Hart: “I’ve become more open to these behavioural ideas, which I was initially not.”
Contracts are a big deal. They have a place in all manner of economics transactions and leading economist Oliver Hart tells The Mint how decisions taken before signing on the dotted line might best be more heartfelt than headstrong.
Oliver Hart occupies a position in the top branches of the economics canopy. He currently holds the chair in economics at Harvard University, has affiliations past and present with the celebrity universities on both sides of the Atlantic, his work on contract theory is pioneering and widely read, oh and last year he picked up a Nobel Prize in economics.
In his recent conversation with The Mint he defined his allegiances early on with a couple of categorical statements: “I am very much a formal theorist. I want to be able to understand things using formal models,” and “I don’t belong to a school”.”
He also made it clear that his thinking had led him to question the validity of the assumptions of rational behaviour that form the foundation of the dominant neoclassical school of economics: “I used to be a big fan of models based on rationality because I suppose I took the view that most of the big things that we wanted to explain could be explained with rationality. It’s not that I thought people were rational all the time. I know that I’m not.”
Hart’s groundbreaking work has focused on incomplete contracts – deals that have to be renegotiated over time because inconceivable future contingencies are likely. Hart established the need in such contracts for a clear decision-making regime and products of his studies have re- shaped contract design with implications for corporate governance, legislation and institutions.
In more recent work, he has looked at firms and the importance of power and control at the point where people write incomplete contracts. He found that traditional approaches could not explain why all transactions do not take place in one huge firm or why indeed firms matter at all.
In his recent book, Firms, contracts, and financial structure – incomplete contracts and renegotiation, he applies his ideas on incomplete contracts to understand firms’ financial decisions, in particular, the nature of debt and equity and why equity holders have votes and creditors have foreclosure rights. He explores the impact of the same ideas on the capital structure decisions of public companies, bankruptcy procedure, and the allocation of voting rights.
“I was trying to understand, at a more formal level, why we have firms and what determines the boundaries of firms. What are the costs and benefits from firm A acquiring firm B, and from the move from arms-length transactions, to inside-the-firm transactions?
“Early work on this by others was largely unformalised, and with co-authors. I thought, ‘perhaps we could do something on the formal level?’,” Hart explains. He continues: “When I started my work on incomplete contracts, I assumed , for sure, at the time, that there must be good answers to these questions. Formal answers – assuming everybody was rational. It would never have occurred to me that you couldn’t develop a decent theory under the assumption of full rationality. I would just have said, ‘surely firms, I mean, why people have firms, it can’t be because they’re stupid’. You’ve got to be able to explain it under rationality.
“Actually, in my work over the past ten years or so I have introduced, not so much trust but something related … let’s call it fairness,”
“But, to my amazement, I found after many years of working at it, it just didn’t work out the way I thought. So, I realised, to really understand this, we have to move away from full rationality. That was a big surprise to me. That’s made me more flexible. I’ve become more open to these behavioural ideas, which I was initially not. But, I just realised at some point, wow I really need to go down that road.”
He has not, however, retreated from his instinct for formal analysis. He pushes back when The Mint suggested his view was akin to that behind institutional economics. It has institutions – a group that includes individuals, companies, governments and social norms – all interacting and evolving, in contrast to the neoclassical assumption of total rationality and equilibrium. Hart responds: “They don’t have formal models, so I would never be able to understand exactly why they needed to depart. I hear what they’re saying. But, I couldn’t sort out exactly what was going on with their work, I want to be able to understand things using formal models.”
He questions the value of introducing the influence of social norms without quantifying the inefficiencies that they introduce and how those inefficiencies can’t be erased by rational contracts. He asks: “What exactly is the contractual failure that opens the door to these norms mattering?
“In my behavioural work with contracts, which I call “contracts as reference points”, I write down these models, and in them I specify exactly what goes wrong and what the source of the inefficiency is. And why, if people are nice to each other, things can get better.”
His work on incomplete contracts encompasses what he calls “residual control rights” – the right to decide on matters not covered in a contract. “I think it’s fair to say that that idea wasn’t really around before we started discussing it. I’m not saying nobody ever thought of anything like that, but it certainly wasn’t emphasised or investigated in any serious way.”
He illustrates the principle behind residual control by comparing the balance of decision-making power in a renegotiation of a contract where a provider and a taker of goods or services are separate companies and where they are employer and employee in a single firm. Two negotiating companies might be expected to have parity in their negotiating influence while the employer would hold sway in its talks with an employee.
“Sometimes, just being nice to people, or paying them a bit over the odds, treating them decently, is a better way to get them to perform well”
Because it is an illustration, the comparison assumes all other factors remain static. An example proffered by Hart of another variable that others have added to the mix is the influence of reputation.
Reputational impact can be depicted in a scenario in which a coalmine is adjacent to a separately owned power station and where the power producer has upgraded its generators so it requires a different coke quality.
