Raghu | Updated on January 16, 2018 Published on October 16, 2016

Winners of Nobel economics prize have made key contributions to contracts

One could be forgiven for thinking that this year’s Economics Nobel for contract theory was for Law, but the all-pervasiveness of contractual relationships in our social and economic life makes the work a significant contribution to our understanding of everything “from bankruptcy legislation to political constitutions, from corporate governance to constitutional law”.

To be sure, the role of incentives and conflicts of interest are not new to economics and we are familiar with concepts such as moral hazard and adverse selection. What the present work adds to the body of knowledge are two important problems with contracts, viz. informational problems and incomplete contracts. Bengt Holmstrom and Oliver Hart, respectively, have made significant contributions in these areas.

Principal-agent conflict

Holmström developed the informativeness principle, at the heart of which is the principal-agent relationship with its known issues of incentives, conflicts of interest and information asymmetry. These abound in our daily life — for example, workers and firms, shareholders and management, businesses and suppliers, and insurance companies and their customers. In a firm, the problem can be stated simply as one where employers are unable to explicitly monitor employee performance and therefore rely on outcomes defined by standard metrics such as profits or stock prices.

But since share prices are also influenced by factors not in the executive’s control, simply linking compensation to the firm’s share price could reward the manager for good luck and punish him for bad luck. On the other hand, if linked to the firm’s share price relative to those of similar firms in the same industry, this could provide more optimal information on efforts and outcomes. Likewise, a common profit sharing scheme that simply shares profits amongst team members only creates a free-rider problem.

Holmstrom suggests that the problem can be resolved by introducing a “budget-breaker”, a third party such as a venture capitalist who assigns rewards and penalties to the team members and keeps what is left for himself. The whole of his work deals with studying the balance between risk and incentives. One early insight, according to the Nobel committee, was that high-risk industries should have more fixed salaries while stable industries should more often consider performance bonuses. The essence of the informativeness principle is that contracts should consider information relevant to employee performance, carefully weighing risks against incentives. This principle has found application in insurance contracts also, where the concepts of deductibles and co-pays provide the checks against the disinclination of the insured to take care.

Incomplete contracts

Hart’s contribution is in the other problem area of contract theory — the issue of incomplete contracts; the problem can be stated as the impossibility of explicitly specifying every eventuality and what the parties should do in such case. The solution he offers is that contracts should focus on determining which party has the right to decide what to do when an eventuality occurs. This is an important insight because the problem is at the heart of nearly every contracting decision around us, especially in the public sphere — own versus lease, make versus outsource, public versus private. The crucial issue, according to Hart, is the extent to which the contracts account for the unexpected.

He quotes two extreme examples. Government foreign policy making cannot obviously be outsourced (due to the impossibility of specifying all eventualities and possible courses of actions) but a service such as municipal waste collection can be contracted out (easier to design the right cost and quality incentives). While this is a case for owning versus contracting, even in a contracting situation, it is possible to address the incompleteness issue. For instance, in a commercial loan contract, since it is impossible for a lender to observe and measure all aspects of the borrower’s effort (resulting in an incomplete contract), the contract could be designed such that the borrower retains a great deal of decision-making control as long as its performance is good, but control (property rights) would revert increasingly to lenders as performance deteriorates. This is already in vogue in venture capital.

Decision rights not only provide greater bargaining power to the party but also better incentives to take the right decisions. For us in India, the problems with PPP contracts in infrastructure, as also the issue of public sector disinvestment come to mind. Perhaps we could consider an approach that focuses on these principles of control, decision rights and relevant information that may probably work well for us.

The writer is an independent consultant

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