Contract theory in institutional economics: the essence, basic principles

The theory of contracts appeared in the 1970s. It was then that world- famous economists began to search for new incentives for effective work in a free market.

The contract theory, which was not widely known to the general public, attracted the attention of the whole world after researchers Oliver Hart and Bengt Holmstrom, who researched it, received the Nobel Prize in economics for 2016. This hypothesis has seriously affected numerous adjacent areas. Its influence has spread to the modern political economy and the theory of corporate finance.

The Essence

The theory of contracts is used to determine the correct remuneration of subordinates. Its application is universal. The theory is equally suitable for enterprises with simple workers with piece or fixed payment and cases with high-paying positions of top managers or different corporate managers (but the scheme of their remuneration is an order of magnitude more complicated). With the help of methods formulated by scientists and leading economists of the world, it is possible to determine the method of payment most suitable for both parties. They suggest the right choice between bonuses in the form of cash, company shares or options for the right to purchase them.

The fundamentals of contract theory can be useful in the field of regulation economics. For research in this area, the Nobel Prize in 2014 was awarded to Jean Tyrol. Another important area of application is corporate governance and corporate finance. For their study resort to the use of agency models.

Also, the theory of contracts adjoins the theory of auctions. These areas of the information economy are quite similar and have many similarities. Today, leading economists are engaged in developing leading auctions. In their work they use the methods worked out, including the theory of contracts. A properly prepared auction brings profit by an order of magnitude greater than a similar event, if it is organized through sleeves.

Conflicts at work

The key principles of contract theory, models and tasks of this discipline are reduced to the construction of abstractions, for example, the "subordinate-superior" or "agent-principal" models. There are two faces in it. Both have their own preferences and interests. Contract theory considers situations in which conflicts between the boss and subordinates arise due to their different goals and tasks.

A dispute does not mean that one side wants to harm another. It has space for both contradictions and cooperation. The main aspects of the theory of contracts affect situations like the one when the boss wants his subordinate to work harder, and his salary does not increase at the same time. The employee desires are directly opposite. In this scenario, the boss has a dilemma: what incentives to give a subordinate for his action in the interests of the employer? The essence of the theory of contracts is reduced to analyzing and providing options for solving such contradictions.

Basic principles of the theory

One solution for the boss may be the option when he sells his project to a subordinate, thereby organizing a new franchise. The buyer pays a certain amount and becomes a beneficiary, starting from that moment to receive all the costs and benefits. This solution looks elegant and effective in theory. However, it has flaws, including conceptual ones. This situation leads to the fact that the manager is insured against possible risks, and the subordinate, on the contrary, takes them all on himself.

Therefore, such a decision can not work. And the whole point is that the ability to take risks is typical for the bosses, not for the subordinates. The theory of contracts, briefly, is devoted to just such a relationship. Working in its framework, scientists and thinkers at different times considered several abstract solutions in a situation of conflict of interest.

It will not be a way out of the impasse and control over the efforts of the subordinate. In this case, the chief would force and force him to do only what corresponds to the employer's own interests. An example of such relations can be the centuries-old history of the economy under the exploitative system. In reality, modern subordinates often act only on their own, which has a significant impact on the result.

Factors of compensation

One of the theorems offered by contract theory in institutional economics is the theorem of sufficient statistics. It belongs to the already mentioned Nobel laureate Bengt Holmström. This theorem proposes a solution to the conflict within the "boss-subordinate" model. What is it? Holmström considered and analyzed in detail the situation in which the chief measures indicators that inform him about the results of the activities of the subordinate. It is from them that the supposed reward or even punishment depends.

Holmström came to the conclusion that the boss should stop taking into account the factors that are not in the power of his subordinate. The decisions taken in the opposite case create unnecessary risk and only hinder the stimulation of the employee's actions. At the same time, the head must be guided by all other information available to him about the effectiveness of the subordinate's efforts.

Simplified incentives

Many situations do not fit into the classical model. An example of this can be the case when the subordinate is assigned several tasks at once, and he needs to apply a variety of efforts. For example, a worker takes care of the machine, takes care of its safety, pours oil there and at the same time sharpens some details on it. Even if payment for such work is piece-work, it can lead to some problems. The basic principles of the economic theory of contracts are built on the desire to avoid such a development of events. An example of a wrong decision is a simple and powerful stimulus that will inspire the worker to work hard and at the same time make him forget about his additional duties (attentive attitude towards the machine that will break if you do not care about it).

Multidimensional efforts are always fraught with risks for the manager. The incentive scheme created for such a case must take into account all the individual peculiarities of the situation. Simplification is what the theory of contracts is struggling with. Briefly it can be described in the example of a teacher. If from the teacher at the school to demand certain results of the Unified State Examination, he will "catch up" the children with the result, forgetting about the most important thing - actually, about knowledge. Even hardened professionals can fall into such a trap if they are given incorrect, perverse incentives. Their students eventually will not receive key skills, including not being accustomed to think critically and independently understand the subject.

Another example of conflict is the draft of a whole team in which the powers and responsibilities of employees are unclear. He implies that the chief can not evaluate the individual contribution to the result of each of his subordinates. It is precisely these collisions that economists study whose studies are concerned with contract theory. Ways of settling conflicts are what these specialists are looking for. They seek to find a point at which the interests of both the boss and the subordinate intersect.

Deferred contract

At performance of some kinds of work the mechanism of reputation plays very important role. In particular, he was studied by Hart and Holmström. The theory of contracts in such situations studies relative contracts. They arise when the subordinate and the boss work together for quite some time. The more experience of effective interaction, the more they will appreciate their cooperation. There is trust. In this case, there is less chance that people will act according to their own interests only, but will proceed from the necessity of mutual benefit. For example, the boss will be generous with bonuses, and the subordinate will not be afraid of a risky initiative.