With the next nearest coal plant many miles away, transportation costs could make coal prices from that mine punitive. So the current coke provider could exploit the situation by adding a mark up on its price to the power station far in excess of a reasonable return on its costs. Or it could keep to more justifiable margin because it is wary of gaining a reputation within the power industry as an unreasonable trader. Hart says most economists acknowledge that this type of interaction plays a significant part in contractual relationships.” “In any complicated contractual situation, that’s been going a long time, you don’t really want to have a huge fight. So if you were very opportunistic in a negotiation you could sour the relationship.
“You might also have other people you’re dealing with so you might want to get a reputation for being a reasonable partner. And all these things can mitigate the situation.”
Is this simply a reflection of the value of trust in business? Few, after all, want to be seen as a Del Boy or even a Gordon Gekko. “Actually, in my work over the past ten years or so I have introduced, not so much trust but something related … let’s call it fairness,” says Hart.
He says he has explored how over exploitation of an unassailable advantage in commercial negotiations can amount to a Pyrrhic victory – something that Hart says, “is not part of standard economics because there everyone’s totally rational.
“People may not respond well in situations where they feel they didn’t get what they should have got. And then might even cut back on performance – I call that shading. They might retaliate in some way.
“So, I’m bringing in some imperfections, I don’t want to call it exactly trust, but it does mean that I care about how you feel about the deal. So I don’t want to extract every last penny out of the transaction, because I know that may not elicit wonderful performance from you going forward.”
Hart’s investigation into the role of fairness in contracts is, he asserts, “early in its development”.” And he emphasises that his findings have not been accepted in all quarters. “I’ve had some pushback. Not everybody accepts the behavioural assumptions as applied to contractual settings. Let me just say also, I view it as complementing my early work. So, it doesn’t obviate the need for ownership. Or make the allocation of ownership or residual control rights unimportant. It doesn’t.”
He is, in his most recent work, applying these ideas “to try to understand the employment relationship better”.” He says he is looking to “analyse this more formally than has been done by economists up to now”.”.
This work, he says, focuses on the “extremely important reference point” that is the current wages a person is paid when the next wage is under consideration. Hart describes this type of arrangement that governs most wage contracts as a continuing contract. He explains: “If I work for you, typically, we don’t have a long-term contract. You can get rid of me or I can leave and go somewhere else, but we’re often in it for quite a long time, and we don’t specify how my wage should adjust over time.”
We are all familiar with the pattern where once the initial wage is set, subsequent increases might follow and “exactly how that happens is a delicate matter,” says Hart. As well as when and how much a pay rise might be, one of the interesting questions, Hart says, is “whether sometimes you might be unwilling to raise my wage.
“I have some sort of outside option. Either I apply for another job. Or maybe someone else just comes and says, ‘Would you like to work for me for a higher wage?’ And, then it’s easy for me to come to you and say, ‘I’d like more money?’, b But that might create a situation where I should leave, even though possibly it might be more efficient for me to stay with you.”
“Given that people’s feelings do matter, it might actually be efficient”
While an employer might well think it’s not reasonable to give someone a pay increase just because someone else has offered him more – particularly if there isn’t a market-wide increase in wages, losing the employee could create inefficiency Hart says. This, he adds, is linked to Keynes’ macroeconomic ideas: “Keynes was very big on the fact that wages wouldn’t go down even in a recession”.” Again, an emotional element is at play says Hart.
He says a leading explanation of this is in Truman Bewley’s book, Why wages don’t fall in recessions, which includes a 1999 survey of businesses. “What shines through,” Hart says, “is the idea that businesses don’t like to cut wages because it’s very bad for morale. What I’m doing is very consistent with that.”
He continues: “You don’t want the supplier, or the guy working for you, to be aggrieved. You want him to feel treated fairly. So you might, actually, prefer to lay some people off, rather than cut wages. Even though this might be, in classical terms, inefficient. Given that people’s feelings do matter, it might actually be efficient.”
To hear a Nobel laureate economist argue the importance of fairness and morale in a world dominated by neoclassical economics’ notions of rationality and efficiency might be heartening to those of us who see the pluralist path as the way forward.
Hart in fact turned his guns on his fellow economists in 2008 when he said they had “abandoned their principles” in supporting bailouts for the banks. And in 2014 he created a stir when he proposed that governments should provide aid to people rather than the banks. But he joined forces with seven other Nobel laureates in economics, and 370 other economists when he signed a letter describing Donald Trump as a “dangerous, destructive choice” as president.
Does his focus on fairness and morale in economics suggest that he sees influences beyond the purely rational as growing in importance globally? “Yes, that’s right. Well, that’s what I’m into but a lot of other people have been into that. I think the implications for economics for the world, are still too early to call. But I suppose some people have realised that sometimes having very explicit contracts or explicit incentive schemes may actually not be the best way to go. And sometimes, just being nice to people, or paying them a bit over the odds, treating them decently, is a better way to get them to perform well than just having, what we call, high-powered incentives.”