Contract Theory and (Nash) bargaining
This year’s Nobel Prize winners, Professor Hart and Professor Holström, made very relevant contributions to Contract Theory. These contributions have two central concepts: Risk sharing and decision making. These are vital for the establishment of contracts and the healthy management of companies in general. The first talks more about how corporations often distribute risks and their possible costs to employees to be able to have payment be linked to performance. Nonetheless, the relevant aspect to networks comes from the decision making capacity that contracts grant. As the article mentions “[…] decision rights are important. Whoever has the right to make a decision on the unspecified elements of the contract consequently has more bargaining power.” As there exists bargaining power, it is safe to assume that Nash Bargaining outcomes will make an appearance, yet how confidently can we make this claim?
We know that contracts would follow Nash Bargaining outcome as the basic principles behind such outcome are that:
1) An exchange between symmetric nodes would let us believe there will be an equal split. This is true in contract theory as actors with equal portions of risk and decision making often have partnerships that leave them both equally benefited (or possibly damaged) with their agreement.
2) Even with extreme settings, employers would not give employees a null split even if demand for the job were incredibly high, as so happens in economic recessions, where minimum wages must be respected as well as other employee rights.
3) The power that one person has in the contract theory’s bargainings is indeed influenced by the power of one’s neighbors. This might be the trickiest to understand under Contract Theory, yet it is still there. Although job applications might not work like a bargaining outcome per se, bargaining outcomes do exist between companies that seek mergers, joint-ventures, or other cooperation that involves two or more parties, must thus engage in consideration of the power they have depending on the power of the other firms. If these firms were less powerful, in this case have a smaller window of opportunities with other parties, then the firm with the most power could thus have higher power in a sense of decision making in their contract. Even when job applications don’t work like this, as the job market is constantly growing, firms have higher power and almost always have decision making power with respects to the non-defined terms of the contract of their employees.
4) Lastly, these bargainings don’t always get stable outcomes. That is to be expected in a world of immense competition and long-run interests over short run ones. In a business market where interests constantly shift to match consumer’s tendencies, contracts and the parties involved are a clear example that power may shift as time goes by, i.e. how an employee becomes more desirable as they spend more and more time working for companies with a reputation known to everyone in the market.
As we see, Nash Bargaining Outcomes in real world applications are far more complex than giving each edge in a network a dollar to split. It goes to prove how interesting a topic may be beyond its simpler theory, as well as how important it is to understand the logic working behind award winning work like the one in Contract Theory.
Link:
http://theconversation.com/why-contract-theory-won-hart-and-holmstrom-the-nobel-economics-prize-64011