Particularly important is the reputation factor, when there is no objective assessment of the results of the work. It can be a picture of an artist or another object of creative work. In such situations, there is often no third party who could resolve the dispute. Determine that the picture is worthy, can only the customer, proceeding from his, perhaps, no one understands the notion of art. Court is powerless here, but the theory of contracts can help. In institutional economics, reputation mechanisms are studied from a variety of sources.

Incomplete contract

Among other things, the contract theory of 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 of the process will conduct negotiations already in the course of the work. Such discussions allow solving new problems and challenges that have arisen in the subordinate and the boss. They fill the gaps that eventually inevitably appear in the very first contract.

Further important parts are played. Who has the power to make decisions and influence negotiations? How much are the parties interested in continuing cooperation, despite the problems that have arisen? All this is the subject of the contract theory of Oliver Hart. It influenced many related disciplines. Hart's ideas touched on the theory of corporate finance and the theory of organizations. The solutions offered by him are used by many businessmen and businessmen. The theory of the scientist has long served investors and planners of capital of public companies. With its help determine the course of the bankruptcy proceedings of ruined businessmen and enterprises.

The theory of incomplete contracts has found application in disputes about the economic distribution between the public and private sectors. This discussion concerns the fate of organizations providing treatment and education services. Should they be public or remain part of the free market? The theory of incomplete contracts in this case affects the same motivation of subordinates. For example, if a manager hires a state, then he has less incentive to invest, since the state may not at all reward its efforts under its own monopoly. In a competitive market with many private companies, everything is completely different. In such circumstances, each employer seeks to introduce something new in their production or service provision to overtake opponents. Therefore, companies will reward managers for their initiative and innovations, which will necessarily become part of the contract.

Incentives and psychology

Together with contract theory, since the 1980s, the behavioral economy has developed. It examines the behavior of people, influencing the decision-making and motivation of employees. All this is directly related to the theory of contracts. Many ideas that formed its basic postulates are derived from the behavioral economy.

An example of such borrowing is the thesis that people are motivated not so much by rewards of a material nature as by a sense of the public good of their work, justice, etc. Nobel Prize in Economics (2016) was awarded for research in this field. The theory of contracts has been especially active in this direction in the past 10-15 years. During this period, a lot of serious work appeared, containing an analysis of the internal motivation of subordinates based on relationships with others. These considerations are superimposed on the classic established models of contract theory, which poses new open questions to science that require a response.

Through the theory of contracts in economics, the concepts of social norms and identity are introduced. In them, the elements of sociology and psychology are traced. Because of this, specialists in various scientific fields work with contract theory. They offer alternative methods of motivating subordinates, focusing on the sense of their identity and belonging (for example, to a certain social group).

Salary and productivity

In 1979, Bengt Holmström in one of his publications formulated one of the principles of an optimal contract. Ideally, he must link pay to the result of the work of a subordinate. For example, if the company manager is responsible for the stock price, then his salary will be lowered if this rate falls. However, financial losses have a chance to happen and not through the agent's fault. External circumstances may interfere (for example, market conditions). The theory of contracts offers different solutions to this contradiction. For example, the salary of the above-described manager can also be determined according to the earnings of competing companies. If the shares grow for outside reasons, affecting the entire industry, then there is no merit of the agent, and then there simply is not anything to encourage him.

The relationship between subordinate performance and company performance is often distorted by a variety of factors. The more such circumstances, the less the manager's earnings should depend on the firm's performance. Separately, the theory of contracts deals with high-risk areas. This may be a new area for investment. The more the subordinate is involved in this zone, the better it is to make his salary fixed. In this case, with fluctuations (regardless of their positivity or negativity), the probability of a conflict between the employee and the employer is significantly reduced.

Balanced incentives

Motivation of an employee can be not only high wages, but also the prospect of career growth. The authors of the theory of contracts examined in detail the interaction of these two intertwining factors. In a competitive market, the company must offer employees a high salary, otherwise they will go to competitors. There are some distortions in this system. For example, there is a threat that the new cadres will work too hard, while specialists on the top steps of the career ladder, on the contrary, will begin to shirk their duties, as their requests are already generally satisfied.

In this context, the fixed wage model has its advantages. We have already cited the example of a teacher, from which high results of students are required in examinations. Such expectations lead to a skew and focus on certain subjects or tasks. If the salary is fixed, regardless of the performance indicators, the distribution of effort between tasks will be balanced.

Features of the theory

The close direction of contract theory is the information economy. Studies in these areas have been conducted from a very recent time. Only a few decades ago, even the most serious and eminent economists paid no attention to people's response to different incentives and to creating these incentives for behavior that was optimal for achieving a certain goal. Interest in such phenomena increased in the 1970s.

The first economic incentives began to study James Mirrlees and William Vickrey. These specialists influenced the formation of the theory of optimal taxation, with which the theory of contracts is closely related. Mirlis and Vikri's books were supplemented with the works of such eminent scientists 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 Holmström also refer to this galaxy of explorers.

Complete lemmas and theorems contract theory 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. Conclusions, which makes the theory of contracts, are widely used in practice. It weighs pros and cons in many controversial issues. An example of the application of the theory can serve as a dispute about the fairness of high salaries of top managers of Russian and foreign companies. Is it not for nothing that these employees receive such considerable rewards for their work? The theory of contracts in simple words can answer this question, since in its arsenal there are numerous economic arguments.