In ancient Greece the first reflections on economic issues were linked to justice. Greek philosophers wondered what the “fair price” of goods was, or whether it was fair to charge interest on loans or gain profits in trade. Economics and law are completely concomitant, complementary and dependent disciplines of one another.
This year the Nobel Prize in Economics was awarded to Oliver Hart and Bengt Holmström for the development of “contract theory” that has laid the theoretical foundation for a huge number of practical applications such as what type of companies could merge, what institutions Should be managed by the private sector, bankruptcies and even how to elaborate a constitution. This last application would be particularly interesting in our country.
The concept of “incomplete contracts” that Oliver Hart has introduced, highlights the fact that signing a contract is impossible to predict or specify all eventualities that may arise during the duration of the relationship between both parties. It then becomes necessary to know how to allocate “control rights”, that is, which parties have the right to make decisions and under what circumstances.
Behind Hart’s and Holmström’s “contract theory” lies one important truth: when people want to work together, individual interest must be kept under control. For example, for the owner of a restaurant and his chef to work together productively, the owner must undertake not to use the power he has to be the owner of the premises, to change the locks and thus prevent the chef from obtaining the part Which corresponds to it.
On the other hand, Holmström’s work focuses on the behavior of individuals rather than on organizations. According to him, most of the basic dynamics of power in society are reduced to relations between a person – principal – who needs others – an agent – to do something for him. The principal may use contracts to shape the work that the agent will perform. The difficult part is in establishing the right incentives.
The owner of the company intends that the salary of its managers encourage them to generate the best possible results. And adding a bonus for performance is a fairly common practice. However, profits often increase and decrease for reasons that have nothing to do with the manager’s effort or performance. Holmström argues that it is preferable to use information to measure the true performance of the manager, such as earnings relative to the industry average. According to him, most of the works are made up of various tasks, some easier to measure than others. Bonds linked to topics that are easy to measure as gains encourage agents to spend more time to increase those to the detriment of other tasks that are harder to measure but are just as important as brand reputation or product quality .
The content of contracts can, in short, determine the structure of jobs, companies and even industries. This reminds us, once again, of the tremendous importance that contracts must be the best expression of the economic relationship that gives rise to them, constituting a consistent and balanced whole that encourages each party to fulfill it continuously. Short lives will have those contracts in which the economy and law do not talk well. Good contracts create value. The others generally destroy it.
Juan Pablo Bórquez Y.
Partner Director BY Advisors
Jpb@byestrategica.com
