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Nobel Prize in Economics for contribution to Theory of Contract

Nobel Prize in Economics for contribution to Theory of Contract
By Ajit Patwardhan,
Contract Management Expert

Announcement of Nobel Prize in Economics:

Last month Nobel Prize for Economics was awarded to two distinguished professors of economics from Harvard University and Massachusetts Institute of Technology for their contribution to contract theory. These U.S. based economists won the prize for Economics for their analysis of contracts, work aimed at helping individuals, businesses, and public bodies, better assess whether the deals they strike are in their best interests.

Citation of Royal Swedish Academy of Science:

In the summary published by The Royal Swedish Academy of Sciences about this prize in Economic Sciences 2016, following issues were mentioned.

  • Contracts are essential to the functioning of modern societies. Prof. Oliver Hart's and Prof. Bengt Holmström's research sheds light on how contracts help us deal with conflicting interests
  • Contracts help us to be cooperative and trusting when we may otherwise be non-obliging and distrusting. Some contracts may fill less than one page, while others may run over hundreds of pages.
  • One important reason for drawing up the contract is to regulate the future actions. For example employment contracts can stipulate rewards for good performance and conditions for dismissal. But it is important to note that contracts have other purposes also such as sharing risks among the parties to the contract.
  • Contract theory provides us with a general means of understanding contract design and why contracts have various types and forms. Another purpose is to help us to work out how to draw better contracts thereby shaping better Institutions in society.
  • The best contract will typically depend on specific situation and context. However the power of theory of contracts is such that it enables us to think clearly about the issues involved.
  • The contribution of this years laureates Oliver Hart and Bengt Holmström are invaluable in helping understand real life contracts and institutions as well as potential pitfalls when designing new contracts.

When Nobel laureate Prof. Oliver Hart was interviewed by Nobel Media, he explained his approach as under:

The contracts are just an incredibly powerful way of thinking about parts of economics, I mean they are just fundamental to the whole idea that trade is quid pro quo. There are always two sides to transaction, and the way the thing is structured you know, is a very useful to think of it as being done to increase efficiency so that both sides have incentive to construct the transaction in the most, so that it generates the greatest value. You know people often think that one side dictates the terms to the other side. It may look like that but actually even then the side dictating the terms wants to choose terms which are acceptable to other side and generate the most value because if there is money left on the table, then you can write a better contract. So in a way it's very good side to the economic transactions and you see it through the design of contract.

The Abstract of Theory of Incomplete Contracts:

If we review some of the articles published by these Nobel laureates in last 25-30 years especially by Prof. Oliver Hart, we find that the issue of incomplete contract was strongly raised by him in the context of complex public body contracts. He felt that it is impossible for a contract to specify every eventuality. It is necessary to spell out optimal allocation of control rights, which party to the contract should be entitled to make decisions in which circumstances. His findings on incomplete contract have shed new light on the ownership and control of business or project and have had vast impact on the several fields of economics as well as political science and law.

For the purpose of this discussion, an incomplete contract is defined as an agreement that does not specify actions and payments for all possible contingencies, containing gaps that must be filled by negotiation, convention or formal dispute resolution process such as courts and arbitration, if provided in the contract.

It was a very heartening news for professionals working in the field of contract management of construction projects that the inadequacy of present contract models is receiving attention at the highest academic and professional level in the field of economics and policy making in government bodies.

To understand better what these Nobel laureates have argued about, we can read this very meaningful position taken by Prof Oliver Hart in his famous article on 'Incomplete contracts and renegotiation 'which is summarized below:

When drawing up a contract, it is often impracticable for the parties to specify all the relevant contingencies. In particular they may be unable to describe the state of (business) world in enough details that an outsider (courts) could later verify which state had occurred and so the contract will be considered incomplete. The parties can make up for this incompleteness to some extent by building into the contract a mechanism for revising the terms of trade as they receive information about benefits and costs.

