10/18/21

CONTRACT
THEORY
AWAN SETYA DEWANTA
FBE UNIVERSITAS ISLAM INDONESIA
2021

All transactions are terminated with

some form of contract
§ A contract is an oral or written agreement between two parties who agree in
advance to exchange goods or services (property rights), either in exchange
for certain payments or not.
§ To increase the likelihood that both parties will remain on the side of the
agreement, contracts often contain some kind of sanction for non-compliance,
or are governed by formal liability rules.
§ However, not all contracts are formal. Informal and implicit contracts that
inherently facilitate compliance with agreements.
§ The contract will provide benefits and protection to both parties from possible
problems that arise as a result of uncertain and opportunistic behavior.
§ The freedom of contract is assumed that the owner of the goods is allowed to
transfer the property rights to whomever he wants under conditions he
chooses, as long as. contractual agreements do not conflict with the law or
with the rights of third parties.

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Ideal of Contract
§ In the context of ideal conditions, where the parties to the transaction act
completely rationally and are fully informed, individuals can transfer
property rights and record their agreement in a complete contract. This
shows that every deal can be monitored and is free of charge (free).
§ In a perfect market, completeness of information would compel all parties
to fulfill their contractual obligations.
§ In fact, incomplete information and bounded rationality lead to incomplete
contracts, because it is too expensive to determine all possibilities.
§ However, a contract occurs as soon as the parties involved have sufficient
confidence that the agreement will be fulfilled, thanks to various enabling
institutions, both formal and informal.

Kind of Contracts (1)

§ A contract is a written or an oral setting of the transaction between two parties and, if
the two or more parties are making a contract, they want to be sure that the
agreements of both sides are keeping within the conditions (Groenewegen, Spithoven,
& Van den Berg, 2010). The contract laws build frameworks to provide a basis that
ensures both parties that they can trust in the compliance of the contracts.
§ First, there is the division between the complete and the incomplete contract which is
the most important one in contract theory. The difference between them is lying in the
flexibility to future changes (Groenewegen, Spithoven, & Van den Berg, 2010).
§ While the complete contract foresees that there can be different situations in the future and is
able to keep the framework of itself alive within the perfect market and full information,
§ the incomplete contract has to be changed caused by missing information. In the incomplete
contract, there is a necessity after some time to adjust it to the present situations. In
conclusion, the incomplete contract is the most common form of contract because of the
rarity of foreseeing future changes in the reality of imperfect markets.

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Kind of Contracts (2)

§ Second, we can divide between the informal and formal contracts
(Groenewegen, Spithoven, & Van den Berg, 2010). The formal ones are those,
who can be enforced by laws and are described through them. Otherwise,
informal contracts are totally free in settings and compliance is in society
regarded as natural. Some do call that two self-enforcing and legally
enforceable agreements, too.

§ Recurring and non-recurring transactions are also part of the feature to

describe contracts. It means simply that we can define contracts as an only
once happening transaction or if there are more transactions through time. If
there are transactions that are coming to get proceeded with the same
participants more than once, we speak about the recurring transaction and if
it´s just a so-called spot transaction, we are talking about the recurring
transaction.

Kind of Contracts (3)

§ The last pair of attributes is the simultaneous and non-simultaneous contracts
which divide in time preferences. The simultaneous contract can be fulfilled at
a certain time that is set. With this, the need for a write-down is very low.
§ On the other hand, if there‘s a contract about something which cannot be
fulfilled immediately or within a predictable space of time, we have a non-
simultaneous one (Groenewegen, Spithoven, & Van den Berg, 2010). The need
to have a written contract is in this situation higher and probably there´s a
higher need for a framework set by law, too.
§ So, for every contract which is made, there can be several attributes.
§ In conclusion, we could describe a contract for example as a formal,
incomplete, and at the same time simultaneous and non-recurring contract
which might be the contract you are making when you are buying a house. But,
the main problem is the hidden information that does in reality cause that
there are mostly incomplete contracts.

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Issues in Contract (1)

§ In the economics literature, contract theory studies how economic
actors can and do construct contractual arrangements in the presence
of information asymmetry.
§ Many community contractual relationships include relationships
between shareholders and top executive management, insurance
companies and car owners, or public authorities and their suppliers.
§ Since such a relationship usually creates a conflict of interest, the
contract must be properly designed to ensure that the parties come to
a mutually beneficial decision

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Issues in Contract (2)

§ Contract formalities in economics literature were carried out by
Kenneth Arrow in the 1960s. "Arrow's impossibility theorem"
(Nobel prize 1972)
§ In 2016, Oliver Hart and Bengt R. Holmström (Economics Nobel
Prize in Contract Theory)..
§ In the late 1970s, Bengt Holmström (2017) demonstrated a basic
principal-agent model, Holmström showing how optimal
contracts weigh risk against incentives, such as:
§ employees are not only given a salary, but also with the potential for
promotion; when agents exert themselves on multiple tasks,
§ while the principal only observes some dimensions of performance; and
when each of the other team members can become free riders.
§ In the mid-1980s, Oliver Hart (2017) made a fundamental
contribution to a new branch of contract theory that addresses
the important case of incomplete contracts.
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Contract Theorem – The agency theory

