Contract Theory

In economics, the theory of the contract or contracts, studies how economic actors can and should build contractual arrangements, generally in the presence of asymmetric information. Because of his connections with both the theory of agency or agency problem and with incentives, contract theory provides us with a means to explain the different forms and designs of contracts and to improve its production (the objectives).

contractENG

Among its most important applications is the design of optimal schemes of compensation to management and general management: How managers of large enterprises are paid to ensure the interests of shareholders and not to maximize their personal benefits.

Contracts for insurance, a loan, or a job are signed. The foundation of many institutions is in contracts who governing property rights, marriage or the constitution of a country.

In the field of economics, the first formal treatment of this subject was given by Kenneth Arrow in the 1960s.

Theory of contracts has again highlighted by the recent Nobel Prize in Economics this year 2016 which was awarded last October 10 Oliver Hart and Bengt Holmström, for their contributions to the theory.

Thanks to the work of Oliver Hart and Bengt Holmström, we now have better tools to analyze contracts not only in financial terms but also the contractual allocation of control rights, property rights and decision rights between the parties.

“Win to win”

A contract establishes the risks and incentives that assume the signatories and is to regulate future actions. Holstrom work established as a principle in the preparation of contracts that: “It is to think of all parties to a contract to be a situation in which everyone wins.

Asymmetric information

There is asymmetric information in a contract or in a market when one of the parties involved in a transaction (sale, loan, services, etc.) does not have the same information as the other about the product, service or asset the transaction or market developments, risks, or any other information relating to the creditworthiness of the parties, customers, competition, the use of products / services / assets, etc.

In the case of a Perfect competition market asymmetric information is a breach of the theory of prices and leads to a market failure, which is an inefficient economic result.

In 2001 economists, Joseph Stiglitz, George Akerlof and Michael Spence, received the Nobel Prize in economics for his analyzes of markets with asymmetric information.

Decision rights

The main idea is that a contract does not expressly specify what the parties should do in future eventualities, you must specify who has the right to decide what to do when the parties do not agree.

In complex contracts, allocation of decision rights therefore becomes an alternative to paying for performance.

Property rights and control

The basic concept of a property right is relatively simple: a property entitles the owner of an asset to the use and benefits (yields) of the asset and the right to exclude others from them. Also, generally gives the owner the freedom to transfer these rights to others. Roman law referred to these as usus (the right to use), abusus (the right to tax or transfer), and fructus (the right to the fruits). See the concept of “Usufruct“)

Incomplete contracts

As opposed to the concept of complete contract (a contract that specifies the legal consequences for all contingencies that may arise), is described as incomplete any contract in which due to the complexity of the transaction, or the uncertainty of the context in which it it is performed, or the practical limits of human rationality to foresee all eventualities that may arise, or even due to the imprecision of natural language in which it is drafted, contains shaded areas; a contract that leaves no loose ends or gaps (unregulated aspects), under which any party can take advantage of circumstances.

It understood the background is not difficult to understand the result: conflicting incentives between the contracting parties. And they generate a voltage, which encourages strategic behavior: each party will seek to create barriers or situations that promote and improve their negotiating position.

Economic theory of incomplete contracts.

The paradigm of Incomplete contracts was initiated by Sanford J. Grossman, Oliver D. Hart and John H. Moore who argue that, at the time of hiring, future contingencies can’t be described in full and on the other hand, the parties they can not commit to no longer participate in the renegotiation later if they are mutually beneficial. Therefore, an immediate consequence of incomplete contracting approach is the so-called problem of captivity (hold-up problem).

The problem of captivity is a situation in which the two parties may be able to work more efficiently through cooperation, but refrain from doing so because of concerns that may give the other party more bargaining power, and thereby reduce their own profits.

Oliver Hart and his co-authors argue that the hold-up problem can be mitigated by ex ante structure suitable property choice.