One striking conclusion of above analysis is that because parties can rescind the original contract and write a new one, severe limitations are placed in the original contract about the form the revisions can take place. Moreover these limitations depend crucially on what means of communication (like notifying provisions) the parties have at their disposal during the revision process.

Relevance of this theory to Contract Problems in India:

Now if we decide to examine the relevance of this contract theory about incomplete contracts in Indian context, we must decide why this type of review is relevant and important.

The reason for this approach is obvious. Construction contracts for Infrastructure projects in India are going through lot of stress and hardships at following stages:

  • Many projects are stalled in incomplete conditions due to many external and internal factors faced by the contractor during execution which are not resolved.
  • Some projects which are completed late and are taken up for dispute resolution are pending under arbitration due to claims and disputes about scope, delays and Force majeure conditions in the project.
  • Even where arbitrations are over and awarded, they are challenged by Contractors or Employers (mainly by Govt departments and public bodies) in the courts which are awaiting decisions for years, due to backlog of pending cases at various levels in the courts.

Now, let us examine if the points raised by Nobel laureates and other experts about incomplete contracts can be applied to these pending issues facing infrastructure projects in India. The pertinent points for such review from Nobel laureates’ theory can be as under.

  • For transactions where there is no uncertainty about scope, specifications and cost, a simple contract will be sufficient and no further safeguards are necessary for efficient outcomes.
  • If there is uncertainty of specification the transaction cost may be affected due to unforeseen contingencies and also the cost of writing and enforcing the contract.
  • If the work quantity is uncertain the efficiency of fixed price contract will be affected unless parties believe that the extent of quantity and financial compensation can be renegotiated and courts are effective in the case of breach of contract.
  • The uncertainty about time and quantity of work in the contract can be taken care with heavy penalty clause.
  • It is impossible for a long duration contract to specify every eventuality and it is necessary to spell out optimal allocation of control rights, which party to the contract should be entitled to make decisions in which types of circumstances.

Any serious reader of above academic and professional issues raised by these Nobel laureates will notice that the impact of relevant contract laws in various countries is not debated here at length by these experts, though judicial interpretation in case of disputes is a big issue in many countries and contract writing parties try to cover themselves to stay within boundaries of legal system. We can now debate these issues in systematic way starting with commonly faced difficulties, followed by more complex issues that are affecting the outcome of projects in India. (Nobel laureates’ point of view is mentioned in bracket after each point so that the remedies can be visualized)

1 One of the simplest issue is about lack of certainty of scope of project contracts. This problem was not very acute some 15 -20 years back when projects were built by contractors as per design and drawings provided by Employer. But in last two decades Government and public bodies are choosing Design and Build or EPC Turnkey contracts, where scope of contract is not well defined and contractor has to guess the scope to some extent and face the surprise when details desired by Employer are evident or made clear during design approval process after the award of contract.(If the work scope is uncertain the efficiency of fixed price contract will be affected unless parties believe that the extent of work quantities and compensation can be renegotiated and courts are effective in the case of breach.)

2 Due long history of awarding contracts by Govt departments and public bodies for infrastructure projects, terms and conditions of any contract are decided by the Employer as standard contracts to be signed by contractors interested in getting work. This is done normally without any debate about suitability of these conditions for risks and contingencies contractors have to face in executing these projects. (Even though one party dictates the terms of contract, those should be acceptable the other party)

3 Public authorities awarding such projects maintain that since all terms and conditions are clearly mentioned in the contract, the participating contractors should carry out their risk assessment and quote the best prices inclusive of cost of such risks anticipated by them. (It is impossible for long duration contract to specify every eventuality in the contract by Employer and its cost implications can't be covered by the contractor.)

4 In some cases risks related to various external factors including Force majeure can be broadly sensed, but can't be properly quantified by contractors bidding for the project resulting into inadequate assessment about costs of such risks. (The parties can make up for this incompleteness to some extent by building into a mechanism for revising the terms of trade as they receive the information.)

