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Contract Theory: A Modern Framework

December 02, 2016
Oliver Hart of Harvard University and Bengt Holstrom of MIT were awarded the 2016 Nobel Prize in Economics “for their contributions to contract theory. Contract theory is a far reaching, modern field of economic theory with abundant applications in business, finance, social order and public policy. In this article, we will delve specifically into the applications of contract theory to public policy, specifically the privatization of public goods and service and the function of election politics.

(Bengt Holmstrom and Oliver Hart, recipients of the 2016 Nobel Prize for Economic Sciences. Source: <a href="http://www.ibtimes.co.in/oliver-hart-bengt-holmstrom-awarded-2016-nobel-prize-economics-contract-theory-699044" target="_blank">International Business Times</a>) (Bengt Holmstrom and Oliver Hart, recipients of the 2016 Nobel Prize for Economic Sciences. Source: International Business Times

Overview of Contract Theory

Contracts are an integral piece of our society used to alleviate the conflict of interests between agents and principals. Simply put, agents work on behalf of the principal. For example, think of the agent as a CEO on a fixed salary, and the principal as a shareholder. The more profitable the CEO makes the company, the more the shareholder benefits through stock price increases. On the other hand, the CEO must expend valuable resources such as time and effort in order to increase profits. This defines one of the central assumptions of contract theory: the utility of the agent—his general welfare—is inversely related to the amount of work he does. Undoubtedly, the more work the CEO does, the less he will benefit under a fixed salary, which leads to a conflict of interests. For the principal to gain value from the agent’s work, he must provide some incentive which opposes the cost of doing more work.

The cornerstone of contract theory lies in the assertion that the optimal contract maximizes the total benefit of both parties involved. Since the agents control their own amount of effort, they minimize their work to maximize their own utility. This leads to suboptimal principal utility and suboptimal total utility. Without a contract, the agent will slack off and decrease the profit of the principal who employs him. Even with incentive-based compensation, we still run into the principal-agent problem as illustrated below, where maximum points are in red, while the outcome in orange is suboptimal since the agent controls the effort.

As the graph illustrates, conceptually, the process of determining the optimal terms of contract are relatively simple; however, in practice, it becomes difficult since the exact benefit gained by the principal and the exact cost incurred by the agent are not easily measured. Think back to the CEO example. The stock performance of the company doesn’t depend exclusively on the CEO. Performance is subject to many uncontrollable factors, such as competitors’ performance and the overall state of the economy. As a result, a large portion of contract theory is concerned with optimizing incomplete contracts—contracts which are formed without perfect information regarding costs and benefits. The central difference between an incomplete contract and a complete contract is that incomplete contracts do not specify exact terms of agent behavior. Instead, incomplete contracts identify which party will have bargaining power in the event of a conflict. For example, the employment of a CEO is an incomplete contract since it appoints an individual to run the business as he sees fit to increase shareholder value (giving him the bargaining power), rather than delineating exactly how the CEO should behave. To simplify, complete contracts are about what, and incomplete contracts are about who.

Privatization of Public Goods

We can use contract theory to analyze whether a public good should be privatized. A public good is a commodity or service that benefits the public at the cost to only a few entities, which means that most public goods must be operated or regulated by the government. Examples of public goods include public schools, hospitals, prisons, or innovative projects like space exploration and genome mapping. Often, the government enters into contracts with firms to provide public goods on its behalf. These contracts for public goods can be viewed as compensation that incentivizes providers of public goods to bear the cost of benefiting society.

In these contracts, the government is the principal, and the providers of public goods are the agents. In practice, the contracts are incomplete, so their terms determine which party (the government or the provider) has the right to make decisions about how and to what extent the public good should be supplied. The important question is then: for which goods should the government hold the right to make the final call, and for which goods should the private company?

Quality Investment vs. Cost Reduction

The private-public contract parity is defined by a few fundamental parameters. The government is seeking to maximize the utility enjoyed by its citizens, while the private provider is seeking to maximize profit. If public goods are completely privatized, the provider will maximize profit in one of two ways: either improve quality to attract a larger consumer base or cut costs and reduce quality. Improving quality requires a guaranteed investment but has an uncertain benefit of increased profits through price or volume increases. Cost-cutting guarantees short-term profits but has uncertain costs, since the lower quality may not necessarily drive away customers, especially for public goods. This means that the incentive to cut costs is almost always far greater than the incentive to improve quality in the market for public goods. Considering the nature of public goods, this is not surprising. Demand for public goods is relatively inelastic with respect to quality because many public goods, such as education and toll-bridges, are necessities. As a result, consumers will purchase them regardless of quality: Improving quality won’t attract many new customers, and decreasing quality won’t cause many customers to leave. But from the consumer’s perspective, improving quality increases utility, while cost-cutting lowers it.

