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Context: Economy today has become one of the most complex system all around the globe. The world has come a long way from barter trading (although not vanished) to the contemporary complex system of banking and currency including e-wallets and bitcoins. Economy has become one of the fundamental instrument to usher inclusive growth and development in the country. In this ever expanding area, incentivising people or companies or corporates for that matter is the most crucial aspect so as to sustain the system and ensure a positive growth. In this context, the Nobel Memorial Prize in Economic Science awarded to Oliver Hart and Bengt Holmstrom for building the foundations of contract theory find immense significance in the contemporary economic world.
Emergence:
This work in microeconomic theory goes back to the 1970s and 1980s when the foundations of contract theory were being firmed up. The contract theory deals with the right incentives or motivations for different parties to work together effectively.
Concept:
Cutting across the studying of legally binding contracts, the ‘Contract Theory’ broadly studies the the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions. It also guides to structure the arrangements between employers and employees, shareholders and chief executives, and companies and their suppliers.
Relevance: ‘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.
Relevance for India:
Contract Theory finds its relevance both Public and Private sector individually, as well as combined (i.e. Public Private Partnership).?For Ex:?The NPA crisis which has hit not only the Public Sector (Banks) but the corporate sector as well can be dealt with by using the fundaments of ‘Contract Theory’. It can optimise the Recognition, Recapitalization, Resolution, and Reform of the stressed assets and also incentivise ARCs to rejuvenate stressed assets. The theory can be utilised to enhance the viability of several infrastructure projects which are crucial for the development and growth of the nation.?The budding corporate sector and the emerging Indian start Ups can benefit a lot from the lessons of contract theory and be more competent visa vis their global competitors. Moreover, theory of ‘’incomplete contracts” has applications in the realm of public policy, which may hold lessons for the Government 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). ?The theory in this regard indicates that the desirability of privatisation depends on the trade-off between cost reduction and quality. The theory thus has a huge potential in New Public Management as well.
Limitations in ‘Contracts’ and Incentives: While it opens up several lessons to be learnt, yet the theory as proposed by Hart and Holmstrom acknowledges the fact that 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. For example clients might be keen on long-term performance, but if bankers’ pay is tied into the short-term share price, this might generate a conflict of interest. Bankers might work to boost the immediate share price at the cost of long-term investment. In other cases too, parties may be unable to articulate detailed contract terms in advance.
Also, there is a limitation in observing the agent’s effort. If agents are offered a fixed salary regardless of effort, there is not much incentive for hard work. We see this in government jobs. ?Thus, in many industries, including banking, we instead see performance-based pay, where better outcomes for the shareholder (greater returns) are to be rewarded with better compensation for the banker.??In other contexts, the outcome of the efforts of the agent might not be measurable. Teachers, for example, are instrumental in the overall development of students, which is hard to measure. However, scores on tests are easy to measure. A contract that links teachers’ pay to only measurable outcomes might lead to teachers focusing on tests alone, ignoring more general learning.
Similarly, 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.
Conclusion:
Hart and Holmstrom have developed contract theory as a term of art because “relationships (contractual) typically entail conflicts of interest. Therefore contracts must be properly designed to ensure that the parties take mutually beneficial decisions.”? Contracts have governed the workings of the economy since time immemorial. As technology advances and organizations becomes more complex, the theory and practice of contract design will only increase in importance. Hart and Holmstrom’s work lays the foundation for thinking more strategically about how to design contracts for optimal outcomes.
By: Chandan Sharma ProfileResourcesReport error
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