Nobel Contract Theory: Opening Up Of The ‘Black Box’ Of Market Economy

The invisible hand of the market, described in Adam Smith’s The Wealth of Nations, is supposed to harness the pursuit of self-interest by millions of atomistic individuals to efficient outcomes. The trouble is, the hand of the market may well be invisible to economic actors, as Smith visualised, but it was also largely invisible to mainstream economists until recently.

It was more of a divine force that only the faithful can feel with their heart, as opposed to an economic institution whose inner workings can be theorised about, and subjected to empirical tests. This gave the discipline an aura of abstract theorising at best, and an ideological dogma at worst, in sharp contrast with its self-image of being a science, albeit a ‘social’ as opposed to a ‘natural’ one.

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 work. The specific economic institution they focus on is contracts.

Classical economists from Smith to Marx accorded a central position to the economic institutions that underlie a market economy. Smith talked about the importance of property rights, and Marx of relations of production. However, until recently mainstream economics took a somewhat ahistorical and institution-free view of the economy. The basic supply-demand model of economics invokes the image of an exchange economy, not much different from a village fair, where individuals decide on what and how much to buy and sell in their capacity as consumers and producers in response to prices.

Even though most examples involve apples being exchanged with oranges, Nobel laureates Kenneth Arrow and Gerard Debreu extended the complexity of the kind of goods and services that can be traded considerably. Still, in the end it is assumed that there is some institutional mechanism that enforces the trades without any friction. In particular, there is no problem of opportunism – once you ‘buy’ something, you don’t have to worry about the delivery of the good in time or of shoddy quality, and similarly, if you ‘sell’ something, you don’t worry about getting paid. If you ‘buy’ inputs to produce a good, such as labour or raw material, you don’t worry about these suppliers not showing up on time, messing around with the specification, or doing a poor job.

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 Holmström, 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 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 healthcare 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 were 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. Oliver 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 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.

This theory does not apply only to private firms but has important implications on the choice between contracting out versus producing in-house, that governments face. For example, in one of his papers published two decades ago, Hart and his co-authors showed that some public services, like running of prisons, should not be privatised because a private contract or might sacrifice important but hard to measure social objectives (example, how prisoners are treated) to increase their profits. Even if it took time, recent reports suggest that the US government has finally accepted this basic logic and decided to discontinue the use of private prisons.

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.

This piece originally appeared on Ideas for India and has been republished here with permission.