In our economic life, we can observe that there are always contracts between two parties, where both sides agree on what they will give and get in return. To ensure that there is compliance on both sides, there are systems in place to ensure that there is no violation of the terms.
The classic example that is quoted in contract theory is the principal-agent conundrum which characterises all publicly held companies. The shareholders own the company; and in turn appoint a management (represented by the CEO) through the board of directors that are nominated by them. The management is to act in the best interest of the shareholders and gets compensated in return. As they are incentivised to do the same, which is specified in their contracts, in terms of bonuses and stock options, there is a Pareto optimal situation created where everyone should be better off. If the shareholders are to do well, then the company must perform and if both happen, the management benefits monetarily.
At a more basic level, the employee is rewarded with a salary by the company though the question always is whether one can get more from the person than is specified in the contract. This is why a fixed salary concept is justified as it is not possible for one to evaluate the work done by an individual beyond what is specified at the time of signing the employment contract. Additional incentives have to be provided to derive more value from them by the company, as they would otherwise not be willing to go beyond the terms of the contract. An extension here spoken of by the theory relates to ‘team work’. Interestingly, where there are difficulties in identifying the main contributors as it is not possible to ‘observe’ members in a team, free-riding results, which can demotivate employees. Separate structures have to be drawn up for the same.
Another area addressed by Hart and Holmstrom relates to education. How do we evaluate teachers in a school? Should it be based on scores of the students in examinations or the quality of education imparted? Drawing up such contracts can create perverse incentive to work at achieving the target of getting better scores and ignoring the basic thrust of education and learning. In such a case having a fixed salary may be better though it could lead to loss of interest as one is sure of the paycheck at the end of the month.
The theory on contracts is, hence, very important as it comes into our lives every day where there are both written and unwritten contracts. Making it formal imposes an obligation that can be sorted out through the legal processes if the need arises. But as it involves human beings, there are interesting challenges involved when drawing up such contracts. In insurance for example, there is a formal contract between the insurance company and insured for compensation based on the happening of an event. If companies agree to pay a larger portion of the contract then there will be an incentive for the insured to be reckless if it is a motor insurance or choose a higher-end medical facility unnecessarily for health. Therefore, the contracts have to be drafted carefully to eschew this moral hazard.
The interesting part of such contracts, according to Hart and Holmstrom is that they can never cover all possibilities as there are several unknowns which have to be addressed. The shareholders can hold the management responsible for the sales or profit targets. But they cannot really determine action taken on a day to day basis. At times an acquisition could be necessitated and while shareholders have to be consulted for the same, taking equity stake can be done independently as part of business decision without consulting them. Therefore, the contract also has to be clear about who has the power to decide when there are such questions. Leaving it to the management is efficient as it can definitely not be going back to the shareholders each time. Demarcating these domains will enhance efficient operations.
Contracts are very important in the financial sector as every deal involves an agreement between two parties. A loan is an agreement between a bank and the borrower and a deposit is the agreement signed between the saver and bank. Both of them have the terms specified—what we call the fine print which tries to address all possibilities so that there is no room for interpretation. The same holds when one trades on exchanges in stocks or any other instruments.
An interesting extension to the theory of contracts is in the area of privatisation. When the ownership is public, what should be the goal of the manager? Generally the focus is on cost cutting rather than improvement in quality, which is a basic flaw in the model. Even at the government level, most departments are keen on tick-marking targets set like the number of schools established or hospitals inaugurated, but never address the issue of quality. Quite clearly, in all such contracts, the shareholder (i.e. the tax payers) must have a right to decide the content.
Some of the issues which are still nebulous can be found in the corporate world. The financial crisis was all about such contracts being broken where managers overpaid themselves and when the chips were down withdrew from the system. While jobs were lost, there could be no punitive action against them as they claimed they followed common business rules. This is a case where such contracts fail. Governments also fail in meeting their part of the deal with the electorate, and rarely lose power on this score. Hence, while the contract theory works where there is recourse, when large numbers are involved and there is limited recourse, this theory tends to melt.
Contract theory can also be extended to even more rudimentary situations such as marriage where partners must decide on what they expect from one another. The higher incidence of divorce in the west is a clear case of enforcement of such contracts. Similarly, shifting allegiance to products in the market due to expectations not being realised is a case of reactions to the terms of the contract with the company ‘not being realised’.
Hence, the extrapolation of this theory is enormous, as it covers almost all economic, social and political options; and would hence get more attention after the announcement of the Nobel Prize this year.
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