We shall discuss the analysis of market behaviour understood as diverse forms of contracting. After discussing the nature of contracts, we will examine how uncertainty, quality doubts and asymmetry of information are especially significant in shaping contractual arrangements in the consumer durable goods markets. Then, we will explore relationships where the quality of goods and services is hard to know and verify, typically common in manufacturing sector and professional services.

A contract is not necessarily a legal document, it may include implicit (tacit) understandings that frame the behaviour of the parties to a transaction. Contract theorists have been interested in the extent to which voluntary contracting can improve efficiency by overcoming ‘market failure’.

Three interrelated dimensions to contracts.

• Time:

• short-term contracts, spot contracts, arm’s length (e.g., primary commodity markets, retail consumer markets, stock exchange).

• long-term contacts, relational contracts, embedded relations (e.g., buyer-supplier relations, labour markets, life-insurance and financial markets).

• Completeness: In long-term contracts, it is impossible to specify in advance all the problems that might arise – unforeseen events, contingencies. Incomplete contracts are the norm. However, long-term contracts vary in degree of completeness, and many cases incompleteness is deliberate.
• Implicitness: Where written contracts are incomplete, mutual and implicit understandings (customs, conventions, routines and trust) underpin the economic transactions.

Implicit, incomplete and long term contracts are most significant and common in the business world. However, traditional, orthodox economists still refer to the explicit and complete contracts as their ideal and standard by which all other types of contracts are assessed.

Given the uncertainties of the future, why should firms enter into long-term contracts? An important set of specific assets is ‘relationship-specific assets’: assets that one party to a contract agrees to invest that are worth more within the contractual arrangement than outside it. For example, a supplier builds a large component plant or trains its workforce only if the buyer agrees to a long-term contract. Without contracts, firms are likely to underinvest, because one party can ‘hold-up’ the other, act opportunistically, to obtain favourable bargaining position.

The implication is that long-term contracts result in greater efficiency. Even if the firms know the each other’s costs, the hold-up problem will cause inefficiently low investment when assets are relationship-specific.

An alternative solution to the hold-up problem is vertical integration, where two firms become one – however, while eliminating contracting problems, this is not costless.

The absence and asymmetry of information of the product’s quality is characteristic of many buyer-seller relationships. This can conceptualised in two ways.

George Akerlof discusses the consequences of asymmetric information of quality of a product for its market (‘market for lemons’).

Discussion of buying apartments.

There are many goods and services (mechanics’ services and televisions) for which it is hard to ensure quality before purchase. The problem that results is an example of adverse selection: while buyers would be willing to buy, and sellers willing to sell, quality products at high prices, under asymmetric information the market operates such that poor quality products drive out high quality ones, and the market collapses. Yet, the sellers can offer guarantees.

Three features of the example of apartments that are relevant to the analysis of contract behaviour.

• These are spot contracts that are also one-off deals. These provide an incentive for opportunism – unlike to deal with same seller or estate agent.
• Eventually, actors will discover the nature of the quality of the product – quality doubts are only temporary.
• Sellers have no control over quality, however, in if this is relaxed then there various ways of addressing ‘the lemons problem’.

In cases of consumer durables, sellers seek to persuade purchasers that they can be relied upon to supply high quality product. We can use game theory to model the attempts of firms to establish reputations for quality. Reputations are not gained in a day – they grow over time. If a firm is concerned with its future market position, then its present behaviour will be influenced by that concern.

A reputation game assumes that a firm builds up, over repeated interactions with consumers, a reputation for particular behaviour (e.g. for producing high or low quality goods), and that its reputation can influence consumers’ behaviour (e.g. their willingness to pay for the firm’s goods).

In a typical reputation game, a firm faces two main strategies: always supply low quality products, or always supply high quality products. Consumers will offer a high price for a high quality product, but they are unwilling to be cheated. The strategy for the firm depends how it compares a single pay-off from cheating a consumer to an infinite stream of lower pay-offs from maintaining its high quality reputation indefinitely.