§ Contracts are categorized into two, namely dividing contact theory into two,
namely agency theory and implicit contract theory (Furubotn & Richter, 2011).
§ In agency theory, a distinction is made between the party giving the
assignment as part of its decision-making authority, and the party having
responsibility for carrying out the assignment, along with the ability to make
certain decisions.
§ The party who gives the task is called the principle; and the party who receives
the task is called the agent. This makes agency theory also called principal-
agent theory. The principal-agent relationship (in this case, an act of
delegation) only becomes a principal-agent problem when two conditions
apply:
§ Principal and agent have different and conflicting interests.
§ There is asymmetric information.

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Principal - Agent
§ Principal and agent have different and conflicting interests. The principal
wants to maximize his own welfare, which is why he needs the agent to do
his best, which need not be the agent's goal. For example, he may prefer to
avoid.

There is asymmetric information. One party,

usually the principal, has less knowledge of
what the other party, generally the agent, can
do (hidden characteristics, hidden
information) before the contract is concluded,
or what the agent does (hidden actions,
hidden decisions) after the contract is signed.
So, one of the actors has an information
advantage.

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Problem sheet 4.1: Principle - Agent

§ https://www.youtube.com/watch?v=hw5yRQt0JHM

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Asymmetric Information
§ When both of the above conditions hold, this will give rise to either
ex ante opportunism or ex post opportunism (Milgrom & Roberts,
1992).
§ Adverse selection: one party to a contract may hide certain facts
(for example, about his true ability to fulfill his obligations)
without the other party knowing before signing the contract.
wrong
§ Moral hazard: one party may not do what is expected of him after
the contract is signed (ex post), without the knowledge of the
other party.

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Adverse Selection
§ The principal-agent problem in the form of adverse selection can cause:
§ Problem people with different risks. Insurance companies can prevent
this adverse selection problem from occurring. Even if they don't know
a potential client personally, they have some tools at their disposal to
differentiate between lower and higher risk. For example, insurance
companies use age and gender data.
§ Young people and men have a high tendency or risk of accidents, while
older people need more expensive health costs.
§ Insurance companies can offer different premiums. Insurance
companies can offer two premiums. The first premium is a low premium
with a high additional risk, while the second premium is a high premium
with a small additional risk.

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Adverse Selection
§ The principal-agent problem in the form of adverse selection can cause:
§ Quality problem. The problem of discrepancy in quality, unknown to
consumers, has the same implications for the insurance market, namely that
low-quality goods stay in the market.
§ For example, a customer purchases a product but cannot distinguish the
quality of the purchased product. Once the customer purchases and learns
that the product is defective or of low quality, the customer will take the case
to court.
§ The court will decide that the seller must compensate the customer. This
means that the supplier is responsible for the damage caused. When the cost
of paying for these defects exceeds the cost of improving product quality, the
manufacturer or supplier will have an incentive to deliver a good quality
product from the start.

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Problem sheet 4.2: Lemons Problem

§ The lemons problem refers to issues that arise regarding the value of
an investment or product due to asymmetric information possessed by
the buyer and the seller. The theory of the lemons problem was put
forward in a 1970 research paper in The Quarterly Journal of
Economics, titled, "The Market for 'Lemons': Quality Uncertainty and the
Market Mechanism," written by George A. Akerlof,
§ The use of "lemon" refers to a slang term for a vehicle that has many
problems and defects that negatively impact its utility.
§ The lemon theory posits that in the used car market, the seller has
more information regarding the true value of the vehicle than the buyer.
This results in the buyer not wanting to pay more than the average price
of the car, even if it is of premium quality. This benefits the seller if the
car is a lemon but is a disadvantage if the car is of good quality.

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Problem of Lemon Market

§ Simple model:
The market for cars has two types, regular cars (probability 𝜇)
and lemons (probability 1 − 𝜇). To seller, regular cars are worth
$1000, lemons are worth $500.
§ To potential buyer, regular cars are worth $1500 and lemons
worth $750.
§ Which cars should be sold (from efficiency perspective)? — All
cars should be sold since more valuable to buyer. — BUT:
buyers do not know type of car, sellers do know

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Problem sheet 4.3: Lemon Market

§ Source: https://www.youtube.com/watch?v=N78gTX7VOwM

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Moral Hazard
§ After the contract is signed, some decision-making power has
shifted from the principal to the agent.
§ In addition to getting power from the principle, the agent has
more information about the "job" assigned by the principle.
§ The agent will try to maximize his own welfare rather than the
welfare of the principal. Because the actions may go
unnoticed, the agent may avoid punishment.

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Problem sheet 4.4: Moral Hazard

§ Clients who hire lawyers, or patients who wish to be treated by
doctors. Agency problems are possible, because often the client
cannot tell whether the attorney actually spent the claimed amount of
time on the case; and the patient cannot know whether the doctor is
prescribing the most effective and also the cheapest medication.
§ Principle-agent problems are also found in the public sector, ranging
from citizens voting for politicians in the hope that elected
representatives will fulfill promises made before the election, to
delegates in parliament who pass laws in the hope that ministers will
carry them out.

