Article: Contract theory offers a different perspective to executive pay issues

Compensation & Benefits

Contract theory offers a different perspective to executive pay issues

Professors Oliver Hart of Harvard University and Bengt Holmstrm of Massachusetts Institute of Technology were recently awarded Nobel Prize for Economics to advance the understanding of the role that contracts play in the economy. We take a brief look at what it entails for the HR community at large.
Contract theory offers a different perspective to executive pay issues

Our economic world today is held together by the consent of various agents who choose to interact with each other on a regular basis.  The functioning of our markets today is dependent upon these economic agents having a series of seamless interaction across levels, which in turn, ensures that the economic engine of today’s globalized world keeps running.  Interactions like the ones between a bank and its customers or a company’s board of directors and its CEO are vital to the smooth functioning of the economic system today. 

But how efficient are we at understanding and regulating such interactions? Most of these interactions today are regulated with the use of contracts. By clearly defining the roles and responsibilities of the various parties involved, contracts play a pivotal role in ensuring that agents work together towards a single cause. 

One of the most nuanced of theories that looks into the designing of contracts to ensure its effectiveness has been the “Contacts Theory”.  Developed by several Nobel laureates over the years, the theory resurfaced after Oliver Hart of Harvard University, Cambridge, MA, USA and Bengt Holmström of Massachusetts Institute of Technology, Cambridge, MA, USA received the Nobel Prize for their contributions to contract theory on the 10th of October 2016. Although previous pioneering researches were around establishing a theoretical framework, the current work by the two professors deals with issues like information gaps between parties and incomplete contracts. 

Contract theory 

Contract theory “studies the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions,” reports Business Insider. Working extensively, both Bengt and Oliver have made crucial contributions towards advancing the accomplishments of the theory in assisting industry heads and key agents of the economy to interact seamlessly across the board. 

Simply put the theory explores the proper design of contracts and the role they play in ensuring that economic agents are functioning cohesively, even in cases where a conflict of interests exist. “One of the theory’s goals is to explain why contracts have various forms and designs,” states the Royal Swedish Academy of Science in its Nobel statement. “Another goal is to help us work out how to draw up better contracts, thereby shaping better institutions in society.” 

Hart's and Holmström's research sheds light on how contracts help us deal with conflicting interests. But to understand its relevancy in today’s corporate functioning entails not treating the Contract theory as a mere study of the legally binding contracts.  It is about understanding each party and creating the right incentives and motivation for them to ensure that they work effectively together. 

 Industry relevance 

Both professors have sought to build on existing work already on done Contract theory. By focusing on more real-time issues that companies face like information gaps and. By focusing on issues that have a direct impact on the industry and subsequently- the economy -, the two professors have built what is now being called the “Modern Contract theory”. With regards to HR professionals over the globe, the theory becomes a valuable asset in helping them to design compensation and benefits contracts of the company. 

Bengt Holmström in 1979 published “the informative principle” to address the usual lack of information that a company faces when it comes to paying its employees for performance. Addressing the ‘principle-agent’ dilemma, the principle suggests that optimal contracts should structure compensation based on all outcomes that can potentially provide information about actions that have been taken by the employee. In the case of setting an executive’s compensation, for instance, that means that the company would take in the external environment to understand the actual work done by the executive and compensate the person accordingly. A firm should then reward the executive based on not just its own performance but also the performance of other firms in that sector — as a way of evaluating not just the actions the executive took but those that the person could have taken. By factoring the larger picture, companies stand a better place to understand the contributions of the various executives, even the ones that are not directly visible.  The theory highlights the need for companies as rational agents to take in a complete picture when it comes to designing executive pay.  

Explaining the role further The Royal Swedish Academy of Sciences added, “The theory also highlights that the harder it is for a company to observe the manager’s effort – due to distorting factors that blur the relationship between the executives effort to the company’s performance – the less the manager’s pay should be based on performance.” A corollary of this is that in cases of industries with high risk, payments should be relatively more biased towards a fixed salary, while in more stable environments it should be more biased towards a performance measure. If a manager’s performance pay solely emphasizes short-term cash flow, his actions may neglect the company’s long-term health.  It also involves states that employee pay shouldn’t heavily depend upon on just observable outcomes. This often ends up distorting employee perspectives. 

In the case of setting an executive’s compensation, for instance, Holmströms work implies that the company would benefit by taking into consideration the external environment and the overall industry performance to understand the actual work done by the executive and compensate the person accordingly.

Adding to the current work, Hart’s work on incomplete contract seeks to tackle with contractual issues that companies often face when it comes to the rapidly changing economic world.  The domain of incomplete contracts addresses the problems designing the best rudimentary contract. Parties are frequently unable to realistically articulate detailed contract terms in advance, which creates unrealistic pressure on the initial contract to stand the test of time. Hence the concept of rudimentary contracts becomes helpful. 

In addition to this, the main idea of the work done by the fellow prize winner Oliver Hart has been to address the inefficiency of contacts to predict and dictate rules for the future. His work states that a contract that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree explained The Royal Swedish Academy of Science. The party with this decision right will have more bargaining power. In turn, this will strengthen incentives for the party with more decision rights to take certain decisions, while weakening incentives for the party with fewer decision rights. In complex contracting situations, allocating decision rights, therefore, becomes an alternative to paying for performance, creating the necessary conditions for the parties to come into a contract. Acting as an incentive, providing negotiation powers can help parties form a contract that enables them to work efficiently. This perspective also enables the analysis of fundamental questions such as whether companies should outsource or integrate production, which assets they should own and how they should choose between equity and debt financing. 

The main idea of the work done by the fellow Nobel prize winner Oliver Hart, has been to address the inefficiency of contacts in dictating the roles and responsibilities for the future. Referred to as the 'theory of incomplete contracts', it helps professionals better understand the incentive structure involved in creating contracts that make it more future proof. 

Most of these economic theories have together and contributed to build and advance our understanding of the role of contracts to ease economic interactions. They have played a pivotal study and understand key features of real-world contractual agreements around the areas of liquidity provision by governments and banks, long-term compensation and promotion schemes for senior managers and executives, and public versus private ownership of institutions. As shifts in technology and demographic preferences make company structures more complex, the theory and practice of designing contracts become even more relevant.  Companies would greatly benefit from taking such academic studies and contextualizing their implication to improve their own working. From creating compensation plans for employees to executing successful contractual obligations, the Contract Theory helps throw a different light in tackling such situations.

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Topics: Compensation & Benefits

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