We’ve all done it: Terms and Conditions pop up and you quickly click “I agree” without even looking at the information. You can bet that, if you polled the next 100 people you saw, 99 of them did exactly the same thing for the last set of terms and conditions they were presented with. Sure, one can argue that Apple won’t put a clause that gives them the right to all of the money in your bank account, but what does our attitude about these casually passing contracts say about our response to the other contracts that pervade our lives?
Many have said that nearly all of economics is based on the contractual human interactions, both explicit and implicit. However, if we care to explore a bit more broadly, one can say that the entirety of a person’s life is based on a web of explicit and implicit contracts. From purchases at the store, to relationships, to job offers, the world is so entwined with contracts that, should they be abolished, one would have ability to operate. This is the work of the two latest Nobel Laureates in Economics, Oliver Hart and Bengt Holmström. Their decades of research form the basis of what is now known as “Contract Theory,” which strives to study the design and implementation of contracts in a way that all parties are benefited proportionately to their share of input. In other words, it is the study of incentives.
While Hart and Holmström focused on different parts of contract theory, their research is very much intertwined. Holmström began his research career in 1979 when he published “Moral Hazard and Observability,” which sought to explain the realtionship between observable effort and performance-based incentives. Holmström described the “informativeness principle” as the idea that “an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken.” That is to say, an employee’s compensation ought not to be tied to only one metric, but rather all available (and relevant) metrics. If their compensation is linked to the company’s stock price, then it should also be linked to the performance of the other companies in its peer group so that the manager is not penalized for an economic downturn, or rewarded for a boom.
Holmström went on to focus on three other primary principles: career concerns, multi-tasking, and team-work. Think about every college student you have ever met. Nearly all of them have uttered something along the lines of “I’ll do the grunt work for a few years, then they’ll hopefully promote me to do what I really want to.” Why is it that people are willing to settle for a hard, unrewarding job for several months (or years) in order to make their way to their dream job? It the idea of career concerns: one is not necessarily motivated by their current job or current salary, but rather their possible career trajectory and where it will lead them at the end.
In almost every job, there is more than one task to be done at a time. Whether it’s filing papers and typing invoices, or taking out the trash and cleaning the dishes, an employee is often expected to do more than one task. So, in a limited work day where they can only do one, which is the employee likely to choose? Frankly speaking, they will likely pick the task that they won’t be able to get away with not doing.
That leaves us with team-work. While most people are strong proponents of team-work, Holmström makes the case that not all team-work is beneficial. In the case of a co-owned and operated firm, whose profits are equally split amongst all the individuals, you will likely have at least one person who does not contribute as much, but takes the same share of the profit. Holmström argues that, by having third party owner, a case can be make to incentivize each person individually so no one falls through the cracks. In all four cases, Holmström implores all firms to use performance-based incentives in cases of low-risk and static incentives in cases of high risk in order to avoid misalignment between the firm’s goals and those of the employee.
Hart, on the other hand, based his research on “incomplete contracts,” the idea that the most optimal contracts should not explicitly say what must happen in each of the cases A through Z, but rather the framework for who has the right to decide. If you think about it, an efficient contract (A.K.A one that can be read in less than a century) cannot account for each and every possible outcome of a situation. Therefore, it is best to have a clearly defined way to come up with a solution to each particular problem that arises, so that they are more suitable. To put it into perspective, imagine you and your buddy want to buy a rental property to make some extra money, which you’ll split down the middle. Well, then you think about what would happen if the sink breaks and you happen to be around to buy a new one and replace it. Will your friend reimburse you for half? Will they make the equivalent improvement to the house? Or will you be stuck with more ‘skin in the game’? In short, you both will be so petrified of being slightly more invested that you won’t move forward with the project. Hart proposes that one person own the house, and the other rent out space to sublet to a third party. This way, there is a clear line of responsibility and ownership.
So, what does this mean for our everyday lives? Well, think about being in a relationship with someone: there are explicit contracts, like loving and supporting one another, and there are implicit contracts, like agreeing with them on how terrible of a person their ex-girlfriend is. The latter wasn’t part of the deal when you decided to be together, but it is what you perceive to be a part of the unspoken agreement to hate who they hate. In economics, we see contracts in everyday events like buying coffee: you pay money for it, and you expect the coffee in return–it should not only be given to you, but it should also be hot, prepared as you requested, and (preferably) in a cup. If not, your split-second contract at the counter allows you to bring the coffee back and demand a new one.
Contracts are all around us, and it is each person’s right to carefully consider them, and enter only into those that are most beneficial to themselves. However, to take a page out of the books of Hart and Holmström, why not enter into contracts that are most beneficial to all of those around us?