Another application of the theory of incomplete contracts refers to the division between the public and private sectors. Should be owned (and management) public or private providers of public services such as schools, hospitals and prisons, or not? According to the theory, this depends on the nature of the non contractile investments (so-called residual control rights, i.e. the right to determine the use of assets in circumstances that are not specified in the contract).

Moral hazard

Moral hazard is an economic concept that describes those situations where an individual has private information about the consequences of their own actions and yet are others who bear the consequences of the risks assumed. Moral hazard informs us how individuals take greater risks in their decisions when the possible negative consequences of their actions are not taken by them, but by a third party. So incentives to strive or be responsible are distorted. Moral hazard reduces the ability of the market to efficiently allocate risk.

Adverse selection

In models of adverse selection, at the time of the contract there is not available information about a particular feature of the agent. The feature is called “type” of agent, for example, the health status of the agent in an insurance contract or life insurance.

Adverse selection, adverse selection or negative selection is a term used in economics, describing those prior to the signing of a contract situations in which one of the contracting parties, which is less informed, is not able to distinguish good or bad quality of what is offered by the other party. There are, however, means trying to avoid this outcome as signaling some method of products or customers good quality, such as passing laws to prevent opportunism, scrutiny, independent comparisons and standards and certifications quality.

Due to the existence of asymmetric information market eject good quality agents and remain only it’s of poor quality. It is an updated version of Gresham’s Law, formulated and applied in England in the late nineteenth century to explain how the adulteration of the composition in gold coins that were rejected generated by the public version. Since the public could not distinguish between all pence which was adulterated he rejected them all. It is as bad money drives out good.

 

If you want to know a little bit more …

 

Holmström, B. (2013) Open Markets http://openmarkets.cmegroup.com/6987/why-bengt-holmstrom-is-an-economist-you-should-know

Hart, O. D. y Moore, J. (1990) Property Rights and the Nature of the Firm. Journal of Political Economy. 98: 1119–58.

Schmitz, Patrick W. (2001). “The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory”. Bulletin of Economic Research. 53 (1): 1–17.

Coase, R. H. (1937). “The Nature of the Firm”. Economica. 4 (16): 386–405.

Maskin, Eric; Tirole, Jean (1999). “Unforeseen Contingencies and Incomplete Contracts”. The Review of Economic Studies. 66 (1): 83–114.

Hart, O. y Moore, J. (1999). “Foundations of Incomplete Contracts”. The Review of Economic Studies. 66 (1): 115–138.

Tirole, J. (1999). “Incomplete Contracts: Where do We Stand?”. Econometrica. 67 (4): 741–781.

Hart, O. y Moore, J. (2008). “Contracts as Reference Points”. Quarterly Journal of Economics. 123: 1–48.

Akerlof,  George A. (1970) “The Market for Lemons:  Quality Uncertainty and The Market Mechanism”.  Quarterly Journal of Economics.

http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf

Ayres, I. & Gertner, R. (2003) Cubriendo vacíos en contratos incompletos: Una teoría económica sobre reglas supletorias. Themis. Revista de derecho n. 47. 2003

http://revistas.pucp.edu.pe/index.php/themis/article/view/9864

Bester, H. (2004) Externalities and the Allocation of Decision Rights in the Theory of the Firm. Free University Berlin, Department of Economics.

http://www.sfbtr15.de/uploads/media/23.pdf

Hart, O.D. (1996) Firms, contracts and financial structure. Revista de Economía Aplicada E Número 10 (vol. IV), 1996, págs. 199 a 204 (original Oxford, Clarendon Press, 1995) [Valentín Azofra, Universidad de Valladolid]

http://www.revecap.com/revista/numeros/10/pdf/azofra.pdf

https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular-economicsciences2016.pdf

http://ocw.mit.edu/courses/economics/14-03-microeconomic-theory-and-public-policy-fall-2010/lecture-notes/MIT14_03F10_lec17.pdf