5 In recent years, Employers are providing exit clauses for exceptional circumstances, such as prolonged suspension of work due reasons beyond the control of contractor. But clauses are so structured that contractor will not receive any meaningful relief from it. Contractor generally do not exit, seeking relief under delay and disruption and idling cost of prolongation. (Because parties can rescind the original contract and write a new one, severe restrictions are put in the contract about the form the revisions can take shape, limiting the choice of affected party)

The discussion about the above five issues brings out the importance of what Nobel laureates have said about the incomplete and deficient contracts. It is high time that opinion of these experts are given due attention and contract modification is thought about.

However the list of issues and problems faced by construction contracts in India is long and unending. We will have to raise them and look for suitable explanation within the contract theory or beyond it. We can list up some of those issues now so that the experts and academicians can look at it and come with suitable theoretical framework to explain and improve upon it.

Debate on Issues beyond Theory of Contract:

1 The scope of projects which is provided by Employers or their consultant is not sufficiently described to create certainty about work scope at tendering stage. However contractors also go along hoping to raise claims later on.

2 Time for project completion stated in tenders, is unrealistic and based policy expectations of the Employers. But these expectations are not contested by bidders to avoid disqualification from tendering process.

3 Land acquisition and other key clearances, though promised by Employer in the contract, take much longer time than indicated. However contractors tolerate it and raise claims about idling and loss of productivity.

4 The tendering authority is required to provide an opportunity to maximum number of participants to bid for project, sometimes by lowering the prequalification standards for the bidders, resulting into incompetent contractors getting the work, who is unable to meet the requirement.

5 Employer's team is normally required to award projects within approved budgets and are naturally reluctant to make any price correction to contract value once the project is awarded, due to budget restrictions.

6 As per contract terms, the project execution risks are substantially transferred to contractors, though it is known that they will not be able to handle some of the risks though agreed by the Contractor to obtain the business.

7 Sometimes contractors even though aware of certain risks, refrains from adding adequate costs during the tender pricing, for the fear of loosing to the competitors who might quote lower prices.

8 Employer's project execution team normally has limited power to issue variation orders if required due to scope changes etc, resulting into delays in resolving the issues or even avoiding the decision on the claims.

9 When claims raised by contractor are decided during the arbitration, they get challenged in the court if awarded against the Employer. These are challenged in the court by the concerned officers to avoid the blame about not anticipating such problems before awarding the project. Also officers are concerned about how auditors and vigilance agencies will view the decision, taken by them.

10 In case of arbitration awards of substantial value, even the highest authority on Employer's side cannot accept and pay very large amounts being beyond their power to grant such payments on behalf of public bodies or Government departments.

All these concerns and many more issues are awaiting attention, analysis and proper interpretation in the context of contract theory which has come to limelight because of recent Nobel prize in Economics for the work done by the two laureates related to Theory of contracts.

To start the wider professional dialogue on these problems of major concern, we can put following issues for debate to all the interested stakeholders in infrastructure development.

  • How do we incorporate compulsions of Government and Public body Employers in the contracts to protect the public interest?
  • How do we anticipate inadequacy of many competing contractors participating in project execution
  • How do we reach a consensus about avoiding unfair terms and provisions in the contract?
  • How do we minimize unbalanced allocation of risks in the terms and conditions of contract?
  • How do we include the concerns of Banks and the funding agencies supporting the projects?
  • How do we provide for the auditing agency's role and expectations of vigilance authorities?
  • How do we manage End users expectations from large infrastructure projects in public services?

Those who work in this field of infrastructure projects, might comment that some of problems raised above are because of inevitable difficulties and limitations faced by any developing country like India. But this cannot be the consolation for the problem ridden stakeholders working in this field. We cannot forget that apart from Employers and contractors, other participants like Public banks financial institutions and end users are suffering because of this situation. Even GDP growth rates are adversely affected in India and many other developing countries

It is high time that we agree on fair and balanced contract models for Infrastructure projects. We can make the beginning by agreeing on a protocol of Best practices in contract writing like Global protocol on Delays and Disruption created in 2004 by Society for Construction Law in London.