Why Contracts Won the Nobel Prize in 2016 & How You Use It

Contracts are the backbone our modern society is built on. But they’re not perfect. And those pitfalls, or rather, how we deal with them, is what won the Nobel Prize in Economic Sciences in 2016.

Over a beer one night, or maybe a glass of wine, you and I come up with a great idea for a new business, we’re going to revolutionize beer brewing with a drag-and-drop, mix-and-match how-to app for home brewing. You’ve got the blueprint for what makes the best beer and the know how for creating different hops mixtures (including great gluten-free beer), and I know the secret sauce for building amazing websites and apps that will catapult our idea to success. We decide to split everything 50/50 and draw up a quick contract on a napkin. Golden.

But, our minds wander and paranoia sets in. Suddenly we’re distrusting of the other’s efforts and concern grows about our coveted 50% return. Should it be more? Will you put in just as much effort as me, or will I, you? Instead of squashing our idea we begin renegotiating our contract language to make sure each of us does what we say we will, and neither of us feel slighted. Our business, and friendship, is saved.

The Nobel Prize recognized this negotiation of interests, what is known as contract theory—the heart of what gives contracts their power—by awarding it the Nobel Prize for in Economic Sciences in 2016.

Contract theory is what helps you take advantage of the economic opportunity working with other people (employees, businesses, etc.) presents. Contract theory–based on the work of Oliver Hart, a British economist at Harvard, and Bengt Holmström, a Finnish economist at MIT–helps us understand how contracts work, why contracts work, and how you can make them work better.

How contract theory works

Contracts comes down to trade-offs and incentives when setting contract terms, i.e., risk sharing. Analyzing Insurance contracts, for example, shows they are predicated on 3 terms: moral hazard, conflict of interests, and measurement.

Here’s what these terms mean:

• Moral hazard: If you were fully insured on your vehicle, would you suddenly become careless, or even drive recklessly? Or, if you were going out to dinner and you know someone else is paying would you order the most expensive thing on the menu? Same idea.
• Conflict of interests: If everyone acted in the best interest of all parties all the time this wouldn’t exist. But they don’t—we are often selfish creatures.
• Measurement: Your actions can’t be observed all the time. If you could, assessing what was a “real” accident versus a reckless action would be easily decided.

How do these terms shape contracts? They lead to trade-offs in the form of the completeness of your insurance contract, the copayment you pay if you require medical treatment from an accident, and the rate of deductible you pay. Each is designed to say, hey, you are sharing some of the responsibility here, so now it works in your favor to act in both our best interests—drive and work safe and get the attention you need but don’t go crazy (i.e. Order the lobster).

Why this matters

Contracts exist to shape power relationships. According to Hart and Holmström, this power is defined by the relationship of outcomes and ownership.

Can a contract ever really be complete? Hart and Holmström say maybe not because all possible outcomes have likely not been considered. Which seems impossible, right? This leads us to decision rights. Because you and I in our beer brewing venture, or your boss, or your insurance company, can’t know everything that will happen, but they can decide who makes important decisions when the unthinkable, or unconsidered, happens. This goes hand-in-hand with ownership. Think of say, a Co-op. If each employee, and their managers, is invested, has a sense of ownership, they may spend their time doing more value-producing tasks than if not.

How you use this to make your contracts better

The lesson here is that power matters, especially in co-operative ventures, which include contracts. And if your decision-makers are important because they have more bargaining power, and if not all elements of a contract can truly be specified, what are you doing to ensure your decision makers are invested?

Is there a way to create a more collaborative effort when it comes to your contract management? To get buy-in? Think of ways you can incentivize your managers, employees, and teams to participate in compliant, efficient contract management. Or ways you can use your contract management solution to streamline your processes and enable your teams.

Then consider your external contracts—suppliers, partners, etc. Can shared risk within these relationships instill a greater ownership, create a strategic relationship?

Hart and Holmström gave us the tools to go beyond analyzing contract financial terms, and look at their everyday implications. With today’s advancements in technology, it’s now possible to make contract management, including your entire contract lifecycle, easier, to help you use your relationships–because that’s what your contracts are–and contract management solution to build trust, build security, and accelerate growth.