Of Contractual Obligations

Guest Post by Prof Ram Singh

Contracts are crucial for the functioning of public and private organisations. Employment contracts are used by the government agencies to regulate future activities of its employees.

Private firms are regulated by the government through regulatory contracts. Alender uses debt contract to guard against default by the borrower. An insurance company uses contract to regulate future behaviour of the insuree. This year’s winners of the Nobel Prize in economics, Oliver Hart and Bengt Holmström, have made pioneering contributions to the Contract Theory.

They have contributed to the understanding of contracts and organisations as well as the potential pitfalls of privatisation of provisions of public goods and services. At work, employees perform multiple tasks.

CEOs are expected to maximise current profit for the corporation as well as future values of stocks. The problem is that some of the tasks are harder to monitor and reward than others.

Current profits can be measured with greater accuracy than the future value of stocks. In a 1991paper, Holmström and Paul Milgrom argued that it is better to avoid putting too much emphasis on rewarding measurable outputs.

Otherwise, CEOs will be tempted to maximise current profits at the expense of future value of the stocks. Difficulty in measurement of tasks is not the only obstacle to drawing up of efficient contracts.

In several real-world contexts, it is not possible for the parties to articulate the terms of the contract in detail. For example, to publish newspapers, the Times Group needs access to a printing press.

Imagine a world in which the group decides to publish its papers without owning a printing press. Suppose it enters into a formal contract with a printer. The contract can specify several aspects of the business: per-page printing charges, quality of paper to be used, number of copies, etc. However, it invariably will leave many relevant aspects unspecified.

It may not specify as to what happens if the publisher changed the template of the front page or the count of monthly supplements, etc. The group decides on these matters depending on how the future unfolds in termsof the marketing strategies of the competitors, political turmoil, etc.

So, the future of the printer-publishing relation is unpredictable, making the initial contract incomplete. When contracts are incomplete, renegotiations become inevitable.

The Times Group and the printer will have to renegotiate the contract whenever the former decides to publish an uncontracted-for supplement. Sensing an opportunity to make extra money, the printer may demand an unacceptably high price.

Apprehending this, the group may invest less in the business. But if the Times Group has its own printing press, the group will have the property right to decide who can use the printing press.

The manager of the press will be its employee and cannot hold up publication. In a major breakthrough in the mid-1980s, Hart argued that in high-ly complex contract scenarios, use of property rights to allocate decision rights can serve as an alternative to paying for performance.

If, say, the Times Group has property rights over the printing press, it can increase investment without fearing any hold-up. The cost of such an arrangement is that the printer as an employee may not work as hard as he would have as an independent printer.

Hart has argued that property rights should be allocated keeping in mind the trade-off involved. Yet, another application of the Incomplete Contract theory developed by Hart deals with the provisions of public goods and services like schools, hospitals and prisons.

The theory argues that due to incomplete employment contracts, under the public sector, employees may not have strong incentives to put in efforts for improving quality and cutting the costs of the service.

However, the private sector will have excessive incentives to cut costs at the expense of the quality. In such situations, privation should be avoided. Guided by the pitfalls highlighted by the theory, during the last decade, the US has come down on use of private prisons.

(This article first appeared on The Economic Times on October 12, 2016)

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