The Economics of Contracts

A gentle introduction to a complicated topic

Introduction:

How does a firm function in the real world? This question seems so ridiculously easy that it would deserve the description of “ululating obviousness”. However, it is an incredibly complex issue…at least in economics.

The usual view of economists, especially microeconomists, is that firms behave in an incredibly rational and orderly way. By this they do not mean that the entrepreneur is a superforecaster with unique abilities to analyze and forecast economic conjunctures, but rather that they behave as if guided by rational mathematical formulas.

For traditional neoclassical economists, the firm is nothing more than a mere production function. You have well-defined, homogeneous inputs (labor and capital) and outputs (production), and managers manage processes seamlessly. For a firm to function properly, it just needs to allocate its resources efficiently according to optimization calculations and be efficient in the execution of projects. In this extremely “Taylor-Ford” view of things, you just need to ensure that the production belt works and everything will be fine.

Obviously, however, the business world is not like this simple panglosian view. Every manager with a minimum of experience knows that the management of a process in an organization involves much more complex aspects than the mere question of optimizing resources.

They have to deal with employees who think and produce in different ways, machines that cannot be perfectly allocated between sectors of the same production plant, suppliers that can delay the supply of some input or break agreements, etc.

This gulf between theory and practice has always been a problem for economists when dealing with the analysis of agents' behavior in the real world. However, a line of research ended up forming over the years that aimed to fill this abyss and give a better understanding of the phenomenon of inter and intra firm relations from the point of view of economic theory.

The theorists in this article are part of this tradition, however to understand their work it is necessary to look at the roots of these new ideas about the nature of firms.

I- Coase, The Theory of Firm and Contracts:

The first to attack the simplistic view of traditional neoclassical economics was the Ronald H. Coase.

In his famous article “The Nature of Firm” (1937), Coase pointed out that traditional economic analysis was too reductionist in treating firms as mere production functions. A company is much more than a mere construct where capital and labor are transformed into a given form of production. They have complex relationships, both intra- and inter-firm, that affect their performance and, as a consequence, their efficiency; even if the inputs are allocated perfectly according to the optimization calculations.

For Coase, all firms had complex processes built on top of negotiations whose effectiveness could never be taken for granted. Workers could operate below the expected productivity at the time of initial hiring, agreements with suppliers could need to be renegotiated, machines could need to be replaced, and shareholders could disagree with regard to the management of the company. In all these situations, the manager would have to negotiate with a given party in order for the firm to continue to operate at full productivity. And such negotiations would impose a cost on him, the cost of the time and resources expended to carry out that negotiation; costs that would not occur if the firm operated according to the neoclassical model of the production function. Economists have called these costs transaction costs.

Each firm, of course, has a different transaction cost. A steel company does not operate and is not managed in the same way as a software development company. Their needs and processes are different, so the negotiations involved in their operation are also different. According to Coase, these different transaction costs will produce mechanisms to deal with these different costs as well. Some companies will choose to have a limited and faithful number of suppliers or operate with few employees, while others will operate with extensive supply-chains and a large number of employees.

For this reason, because of the variations in the forms of firms that occur due to different transaction costs, that disciples of Coasean thought such as Williamson (1981) and Cheung (1983) will argue that the nature of firms is essentially contractual, since contracts are the most efficient mechanisms to deal with the problem of transaction costs.

The form of organizations is given as an adaptive process to the circumstances of each market, where each firm will try to get as close as possible to that ideal performance of neoclassical theory by developing its own mechanisms to deal with its transaction costs. Although this view of “firms as a nexus of contracts” is typical of Coasean thinking, we can find similar thinking in organizational theorists such as Chester Barnard (1948).

This emphasis on the importance of contracts for economic performance later attracted the attention of researchers in the area of Law & Economics, such as Richard Posner (1973). For these researchers, the obvious conclusion of the line of thought established by Coase is that transactions in an economy will be facilitated where there is a series of traditions, conventions or laws, known by the parties, to be applied as ordering such transactions. The parties do not need to spend time and resources to decide and negotiate how to deal with contingencies that may arise during the process established by the transaction if a series of adequate rules already exist. In this way, rules such as those of contract law help to improve economic performance.

For authors like Posner, contract law is necessarily efficient. This means that these authors saw contracts as ideal mechanisms to solve the problem of transaction costs. Contract law is subject to a competitive process that makes it economically efficient due to the doctrine of freedom of contract. If a certain contractual doctrine is not adequate to the type of exchange of the parties, they can replace it with terms that approach their ideal for a given negotiation. Therefore, only those contractual doctrines capable of maximizing the social welfare of the parties will be selected during the negotiation process and contract law, consequently, will necessarily be efficient.

From an analytical point of view, we can say that the value of a contractual promise for a promisor can be given as:

ρB — (1 — ρ)R

Where ρB is the probability of the gain benefit from such contractual transaction and (1 — ρ)R is the risk and cost of breaching it.

The social value of transaction expectations for the given agents X and Y can be given as:

ρBx — (1 — ρ)Rx + ρBy — (1 — ρ)Ry

Since the ideal contract law will be the one that maximizes the social welfare of the parties, this means that the transaction must meet the condition that MC = MR. Since the transaction in question is a legal relationship, we can say that the maximization condition will be satisfied when any expectation of additional benefit on the part of the promisor implies a loss on the part of the promissory and vice versa. That is, when the terms of the contract have reached a condition of paretian efficiency. This means that the marginal social value will be optimal when the social value equation equals zero, where:

ρBx — (1 — ρ)Rx = (1 — ρ)Ry — ρRy

Posner point out that in this situation we must assume that the contractual terms and process are fully known by both parties. Therefore, in a perfect contract, the promisor has the possibility of setting up his strategy based on the effect of the contract on the promissory. How will he act in the possibility of default by the promisor? One way of analyzing this situation is noting that, in the event of breach of contract by the promissory party, the equation for the loss or social cost of the breach will necessarily be equal to the value of the promisee's expected loss; soon:

(1 — ρ)D = (1 — ρ)Ry — ρBy

Where D is the loss of the breach of contract between the parties.

