Oliver Hart and Bengt Holmström, who won the Nobel Prize in Economics (or to be precise, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) this year for their work on Contract Theory are part of an important line of research in microeconomics that has patiently tried to open up the black-box of how the economic institutions that underpin that grand abstraction called the “invisible hand of the market” actually works. The specific economic institution they focus on are contracts.
Most economic transactions are not spot trades like buying an apple from the fruit-seller. Most of the time what is traded is money with a promise to deliver something. Think of getting a loan. You get the money while the lender only gets a promise of a certain schedule of repayment. As a result, a mechanism is needed to ensure promises are kept. That is what contracts are: They are the glue that connects exchanges of goods and services that are separated over time by making promises credible. They govern all economic relationships ranging from those between banks and borrowers, firms and investors, employers and employees, insurance companies and clients, and landlords and tenants.
Contracts require a method of verification whether the parties complied its terms, and a legal system that would impose penalties if they did not. For example, a landlord can claim the tenant did not pay the rent when he did, and similarly, a tenant can claim he paid the rent when he didn’t. The more complex the transaction, the harder it is to measure all aspects of performance or compliance, and harder even to get an external third-party to ensure compliance in the event of a dispute.
Contract Theory starts with the premise that a perfect contract is not feasible. It provides a theory of understanding contract design in a second-best world, where some efficiency has to be sacrificed whichever contract is chosen. For example, should a lender choose an equity contract or a debt contract with a borrower? Should a landlord choose a fixed rent contract or a sharecropping contract or a wage contract with a cultivator? Should a franchise agreement go for revenue or profit sharing or should it use a fixed fee?
It turns out that these seemingly disparate examples share a common structure that suggests what factors will govern contract choice. The greater is the stake of a contracting party, the higher is the initiative. If a cultivator has to pay a fixed rent to the landlord independent of how good the crops are, his stakes are high. However, there is a cost of having a high stake — greater exposure to risk. That is why sharecropping can dominate fixed rent and similarly, equity contracts can dominate debt contracts. Early work in Contract Theory, with independent contributions by Mr Holmström, Mr Hart (jointly with Sanford Grossman) and others, such as Steven Shavell, identified this trade-off between risk-exposure and incentives as a key factor played in contract choice.
Another key factor in contract choice identified by Mr Holmström in his joint work with Paul Milgrom is the potentially distortive role of high-powered incentives in any one dimension of performance. In most situations, individuals have to perform a number of tasks whose outcomes are not equally easy to measure. Giving high-powered incentives on the more easily measurable dimensions might undermine overall productivity by inducing a person to neglect other dimensions of performance. For example, fixed rent contracts may induce tenants to put too much effort to maximise current yields and not pay enough attention to preservation of soil quality. Private provision of health care or education may lead to too much focus on cost-cutting given the direct incentives in terms of boosting profits, at the expense of quality of the service, which is harder to measure or stipulate in a contract.
Contracts are not just subject to problems of measurement and enforcement, they are also by their very nature, incomplete. If contracting was costless and complete, all economic activity could be organised by the appropriate contract and each individual would be able to organise their economic lives through a nexus of contracts. In this world, owning an asset (such as land) or renting it makes no difference, since a contract would exactly stipulate the rights of the lease and lessor in all eventualities. However, if contracts are costly and incomplete, then some economic decisions would be discretionary. This is where the role of authority would come up, namely, who calls the shots. Mr Hart, along with his co-authors Sanford Grossman and John Moore started with a simple insight, namely, ownership of assets gives decision-making power to the owner and thereby enhances his incentives. At the same time, it reduces the authority of those who work for the owner, as opposed to deal with him at arm’s length as an independent contractor, and thereby diminishes their incentives.
This trade-off provides a theory of the boundaries of the firm, or the degree of vertical integration. This is known as the property rights theory of the firm, in which Mr Hart and his collaborators develop and extend the insights of Nobel Laureates Ronald Coase, who won the prize a quarter century ago, and Oliver Williamson who won the prize in 2009. What should a firm produce in-house versus what should it procure from outside suppliers relying on contracts? The reason firms exist is they can replace by hierarchy what contracts achieve on a more horizontal basis. This cuts down on contracting costs and the risk of being held up by a supplier. At the same time, the employee who produces the relevant part in-house, has lower incentives than an outside supplier since the owner exercises control over him. This puts a limit on the size of the firm. An empirical implication of this theory is reductions in contracting costs (say, due to improvements in information technology) would lead to less vertical integration in firms.
Contract Theory helps us understand the hidden wiring that contracts provide in a market economy to connect economic agents. In the absence of contracts, self-interested individual behaviour, rather than providing the harmonious outcome that Smith postulated, would lead to opportunism and breakdown of cooperation. With their imperfect legal systems and rampant political interference in the economic domain, developing countries illustrate this possibility quite vividly.
The writer is professor of economics at the London School of Economics
Published with permission from Ideas For India (www.ideasforindia.in), an economics and policy portal