Contract Theory appeared in the 70s. It was then that world- famous economists began to search for new incentives for effective work in a free market.
The theory of contracts, little known to the general public, attracted the attention of the whole world after the scientists who studied it, Oliver Hart and Bengt Holmström, received the 2016 Nobel Prize in Economics. This hypothesis has seriously affected numerous related areas. Its influence has spread to the modern political economy and corporate finance theory.
Essence
The theory of contracts is used to determine the correct remuneration of subordinates. Her application is universal. The theory is equally suitable for enterprises with simple workers with piece-rate or fixed pay, and cases with high-paying positions of top managers or various corporate managers (but the scheme of their remuneration is much more complicated). Using the methods formulated by scientists and leading economists of the world, it is possible to determine the most suitable way of remuneration for both parties. They suggest the right choice between cash bonuses, company shares or options for the right to purchase them.
The basics of contract theory can come in handy in the area of ââregulatory economics. For research in this area, the 2014 Nobel Prize was awarded to Jean Tyrol. Another important area of ââapplication is corporate governance and corporate finance. To study them, resort to the use of agent models.
Also, the theory of contracts is adjacent to the theory of auctions. These areas of the information economy are quite similar and have many common features. Today, leading economists are developing leading auctions. In their work, they use methods developed including the theory of contracts. A properly prepared auction generates profit orders of magnitude greater than a similar event, if it is organized through the sleeves.
Conflicts at Work
The key foundations of contract theory, the models and tasks of this discipline are reduced to the construction of abstractions, for example, the âsubordinate-bossâ or âagent-principalâ models. Two faces collide in it. Both have their own preferences and interests. Contract theory considers situations in which conflicts arise between the boss and the subordinates caused by their different goals and objectives.
An argument does not mean that one side wants to harm the other. It has space for both contradictions and cooperation. The main aspects of the theory of contracts affect situations such as the one when the boss wants his subordinate to work more and his salary does not increase. For a worker, desires are directly opposite. In this situation, the boss has a dilemma: what incentives should be given to his subordinate to act in the interests of the employer? The essence of the theory of contracts is to analyze and provide options for resolving such contradictions.
The basic principles of the theory
One of the solutions for the boss may be when he sells his project to a subordinate, thereby organizing a new franchise. The buyer pays a certain amount and becomes the beneficiary, starting from that moment to receive all the costs and benefits. Such a solution looks elegant and effective in theory. However, he has flaws, including conceptual ones. This situation leads to the fact that the boss is insured against possible risks, and the subordinate, on the contrary, takes all of them upon himself.
Therefore, such a solution cannot work. And the thing is that the ability to take risks is characteristic just for superiors, and not for subordinates. The theory of contracts, in short, is devoted to just such a relationship. Scientists and thinkers working in its framework at different times considered several abstract solutions in a conflict of interest situation.
Nor will control over the efforts of the subordinate become a way out of the impasse. In this case, the boss would force and force him to do only that which corresponds to the employer's own interests. The centuries-old history of the economy under the exploiting system can be an illustration of such relations. In reality, modern subordinates often act only at their discretion, which has a significant impact on the result.
Reward Factors
One of the theorems proposed by contract theory in institutional economics is the theorem of sufficient statistics. It belongs to the already mentioned Nobel Prize winner Bengt Holmström. This theorem offers a solution to the conflict within the boss-subordinate model. What is she like? Holmström examined and examined in detail the situation in which the boss measures indicators that inform him of the results of the subordinate's activities. It is on them that the alleged reward or even punishment depends.
Holmstrom came to the conclusion that the boss needs to stop considering factors that are not in the power of his subordinate. Decisions made in the opposite case create unnecessary risk and only interfere with stimulating the employee's actions. In this case, the boss needs to focus on all other information available to him about the effectiveness of the efforts of the subordinate.
