Clause theory

The exertions of Hart and Holmstrom have elevated the understanding of real-life contracts

For all the abstraction that characterises the microeconomic theories formulated by Oliver Hart and Bengt Holmstrom, the winners of this year’s Nobel prize in economics, their work in the area of ‘contract theory’ touches numerous lives in everyday situations. Virtually everything from the terms of employer-employee relationships to customers’ engagement with banks, credit card companies, insurers and an assortment of service providers is governed by the terms of contracts. Likewise, companies’ relationships with vendors and others on the supply chain, and the considerations that they must weigh when going in for mergers and acquisitions are underwritten by iron-clad contractual arrangements. In many ways, contracts are the lubricants that grease the tracks of the market economy: drafted wisely, they can apportion risks and rewards among the parties to the contract in a fair manner. More importantly, they can optimise efficiency of transactions, and shape outcomes for the better.

And, yet, as the work of Hart and Holmstrom — independently and collaboratively — over the decades has established, it is virtually impossible for contracts to cover for every conceivable contingency that real-life situations may throw up. In some situations — for instance, in the context of providing matching incentives in the workplace — the lack of precision in measuring employee performance may serve as an obstacle to drawing up efficient contracts. Holmstrom’s ‘multi-tasking model’ also demonstrated, for instance, that if a manager’s performance-pay places an excessive emphasis on short-term cash flow, his actions may wilfully or otherwise work against the company’s long-term interests. In other cases too, parties may be unable to articulate detailed contract terms in advance. Hart’s work provided a template for such situations: a contract that cannot explicitly specify what the parties should do in future eventualities must instead specify who has the right to decide what to do when the parties cannot agree. In these and other ways, the exertions of both Hart and Holmstrom have elevated the understanding of real-life contracts and helped institutions and individuals avoid potential pitfalls when designing contracts.

The same theory of ‘’incomplete contracts” has applications in the realm of public policy, which may hold lessons for the Centre too as it seeks to find the right mix between the public sector (which emphasises collective ‘social good’) and the private sector (which lays claims to greater efficiency). It is easy to argue, for instance, that government has no business to be running airlines or hotels, but what about public services and facilities such as schools, hospitals — or even prisons, which Hart and his collaborators specifically considered? Their conclusion: the desirability of privatisation depends on the trade-off between cost reduction and quality.

Published on October 13, 2016
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