What do the 2016 Nobel Prize winners in economics teach us about Vested and alternative Sourcing Business Models? – Pt 1

This post was written by David Frydlinger, Kate Vitasek and Henrik Järleskog.

 

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Bengt Holmström

On October 10th we learned that the 2016 Nobel Prize in economic science was awarded to professors Bengt Holmström (MIT) and Oliver Hart (Harvard) for their work in contract theory.

This Nobel Prize is of great practical importance in daily business. For procurement professionals, for lawyers, for contract managers, for anyone working with more or less complicated contracts. It reminds us of what is too often is ignored, namely the importance of proper contract design to ensure success in business relationships. Says the prize committee press release: “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.”

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Oliver Hart

What can these Nobel Prize winners teach us? The underlying problem addressed by Holmström and Hart are conflicts of interests. When a customer’s interests are not aligned with the supplier’s interests – and vice versa – problems will 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. The result is known from the 10 ailments of outsourcing, explored in the Vested research. The pie will shrink instead of grow and a lot of potential value will simply leak out. How can this be avoided? How can commercial deals and contracts be designed to optimize chances of success, avoiding conflicting interests? These are some of the underlying questions of great practical importance raised by Holmström and Hart.

When looking for optimal contract or deal design, the focus must be on both the economic incentives and the contract rules, i.e. the stakes of the game and the rules of the game. Together, they set the incentive system of the parties, deciding whether interests are aligned or misaligned. Holmström focuses more on the economic incentives, the stakes of the game. Payment-for-performance can be one way to achieve alignment of interests. Pay a seller based on the volumes sold. Pay a supplier based on the costs saved or quality level achieved. This form of compensation mechanisms is at the heart of the Vested model.

However, for performance-based and similar economic models to work, says Holmström, it is critical to ensure that the supplier is in enough control of the output to which the compensation is tied. Otherwise, the risks will be too high for the supplier and the output wanted won’t be achieved. We could not agree more. But what do you do when your business environment is dynamic, uncertain and risky and the supplier does not have adequate control? We will explore how the Vested model addresses this in Part 2 of this article.

Hart, instead, focuses more on the contract, i.e. the rules of the game. He points to the simple but often ignored fact that all contracts are incomplete. We simply cannot, in the contract, predict everything that will happen in the future and write contractual rights and obligations to deal with this future. 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 may start to erode a lot of value, unless the parties have established mechanisms to deal with this.

This insight is crucial. The typical attitude of most lawyers is to attempt to write a complete contract, even though everyone knows they will fail. Having a Nobel Prize winner point out the incompleteness of contracts will hopefully help make it impossible to ignore this incompleteness. The relational contract, for example, which underlies Vested Agreements, embraces this fact and has built-in mechanisms to deal with the potential conflicts arising in the areas of incompleteness.

But here is also an area where Hart’s theory is incomplete, just as Holmström’s theories are insufficient to explain why Vested deals and relational contracts are so successful. While Hart and Holmström correctly point to the importance of contract design, they have some building blocks missing in their contract theory, and hence also in their practical advice for those who want to design successful deals.

We will return to this point in Part 2 of this post.

Images: Holmström and Hart via Nobelprize.org

Comments

  1. Håkan Bladh says:

    Thanks

  2. While Vested is clearly superior as a method of creating collaborative agreements, you guys continue to get this part dead wrong: “The typical attitude of most lawyers is to attempt to write a complete contract, even though everyone knows they will fail.”

    Further, such generalizations raise questions as to whether you get the essence of the theory put forward by Holstrom and Hart. Their work points to “optimal contractual arrangements”, and not the functionally neutral role of lawyers. Every lawyer who ever studied contractual theory knows that contracts are only “complete” if the obligations of the parties are fully specified FOR ALL FUTURE STATES OF THE WORLD. It would be the rare exception to “typical attitude” who could dare imagine such an accomplishment, any more than defining how many angels can dance on the head of a pin.

    I don’t think I ever knew a lawyer who is not professionally dedicated to complete the contract according to the preferences of their clients as to what terms are immutable and which are allowed to be default terms. I would respectfully suggest that you adjust your perspective toward the clients, not the “typical” attitude of the lawyer sworn to protect that client perspective. As in, symptoms/causes.

    • David Frydlinger says:

      Paul,

      Thank you for you comment! Being a lawyer myself, I highly welcome this discussion. Let me tell you my view on this.

      You are of course right that Hart and Holmstrom do not point to the role of the lawyer but to optimal contract arrangements. But I do think that Hart and Holmstrom forces us lawyers to think whether we really are functionally neutral, just executing the will of of clients, when it comes to how contracts are written. For we are really the experts on how contracts should be written to achieve those optimal arrangements and our clients rely on our advice.

      Of course, any sane lawyer would, when asked, admit that it is impossible to write “complete” contracts and that Hart is right in saying that all contracts are incomplete. But to be honest, I also see that many lawyers have a hard time knowing how to deal with the fact of incompleteness. The standard solution is, in my experience, to first of all try to nail us much possible in the contract (making many contracts very extensive) and then use the Entire Agreement clause to make sure that nothing unexpected can be interpreted into the contract and finally rely on the change control procedures to deal with situation when the unexpected happens.

      But if the essence of Holmström’s and Hart’s theory is the question how to deal with conflicts of interests in the market through optimal contract arrangement, I personally don’t think this is very much of a solution. For, as you know, when the contract is silent and unless other steps have been taken to ensure alignment of interest, a power struggle will occur to deal with the conflict of interest that will come to surface. The problem of conflicting intersts is not solved at all.

      Hart’s solution is – if I have understood him correctly – to look closely to the allocation of ownership rights before the contract is signed, which means to either vertically integrate or to ensure that there, when the contract is silent, the other party don’t control resources that give them veto rights and hence power. This is, in my humble opinion, also somewhat of a weakness in his theory and I think, right or wrong, that Vested and the relational contract underlying it, provides a much better solution.

      At least for me, especially Hart has been important in the way he challenges our profession to think about how we deal with contract incompleteness. We play an important role here in helping our clients do good business.

      Again, thank you for your post. We will soon post part 2 of the article and we would welcome furhter discussions!

      /David Frydlinger

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