Have you ever wondered why your services contract is just not working properly? Why the incentives you put in the contract are not delivering the desired outcome? The reason is most likely due to an area of study called contract theory and this year, the Nobel Memorial Prize in Economic Science was awarded to the economists Hart and Holmström for the development of contract theory.
These prize-winning economists have provided valuable theoretical tools for understanding real-life contracts as well as potential pitfalls in contract design.
Is there something we can learn from this as contract owners and apply to services contracts? At Acquire, we think so.
What is contract theory?
When we draw up contracts, the main reason we do so is to regulate future actions and align incentives to maximise the gains from co-operation. The goals of researching contract theory as an economic discipline include:
- Providing us with a way to understand contract design
- Help explain why real-life contracts have various forms and designs
- Inform us on how to draw up better contracts in the real world
How influential has contract theory been?
The idea that incentives must be aligned has been discussed by economists as early as in the 1700s in relation to sharecropping contracts. In the past few decades, more formal analysis and theoretical models have been used to approach these old ideas and according to the Nobel Prize background paper, contract theory has had ‘major impacts in the fields of organisational economics, corporate finance, industrial organisation, labour economics, public economics, political science and law‘.
These impacts, for example, include:
- liquidity provision by governments and banks
- long-term compensation and promotion schemes for senior managers and executives
- public versus private ownership of institutions such as prisons and utilities
A quick search for ‘Contract Theory’ as an economics discipline on the academic article database JSTOR, shows a staggering 40,000 academic articles from as early as a 1851 article about insurance incentives.
What can we learn from contract theory that is related to services contracts?
Services contracts actually have a lot of problems that Contract Theory tries to address. Here are just a few:
(1) To what extent should my supplier’s payment be linked to financial incentives?
Commonly, when we structure a pricing model for our services provider, we are trying to address the principal-agent problem where the principal (buyer) creates an environment for the agent (supplier) where the supplier’s incentive doesn’t necessarily align with their own. We can make the contract very weak in incentives (e.g. cost reimbursable contract) or very strong in incentives (e.g. paid per unit delivered) or somewhere in between.
How do we determine how ‘intense’ the incentive should be? According to the ‘Incentive-Intensity Principle’, the optimal intensity of the incentive to maximise benefits should depend on the following factors:
- Incremental profits created by additional effort (the higher profits, the higher the incentive intensity should be): e.g. if the next stage of the production plant cannot handle the increased output you are incentivising your supplier to deliver, then the less linked your supplier payment should be in relation to output
- Precision with which the desired activities are assessed (the higher the precision you can measure their desired effort, the higher the incentive intensity should be): e.g. if you can’t measure your supplier’s customer service with precision, the less you should link customer service to supplier payment
- The supplier’s risk tolerance (the higher the supplier’s risk tolerance, the higher the incentive intensity should be): e.g. for a small company with low risk tolerance for fluctuations in their profits, the less their payment should be linked to output especially when there are unknown factors that may impact output
- The supplier’s responsiveness to incentives i.e. their capability they have to influence output (the less capability the supplier has to influence the output you want, the less the incentive intensity should be): e.g. where the supplier is very constrained to work in accordance to your processes and materials and there is no room for them to be innovative, the less they will be able to respond to your incentive and therefore it may be better to lean more to a core-reimbursable than paid per output model
(2) If I can’t measure all my supplier’s efforts properly, should I just financially incentivise them on the efforts that I can easily measure?
Say in an area of your operations, the profit or outcome is impacted by two key components of the supplier’s effort being:
(a) Delivery on Schedule
(b) Customer Service
The supplier’s ability to achieve (a) is very easy to measure but (b) is much more difficult or too costly to measure for now.
How should we incentivise the supplier to ensure that they spend an equal amount of effort on both?
The multi-tasking model developed by Holström-Milgrom addresses this question and its results show that making pay too sensitive to the effort that is easier to measure will lead to the supplier concentrating too much on achieving (a) and not (b) when (b) is equally important. Therefore, it may be best to offer weak overall incentives like a fixed fee in a situation like this.
(3) How can I structure my contract with the appropriate incentives to drive cost reduction collaboration between myself and the supplier?
When you seek to collaborate with your supplier to drive cost reductions, the supplier may be unwilling to collaborate because doing so will force them to provide you with more information of their cost structure. This information asymmetry (where the seller has more information than the buyer) is a source of informational advantage to the seller which the buyer may exploit if they know it and can play a big role in shaping both party’s incentives to collaborate.
Nevertheless, true collaboration will bring benefits to both parties as a whole. So, is there a way we can structure procurement contracts to increase both party’s incentive to collaborate in such a situation?
An interesting paper studying this problem found that:
- Screening contracts (where after all collaboration efforts have been made, the buyer presents a menu of price and quantity points for the supplier to choose from) has been shown to address information asymmetry problems in such situations but actually hinders the supplier’s incentive to collaborate
- Committing to a fixed margin over the expected resulting cost is a better instrument than price commitment
To qualify, the above comments are more applicable in the context of the development of an innovative product and collaborating to lower the products final expected cost.
Can contract theory help solve the problems you are facing with your services contract?
If your services contract isn’t driving the right outcomes, there is probably a reason and potentially an answer somewhere in the mountain of research that has been done in the field of contract theory.
At Acquire, we believe that there is something to learn from these academics.
The above questions are just the tip of the iceberg. If you want to discuss these questions in further detail or if you have any other contract design questions in general, please contact Simon Thompson.
These links are a good place to start if you want to read further on the contributions of contract theory:
- Popular science background on contract theory
- Australian professors explain contract theory and why it deserved the Nobel Prize