Simplified Incentives
Many situations do not fit into the classical model. An example of this is the case when a subordinate is assigned several tasks at once, and he needs to make a variety of efforts. For example, a worker takes care of the machine, takes care of its safety, adds oil there and at the same time grinds some details on it. Even if the payment for such work will be piece-rate, it can lead to some problems. The basic principles of the economic theory of contracts are based on the desire to avoid such a development of events. An example of a wrong decision is a simple and strong incentive that will inspire an employee to work hard and at the same time make him forget about his additional duties (attention to the machine, which will break if you do not care about it).
Multidimensional efforts are always fraught with additional risks for the boss. An incentive scheme created for such a case should take into account all the individual characteristics of the situation. Simplification is what contract theory fights. Briefly it can be described on the example of a teacher. If the teacher at school requires certain results of the exam, then he will âcatch upâ the children with the result, forgetting about the most important thing - in fact, knowledge. Even seasoned professionals can fall into such a trap if they are given the wrong, perverse incentives. Their students as a result will not receive key skills, including they will not get used to think critically and independently understand the subject.
Another example of a conflict is the project of an entire team, in which the powers and responsibilities of employees are unclear. He implies that the boss cannot evaluate the individual contribution to the result of each of his subordinates. It is precisely such collisions that are studied by economists whose studies deal with contract theory. Conflict resolution techniques are what these professionals are looking for. They seek to find a point at which the interests of both the boss and the subordinate intersect.
Relationship contract
When performing certain types of work, the reputation mechanism plays a very important role. He was specifically studied by Hart and Holmstrom. Contract theory in such situations studies relational contracts. They arise when the subordinate and the boss have been working together for quite some time. The greater the experience of effective interaction, the more they will appreciate their cooperation. There is confidence. In this case, there is less chance that people will act according to their own interests, but will proceed from the need for mutual benefit. For example, the boss will be generous with bonuses, and the subordinate will not be afraid of a risky initiative.
The factor of reputation is especially important when there is no objective assessment of the results of work. It can be a picture of an artist or another object of creative work. In such situations, there is often no third party that can resolve the dispute. Determine that the picture is worthy, can only be the customer, proceeding from their own, perhaps unclear, ideas about art. The court is powerless here, but the theory of contracts can help. In institutional economics, reputation mechanisms are studied from a wide variety of perspectives.
Incomplete contract
Among other things, the theory of contracts by Oliver Hart, for which he received the Nobel Prize, is devoted to the topic of incomplete contracts. Its essence boils down to the thesis that life is too complex and diverse so that the initial contract concluded between the parties could provide for any unforeseen circumstances. That is why the participants in the process will negotiate already in the course of work. Such discussions allow us to solve new problems and challenges that a subordinate and boss have. They fill in the gaps that inevitably appear over time in the very first contract.
Further details play an important role. Who has the rights to make decisions and influence negotiations? How interested are the parties in continuing cooperation, despite the problems encountered? Oliver Hart's theory of contracts is dedicated to all of this. She influenced many related disciplines. Hart's ideas touched on corporate finance theory and organization theory. The solutions proposed by him are used by many entrepreneurs and businessmen. The scientist's theory has long served investors and capital planners of public companies. With its help determine the course of the bankruptcy procedure of bankrupt businessmen and enterprises.
The theory of incomplete contracts has found application in disputes over economic distribution between the public and private sectors. This discussion concerns the fate of organizations providing treatment and education services. Should they be state owned or remain part of the free market? The theory of incomplete contracts in this case affects all the same motivation of subordinates. For example, if the state hires a manager, then he has less incentive to invest, since the state may not reward his efforts at all in the conditions of his own monopoly. In a competitive market with many private companies, everything is completely different. In such conditions, each employer seeks to bring something new to his production or service provision in order to overtake his opponents. Therefore, companies will reward managers for initiative and innovation, which will necessarily become part of the contract.
