Hart, Holmstrom: Contract theory and incomplete contracts

Posted: 01/06/2017 - 20:53

Professors Bengt Holmström (MIT) and Oliver Hart (Harvard) received the 2016 Nobel Prize in economic science in October for their work in the realm of contract theory and, most intriguing, the nature of contracts as being essentially incomplete.

The Nobel Prize committee’s press release said, “The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.”

I am particularly interested in Hart’s work, which delves into the importance of the correct contract design to ensure success in business relationships.

When a customer’s interests are not aligned with the supplier’s interests – and vice versa – problems inevitably arise. When the customer wants lower price and the supplier higher margins – which is typically the case – they end up in a zero-sum game where one party’s gain is the other party’s loss.

How can this be avoided? How can commercial deals and contracts be designed to optimise chances of success, avoiding conflicting interests? Can contracts be written that answer every possible conflict of interest or eventuality?

Hart’s focus is on contract design and the rules of the game. He points to the simple but often ignored fact that all contracts are incomplete.

The idea of contract incompleteness has been explored most notably by another Nobel laureate, Oliver Williamson, and is a foundational idea behind the Vested sourcing business model. It is not possible to predict everything that will happen and write contractual rights and obligations to deal with every eventuality. The contract will be silent on many points. This fact must be embraced and dealt with, for when (not if) the contract is silent, conflicting interests between the parties could erode value, unless the parties have established flexible, relational and collaborative mechanisms to deal with this.

Hart’s (and Williamson’s) insight on this is critical: The typical attitude of most lawyers is to attempt to write a complete contract, even though everyone knows this is virtually impossible. Having a Nobel Prize laureate point out the incompleteness of contracts will hopefully help make it impossible to ignore this simple fact. The relational contract, for example, which underlies Vested agreements, embraces contract incompleteness and has built-in, flexible mechanisms to deal with the potential conflicts that arise in the “gray” areas of incompleteness.

Hart’s work into contract theory has evolved significantly over the years. Hart’s message – outlined during a recent seminar in Sweden on contract theory that was hosted by Lindahl Law Firm (view the videos here) – is the idea that when contracts are incomplete, ownership of the asset becomes an important and controlling factor. Hart’s advice is to allocate ownership of assets before the contract is signed.

Hart’s early work is heavily influenced by traditional economic theory and using power to allocate decision rights in a contract. Hart advised if it is possible to achieve an allocation that creates a power balance, the parties should enter into a contract. If it is not possible to achieve a power balance, one of the parties should buy the other, i.e. vertically integrate. Why? Because it is assumed to be impossible to avoid that, in case of a conflict of interests, the parties will try to exploit one another.

The video from the seminar explains how Hart has had a change of heart in his views on traditional economic theory as it relates to contract. His later work is heavily influenced by behavioural economics. In the seminar sponsored by Lindahl, Hart acknowledged that, “I learned and had to accept that my theory had gaps in it, and had to introduce some behavioural features; my experiments support the theory.”

Hart stresses the importance of communication. Maybe if things are talked out early on, “you can get away from bad feelings and get good performance. Rather than something completely binding and everything is spelled out, you have to think more about the fuzzy stuff, the trust, the relationships, the fairness, and how you deal with new situations in a way that both parties feel comfortable about.” Hart noted that this relates to relational contracts; “I’m very sympathetic to relational contracts.”

In the seminar attorney David Frydlinger sums up the application of behavioural economics with a simple but profound statement: “It is simply not true that only self-interest and power rules the market,” adding “research does indeed show that a “what’s in it for we” (WIIFWe) mindset exists.

Daniel Kahneman is one such expert provided strong evidence for people’s strong sense of fairness in his own 2002 Nobel Prize-winning research. Kahneman’s work clearly shows individuals are inclined to a fair sharing of value and moral behaviour, even when it is against strict economic rationality.

I see the WIIFWe mindset every day between customers and suppliers implementing the highly collaborative Vested model. The results are real, as demonstrated in Vested: How P&G, McDonald’s and Microsoft are Redefining Winning in Business Relationships.

It is great to hear first-hand how a big thinking economics guru such as Hart has evolved his thinking over the years to include the softer side of economics. And it is even more exciting to see the Nobel Prize committee rewarding him for this big thinking.

About The Author

Kate Vitasek's picture

Kate Vitasek is an international authority for her award-winning research and Vested business model for highly collaborative relationships. She is the author of six books on the Vested model and a faculty member at the University of Tennessee. She has been lauded by World Trade Magazine as one of the “Fabulous 50+1” most influential people impacting global commerce.