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Problem sheet 4.5: Moral Hazard

§ In the insurance market, this post-contract opportunism
can take different forms.
§ For example: someone takes health insurance in
consultation with a doctor. The person will consult a
doctor more often than if the person had to pay a fee
every time.
§ This moral hazard behavior will increase the cost of the
insurance company, which has to pay more and more
claims, which pays lawyers to prove that the claim is
unacceptable. Eventually, people's welfare declines, and
they have to pay or buy higher insurance premiums.

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Problem sheet 4.6: Moral Hazard

§ This problem is also found in everyday life. People often try to claim
that they have lost expensive items while on vacation, when in fact they
are still in their possession. Or maybe they did lose the item, but only
because they weren't careful enough.
§ In the same vein, people visit the doctor more often after their health
insurance covers the visit.
§ Insurance companies cannot observe this opportunistic behavior, but
can try to prevent it by establishing institutional tools such as the
introduction of “self-risk”, or setting up a system whereby insurers pay
lower annual premiums in the year if they did not make a claim in the
previous year.

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Problem sheet 4.7: Hold up problem: General

Motor
§ Fisher Body has an exclusive contract to supply parts for General
Motors cars. They are the only ones who can ship parts to GM's required
specifications.
§ In the 1920s, there was a sharp increase in demand that exceeded all
expectations held at the time the contract was written.
§ Fisher Body used this unexpected development to restrain General
Motors, among other things, by increasing the price of the additional
parts it produced.

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• If no investment is made, both

players get zero.
Hold up problem: • The investment costs 500 and
the gross value produced is
1500. In the initial contract all
surplus goes to the Buyer and
they get 1000 while the
Supplier makes zero profit.
• The Supplier can hold up the
Buyer by raising their price by
750 and leaving the Buyer with
250.
• The Buyer could change the
Supplier, but this hurts
everybody. The Buyer loses
their investment and the
Supplier loses all their business
with the Buyer.
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Hold up problem: • The supplier (Fisher Body)

The General motor made a specific investment
to make a specific body
that was ordered for GM.
• There was an increase in
GM demand, Fisher Body
raised the price of a
specific body order GM.
• The option of Gm sharing
profits with Fisher Body or
terminating the contract
with the consequence of
losing the opportunity to
earn profits.

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Problem sheet 4.8: Hold up problem: Gazprom

§ The Russia-Ukraine gas dispute refers to several disputes between Ukrainian oil and
gas company Naftohaz Ukrayiny and Russian gas supplier Gazprom over natural gas
supplies, prices and debts.
§ The dispute has grown from a mere business dispute to a transnational political one —
involving political leaders from several countries — that threatens natural gas
supplies in many European countries that depend on imports of natural gas from
Russian suppliers transported via Ukraine.
§ Russia provides about a quarter of the natural gas consumed in the European Union;
about 80% of these exports are sent via pipelines across Ukrainian soil before arriving
in the EU. Efficiency losses due to moral hazard behavior are better known as “agency
costs”, which consist of three categories (Jensen & Meckling, 1976):

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Implicit Contract
§ If the parties are considering a transaction even though they know it
will be difficult to legally enforce the contract, there are still several
ways to reach an agreement.
§ The contract entered into is called a self-enforcing agreement which
the agent complies with in the best interests of those who can do so.
Such agreements are closely linked to self-enforcing and regulating
mechanisms.
§ In other words, contracts are designed in such a way that violating the
agreement causes costs so high that people will spontaneously refrain
from doing so (Rosen, 1985).

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Implicit Contract
§ 1. Threat of loss of reputation. The fear of losing reputation is very real in business
life. Others will know that you have cheated your contract partner, so that your
reputation will be damaged and your business or career will end.
§ 2. Tit for tat. Cheating business partners, you can get a reply in the same way. This can
help prevent contracting parties from breaking their promises, because the costs to be
borne are greater than the benefits received. This condition can be described through
the prisoner's dilemma game.
§ 3. Use of third parties to resolve disputes and to evaluate performance. These
independent parties can act as mediators with non-binding awards, or even as
arbitrators who have the right to render binding awards. The independent mediator or
arbitrator is usually an expert in a particular field or trade, which makes him much
more knowledgeable than a judge in court.

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Implicit Contract
§ 4. Existence of (shared) commitment. This can lead to feelings of solidarity or
loyalty that help people fulfill their side of the contract. A stronger form of
bonding is the use of what the hostage calls a credible commitment
(Williamson, 1983). If the parties are going to transact with a high-value
product, the most losers may demand extra security to support the contract.
This guarantee is often in the form of a forfeited advance if not all obligations
are met.
§ 5. Unification of parties. If the parties to the contract decide to merge (vertical
or horizontal integration), the advantage is that previously existing
arrangements between independent companies are now handled internally.
This can save a lot of transaction fees, but on the other hand it can also lead to
new fees.

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Thank you

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