Prisons are an especially interesting case because the consumers of prisons (the prisoners) aren’t actually paying for the service. What’s more, those who commit crimes must go to prison; they don’t choose whether they want to consume the product. These two features make prisons the perfect example of why non-marketable public goods–public goods with almost perfectly inelastic demands–cannot adequately be privatized. Forced consumption creates demand which is perfectly inelastic with respect to quality. This means private prisons cannot influence the number of “consumers,” so they have no incentive to improve quality. Thus, private prisons will always choose to reduce quality by cutting costs. But cutting cost comes at the expense of public utility.

In August 2016 the Justice Department announced that they would allow present contracts with private prison companies to expire without renewal for this very reason. They concluded “that the [privately run] facilities are both less safe and less effective at providing correctional services than those run by the government.” However, in the wake of the Presidential Election, the stock price of private prisons has skyrocketed, with shares of Correction Co. rising “as much as 60% before paring their surge to 34 percent by 10:14 a.m. (Wednesday morning).”Analysts contend that this surge is correlated with Donald Trump’s apparently imminent “deportation agenda”. Carrying out such policy would require contracting private corporations, which have more available space. This scenario provides a great example of how contracts take a form intimately related to the intentions of those that create them. In the simplest case, which we discussed above, we demonstrated why prisons should essentially always be publicized; however, we see that for a different administration with different intentions, a purely public contract would not work optimally.

Optimal Incomplete Contracts

Using the intuition gained from the previous example, we can distinguish between public goods based on how they operate in the free market. To ensure optimal citizen benefit, goods that have inelastic demand with respect to quality will require contracts that give bargaining power to the government rather than private corporations. On the other hand, the line between public and private for services like education and health care is not quite as simple. Demand for education and health care is not perfectly inelastic with respect to quality, and for consumers with high incomes, it is actually elastic: Those with the money to spend are willing to pay the premium for high quality education and healthcare. For this reason, privatization can yield increased total utility since private suppliers can increase their own profit by improving quality to attract consumers with high willingness to pay rather than cutting costs and losing consumers due to quality degradation. In this example, we can see that it is not always optimal for the government to take total control of the market for a public good.

In sum, when deliberating on the optimal incomplete contract between the government and private suppliers of public goods, the most important factor is the elasticity of demand with respect to quality. The more inelastic demand is for a public good, the more important it is that public policy should give bargaining power to the government.

Election Implications

Contract theory can be used to analyze elections if we consider the political process to be a contract between the represented population and an elected official. We can consider the relationship between the politician and the people as an incomplete contract where the people are the principal and the politician is the agent. Due to the nature of the election process, bargaining power shifts during the pre- to post-election transition. Before being elected, bargaining power lies strongly with the voters because they make the pertinent decision: “who will be elected?”. Consequently, during this stage the politician must exert effort and resources by marketing himself to the electorate. After being elected, however, bargaining power shifts into the hands of the politician who now has the decision power (What policies should be enacted? What can and should be done for the people?).

We can see this dynamic in effect with President Elect Donald Trump. During the campaign phase of the political contract, when the voters hold dominion over the representatives, Trump expressed intensely radical views. This strategy can be understood as Trump marketing himself to the demands of his chosen voter market– characteristically anti-establishment individuals disillusioned with “politics as usual.” Now, in the post election phase of the political contract with bargaining power in the hands of the representative, we see Trump scaling back on some of his campaign promises. He says he will not appoint a special prosecutor to investigate Clinton, repeal Obamacare outright, or ban all Muslims from entering the country. Unencumbered by the will of the electorate, Trump is more likely to optimize his own benefit by pursuing policy that he deems personally advantageous rather than explicitly continuing to appeal to the people that put him in office. No one can say exactly what Trump’s intrinsic motivations are, but what is clear is that his actions have undergone a marked change from the pre to post election phase.

Conclusion

Promises, deals, or laws, no matter what you call them, contracts are used every day in our society from conversations with friends to impactful policy decisions, and Nobel laureates Oliver Hart and Bengt Holmström have furthered our understanding of contract theory. We have used incomplete contracts to understand why private prisons cut costs instead of improving the quality of their facilities, how elasticity with respect to quality justifies private education, and how asymmetry of bargaining power between voters and politicians allows candidates to renege on promises made during campaigns. Contract theory provides a framework for investigating the political and economic interests that hamper society’s ability to reach the optimal solution. Looking forward, we should look for incentive problems that arise from principals and agents in incomplete contracts, especially in emerging fields such as automotive technology, space privatization, and cybersecurity.

Sources

  Nobelprize.org. Nobel Media AB 2014. Web. 18 Nov 2016. http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/advanced.html

  Nobelprize.org. Nobel Media AB 2014. Web. 18 Nov 2016. http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular.html

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