Replacing (1 — ρ)Ry — ρBy by (1 — ρ) D in the equation of social contractual value, we will obtain the value of the contractual promise under the condition of full knowledge of the potential damages of breach as:

ρBx — (1 — ρ) • (Rx + D) = 0

Therefore, in an ideal contract, when the initial promise is kept, the promisor achieves his expectation of benefit Bx and the promisee recognizes his initial obligations; or, if the contract is breached, the promisee bears the legal costs plus the breach damage. Once the effects of the contract on the parties are fully known mutually, the rational strategy of both parties will be to try to maximize their results individually, thus generating an efficient competitive equilibrium. The promisee will put terms in the contract that protect him from the risk of an opportunistic act on the part of the promisee and the promisee will do everything to ensure that the signed contract causes him less costs over time and in its execution.

A banker, for example, wants his loan to be honored within the interest payment terms and the borrower, in turn, wants the loan contract to generate the lowest cost in terms of interest over the term of the loan.

According to this view, firms manage, thanks to the competitive nature of private contracts, to always establish efficient agreements and reduce their transaction costs. But is this view really valid? According to our theorists (and the practical experience of any manager) the answer is an emphatic NO!

II- Incomplete Contracts and Blockchains:

The problem with the model presented above is that it only applies if the contractual terms are perfectly fulfilled and the parties know whether or not they will incur losses. However, this is rarely the case in the real world.

Even if the parties know all the terms of a contract, it is impossible for them to be able to predict how the other will act throughout the process of executing the agreement.

Contracting parties are subject to information asymmetry problems at the time of formulation. One of these major information asymmetries arises from the phenomenon that Berle and Means (1932) called the “corporate shareholder problem” or principal-agent problem. In this type of organization, ownership and control of a firm's assets are inevitably separate. The shareholders, even though they have ownership over the company, do not manage it, who do that are the managers and directors.

In this way, directors and managers have more knowledge about the company and power over its productivity than the anonymous shareholder who receives its dividends. However, as much as they directly control the company's assets, administrators are not their owners, so they do not have the right to appropriate the productivity gains. Thus, what is the incentive for an director to manage the process of a company to seek its maximum productivity if he has nothing to gain from it and how can the shareholder defend himself from this complacent behavior on the part of his manager if he has less knowledge about your company than they?

The distrust that emerges from this type of situation can destroy any contractual relationship. Following our previous model, in a situation of asymmetric information and imperfect knowledge of the parties about the effect of the contract, the individual maximization behavior of both parties will end up generating a Prisoners' Dilemma scenario:

The promisee, knowing that the promisee cannot know everything about his situation, will realize that the best possible strategy for him is to break the contract, because in this scenario he avoids the costs of contractual compliance and still manages to maximize the benefit of the value of the contract. For the promising party, the rational strategy will be to avoid entering into the contract, as this is the only way he will be able to perfectly minimize the legal cost and the risk of losing his assets in the event of a breach of contract. Therefore, in a scenario of incomplete contracts, where there is permanent distrust between the parties, it is impossible for any transaction of this type to be carried out.

What the works by Hart and Holmstrom (1987), Hart (1988) and Hart and Holmstrom (2010) try to do is to show that even in scenarios of this type, contracts can exist and firms can be understood as contractual links.

To solve the problem of incomplete contracts, Hart and Holmstrom note that in the establishment of maximization strategies in the condition of asymmetry between the parties there will be an incentive for the party most interested in the contract (usually the contracting party) to adopt the Information Principle in the elaboration of the contract. contract.

According to this principle, the parties will put in the contractual terms conditions that give them the greatest possible amount of information about each other. A supplier, for example, may want information about the payment terms of a company that hires him and the contracting company may be interested in knowing the supplier's service history. Once this information is provided, it is more likely that the parties, in their individual maximisations, will reach a more efficient contract than in a scenario where this principle is absent. For this reason, it is perfectly normal for a bank to require a huge amount of information for a loan agreement.

Similarly, the parties may also agree to enter into the contract incentive mechanisms that correct the effects of an incomplete contract. An example of this are the compensation contracts based on results, where managers are paid in proportion to their productivity; although this type of mechanism is quite fragile due to the monitoring problem (Alchian and Demsetz 1972).

According to Hart and Holmstrom, firms will evolve within this strategic game resulting from incomplete contracts. Some may see this in a negative light, as it initially appears that shareholders and directors will have to deal with an endless chaos of contractual litigation. However, in the end, incomplete contracts are essential for the very survival of firms.

Contractual incompleteness allows firms to have a gap, a space, to negotiate terms whose initial conditions changed during the execution process. A company's consumer market may change its tastes and, as a result, the company may demand a different quantity of the inputs it purchased from its suppliers. Since the contract will always be incomplete, it will have room to renegotiate its terms and, with that, allow your organization to adapt to a new situation not initially foreseen.

It is for this reason that smart contracts have a very limited application.

Since they are rigid and self-enforcing, not allowing the parties to modify them during the process, they do not allow their parties to modify their terms in order to adapt to a new economic condition. In this way, smart contracts become very little resilient from an evolutionary point of view and end up making organizations based on their mechanism rigid and vulnerable to changes in the initial conditions of the contract. Not strangely, smart contracts end up being limited to simple transaction contracts and not complex and long-term transactions; such as industrial financing and construction contracts for real estate plants, for example.