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