Contract theories you should know

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Author: Dr Sara Cullen

In November 2016, the Nobel Economics prize was awarded to Professors Oliver Hart (Harvard) and Bengt Holmström (MIT) for their contributions to contract theory. They analysed the optimal construction of contracts ranging from employment contracts, to those between shareholders and executive management, to insurance contracts, and related to public authorities. They covered many issues in contractual design – like performance pay, insurance deductibles and co-pays, and the privatisation of public-sector activities such as schools and prisons.

For those of us researching and working in this area, it was cause for celebration. It was recognition of the deep intellectual rigor, the importance of contract theory to the workings of our society, and the complexity of designing contracts to drive the desired behaviours.

I was teaching contract management to a class of mid-level managers when the announcement was made. My squeals of glee were not echoed by the group.

“What’s contract theory?” asked one participant.” My reply, “There are many, actually.” Then in poured in. “Which ones are the important ones?”, “How are they useful?”, “What theories should I know?”

As I started addressing these queries, the class continued to ask truly insightful questions. I realised these career professionals who worked with contracts know little about the vast body of academic work and the fundamental theories that explain why we do what we do. Most of all, they were hungry for deeper knowledge.

So in celebration of contract theory, and our esteemed Nobel Prize winners, in this article I will do my best to highlight many of key theories.

Let’s start with the theory underpinning why we have contracts in the first place.

Agency theory emerged in the 1970s. At its core, the theory states that parties will act in their own self-interest. Put simply, the provider (agent) will act in a manner that increases margin and/or revenue; the buyer (principal) will take advantage of opportunities to minimise costs. This leads to the problem of moral hazard whereby one party maximises its own interests to the detriment of others. It is this concept of moral hazard as to why the Australian Consumer Law has been applied to small businesses as of 12 November 2016 to protect against unfair contract terms issued by principals in their standard form contracts.

Moral hazard is exacerbated when there is hidden information, or information disparity – when one party knows something the other doesn’t. For example, a head contractor might bid in a subcontractor to make a tender response more attractive, but doesn’t intend to actually use them. This is why contracts often address the parties’ responsibilities and what they can and cannot do (e.g. the use and substitution of subcontractors, to go back to the example). Agency theory assumes a complete contract can be written, which Hart and colleagues argued against beginning in 1986. This actually divided the schools of contract theory into two camps – those supporting the theory of complete contracts and those who do not.

For those wanting to write complete contracts, another economic theory comes into play – that of transaction cost economics (TCE). Two Nobel Economics prizes have been awarded in this space to Ronald Coase in 1991 and Oliver E. Williamson in 2009.

Basically, TCE concerns itself with the total cost of contract, rather than just the ‘sticker price’. It is comprised of the cost of: (1) finding a supplier (search and information costs), (2) negotiating with it (bargaining costs), and (3) managing the contract (policing and enforcement costs). To make a sound decision, these must be included in the business case -not just the price on offer.

We’ve seen procurement focus heavily on reducing the principal’s first TCE through e-tenders and templates, and legal on reducing the second TCE with standard form contracts. However, these have led to cumbersome bidding processes and one-sided, opaque template contracts. So much so that the cost savings may be eroded due to the provider’s TCE. The Local Government Association of SA estimated that its 68 councils spend $4 million per year in tendering and the providers spend $20 million to respond for high value goods (plant, trucks, IT, vehicles, etc.) alone.[1]

But these are hidden transaction costs. Providers’ bidding costs are paid for by buyers, but are hidden in the price. The buyer’s cost to tender and negotiate is hidden divisional costs rather than attributed to each transaction. And the third TCE, that of contract management is notoriously minimised to the extent it reflects only the most basic administration rather than an investment in ensuring the benefits have been achieved, risks minimized, and costs controlled.

The obvious point of knowing TCE is to minimise transaction costs that don’t have a return on investment. This leads to another stream of contract theory, taking in Hart’s work in the theory of incomplete contracts. This argues that a contract cannot specify the action required for every possible contingency because such unforseen events are rarely identifiable at the time a contract is formed. Trying to write, and then properly manage, a complete contract is unlikely to yield a return given the uncertainty of future events at the time of signing. This was put forward by Hart and colleagues beginning in the late 1980’s and has more relevance today than ever given the uncertain times in which we live. Under this body of work is the differentiation between perfunctory performance (letter of the contract) and consummate performance (within the spirit of the contract). The former can be enforced in court, the latter possibly not. Yet the latter is crucial to having flexible contracts that deal with uncertainty.

Rather than fixating on a complete contract, relational contract theory suggests that priority should be given to the business relations, secondary attention to the economic deal, and the contract should be relegated to a peripheral role. The role of the contract is to act as a device for facilitating economic exchange and giving the possibility of legal sanctions in the event of breach. Inevitably, however, the behavioural norms exhibited outside the particular legal form of contract influence the court just as much (through estoppel).

Behaviours are influenced by the written contract, but are influenced more by the psychological contract, which my colleagues and I at the University of Melbourne are currently focused on. The psychological contract represents the mental beliefs and expectations individuals have on the obligations formed within a relationship – the spirit of the agreement. Like the written contract, the psychological contract can be breached. When this occurs, it creates conflict and breaks down trust. This leads to us back to a higher than normal TCE and acting in self-interest (agency theory).  These are some of the core theories. There are many more facets of contract theory such as game theory (choices regarding getting a payoff from an action), hold-up (creating a situation where one party gains a later advantage over the other), and mechanism design (designing incentives to achieve objectives[2]), to name just a few.

Knowing these theories is important. Most people spend their entire professional lives learning the hard way – through experience and the accompanying mistakes and successes. But no one can achieve mastery through personal experience alone. And it takes a lifetime to learn just a few things.

It is far swifter to understand the rich knowledge that is already in place. Nearly everything we experience about contracting in our professional lives has been researched and reported upon well before we stumbled upon it.

In our now ‘alternative fact’ world, evidence-based management is more critical to good decision-making than it ever has been. Nobel Prize winning research is a good place to start this journey.

Dr. Sara Cullen is the Founder and Managing Director of The Cullen Group. She is a Fellow at the University of Melbourne and an Associate at the London School of Economics. Most recently, Sara has been elected to the inaugural ANZ Board of IACCM (International Association for Contract and Commercial Management). 

  • This article was sponsored by Open Windows, a leader in Contract Management Software for Australian organisations www.openwindows.com.au

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[1] “Is Tendering A Waste of Money?It Can Be …” https://www.lga.sa.gov.au/webdata/resources/files/LGAP%20-%20Is%20Tendering%20a%20Waste%20of%20Money.pdf

[2] The 2007Nobel Economics Prize was awarded for laying the foundations of mechanism design theory to Leonid Hurwicz, Eric Maskin, and Roger Myerson.

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