The game suggests why firms expend resources establishing reputation – advertising, publicised commitment to investments in high quality production systems. Firms maintain and benefit from reputational capital.

There are many market contracts (say, buyer-supplier relationships) where the quality may never be entirely observable or verifiable, including professional relationships, such as doctor-patient, lecturer-student, lawyer-client. The customer (or client) relies on the supplier (or service provider) to maximise effort (or behave professionally). The results or outcomes may bear an uncertain relation to effort. This situation is called the principal-agent problem.

The principal in the buyer-supplier transaction is the buyer. The buyer’s problem is that the agent, the supplier, has information that can be withheld from the principal. The agent’s actions may not be observed by the principal (hidden-action) or the supplier may have information about the project unavailable to the principal (hidden-knowledge). The principal’s problem is to devise an incentive scheme to persuade the agent to act in the principal’s interest.

In such circumstances, market contracts can be seen as an attempt to solve an incentive problem: how can the supplier be encouraged to out in its best efforts unobserved. The ‘theory of incentive contracting’ seeks to answer this kind of question.

Discussion of a car assembler (the principal) that cannot observe the effort put in by the component supplier (the agent). The principal does not know how far costs might be reduced by the supplier, only what is achieved. One way is to create incentives for cost reduction that links payment to agreed target level of cost and actual costs.

If the supplier achieves actual costs below target costs, then the supplier receives a bonus. However, the supplier risks being penalised for failing to realise the target level. If the coefficient of the difference is large, most of the risk shifts to the supplier. The supplier’s reaction to the contract will depend on the extent of this risk and how it regards risk. If it is a small business, it may be risk-averse and so fail to undertake cost-saving investment and restructuring of work.

In negotiating an incentive contract, the principal faces a difficult trade-off, in balancing incentives for effort by the agent against efficient risk-sharing between principal and agent. A contract that provides strong incentives for efforts shifts most of the risk to the supplier.

There are many principal-agent relationships where the agents (such as lawyers, doctors, lecturers and accountants) are more powerful, and where even after the service has been provided, it is still hard to know whether the professional service provider has done its best. Consider a patient’s relationship with a doctor. Doctors have scope for hidden action. The contract creates moral hazard (i.e., to act opportunistically in promoting self-interest): incentives for hidden actions (over-charging, over-treating to boost income, or under-providing and negligence) against the interests of the patient, the principal. How can a vulnerable principal establish an effective incentive contract with the agent?

Reputation games will work poorly as quality or performance is hard to judge even after the event. In addition, monitoring of professionals’ behaviour is difficult and costly. Alternatively, we may consider ways of changing their motivation away from profit motive to other ideals.

The ‘theory of non-profit firms’ is a response to contract failure, that is, situations where it is difficult to set effective incentive contracts because quality and performance is unobservable. This approach focuses on ways of changing the agent’s motivations, and suppressing its profit-motive. If the contracting agent is a non-profit firm (e.g. a charity, mutual, or trust), then those who work for it may have fewer incentives to act opportunistically, because the staff’s (agents’) motivation is closely aligned to the needs of the clients (the principals) they serve, so lessening the principal-agent problem. Non-profit firms may pursue objectives concerning the output they produce (say, patient’s health and care irrespective of the cost), as opposed to financial targets. Principals (patients) may prefer to be treated by a non-profit organisation (trust hospital and clinic) seeing it as more trustworthy.

There are two other ways in which professional providers’ motive can be shaped. The role of professional ethics influences professional providers’ motive either through the internalisation of the professional code, or through the regulation by a professional governing body. This is especially powerful if it backed up with a threat of being struck off from the professional list for unethical behaviour.

Professional and trade rules also regulate professional behaviour, curbing moral hazard. Examples include prohibitions on advertising that reduce the scope for false claims, referrals and cross-checking within the profession that reduce information asymmetry, and rules that encourage openness and reduce competitive behaviour.