Incentives and Psychology
Along with the theory of contracts, beginning in the 80s, a behavioral economy developed. In its framework, human behavior is studied that affects decision making and employee motivation. All this is directly related to the theory of contracts. Many of the ideas that shaped its basic tenets are gleaned from behavioral economics.
An example of such borrowing can be called the thesis that people are motivated not so much by material rewards as by a sense of the public good of their cause, justice, etc. The Nobel Prize in Economics was awarded for research in this area (2016). The theory of contracts has been particularly active in this direction over the past 10-15 years. During this period, many serious works appeared containing an analysis of the internal motivation of subordinates, based on relationships with others. These considerations are superimposed on the classic well-established models of contract theory, which poses new open questions for science that need to be answered.
Through the theory of contracts, the concepts of social norms and identity are introduced into economic science. They trace elements of sociology and psychology. Because of this, specialists in various scientific fields work with the theory of contracts. They offer alternative methods of motivating subordinates, the emphasis of which is on the sense of their identity and belonging (for example, to a certain social group).
Salary and Productivity
In 1979, Bengt Holmstrom in one of his publications formulated one of the principles of an optimal contract. Ideally, he should tie wages to the result of the work of a subordinate. For example, if a company manager is responsible for the stock price, then his salary will be lowered if this rate drops. However, financial losses have a chance to happen and not through the fault of the agent. Extraneous circumstances (e.g. market conditions) may interfere. Contract theory offers different solutions to this contradiction. For example, the salary of the manager described above can also be determined according to the earnings of competing companies. If stocks are growing for external reasons affecting the entire industry, then there is no merit of the agent, and then there is simply nothing to promote it.
The relationship between the work of a subordinate and the productivity of a company is often distorted by many factors. The more such circumstances, the less manager's earnings should depend on the performance of the company. Separately, contract theory considers high-risk areas. This may be a new investment area. The stronger the subordinate is involved in this zone, the better it is to make his salary fixed. In this case, with fluctuations (regardless of their positive or negative), the likelihood of a conflict between the employee and the employer is significantly reduced.
Balanced Incentives
The motivation of the employee can be not only high wages, but also the prospect of career growth. The authors of contract theory examined in detail the interaction of these two intertwining factors. In a competitive market, the company must offer employees high wages, otherwise they will go to competitors. This system has its own distortions. For example, there is a threat that new personnel will work too hard, while specialists on the upper steps of the career ladder, on the contrary, will begin to take off from their duties, as their requests are already generally satisfied.
In this context, the fixed salary model has its advantages. We have already given an example of a teacher who is required to have high student results in exams. Such expectations lead to a bias and focus on certain objects or tasks. If the salary is fixed, regardless of performance indicators, the distribution of efforts between tasks will become balanced.
Theory features
A close area of ââcontract theory is information economics. Research in these areas has been under way since very recently. Even a few decades ago, even the most serious and eminent economists did not pay attention to people's reactions to various incentives and to the creation of these incentives for behavior that is optimal for achieving a certain goal. Interest in such phenomena increased in the 70s.
The first economic incentives began to study James Mirrlis and William Vickrey. These specialists influenced the formation of the theory of optimal taxation, with which the theory of contracts is closely related. The books of Mirrlis and Vickrey were supplemented by the works of such eminent scholars as Jean Tyrol, Eric Maskin, Jean-Jacques Laffon, Roger Myerson. Many of them were awarded the Nobel Prize in economics. The aforementioned Oliver Hart and Bengt Holmstrom also belong to this galaxy of researchers.
The complete lemma and theorem theory of contracts operates with abstract concepts and in this sense is very close to mathematics. At the same time, the models considered by her are built according to real life motivation. The conclusions of the theory of contracts are widely applied in practice. She weighs the pros and cons of many controversial issues. An example of the application of the theory is a dispute about the fairness of the high salaries of top managers of Russian and foreign companies. Is it not in vain that these employees receive such significant rewards for their work? The theory of contracts in simple words can answer this question, since there are numerous economic arguments in its arsenal.