Contract Theory and Business
Strategy: Reoptimization under
Changing Opportunity Sets
Shyam Sunder
Yale University
IBM Faculty Summit, May 17-18, 2004
Overview
• The problem
• A contract model of the firm
• How firms work
• Role of controls
• Necessary conditions for firm to work
• What goes wrong?
• How do we prevent things from going wrong
• Concluding remarks
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(c) Copyright 2004 Shyam Sunder
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The Problem
• Identifying sources of success and failure
is difficult
• Tendency to extrapolate the past
• Model of success yesterday, model of
failure today
• Guiding framework for continual reoptimization of the firm in changing
environment
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Examples of Failure
• Enron
• WorldCom
• Xerox
• Barings Bank of London was
acquired for $1 by ING Bank
• Adelphia
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Changing Labels for Senior
Managers’ Challenge
• Long term planning
• Business policy
• Strategic management
• Changing paradigms, metaphors,
myths, lexicon?
• Essence does not change
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Firm As a Set of Contracts
• Among many individuals
– Shareholders
– Customers
– Employees
– Managers
– Suppliers
– Government
– Community, etc.
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Firm as a Set of Contracts
Managers
nagerssss
Shareholder
s
Government
Creditors
Auditors
Employees
Vendors
Customers
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Role of Individuals
• Each party contributes resources
• Each party receives resources
• Each party seeks his own goal
through participation in the firm
• Firm’s goals are combination of
individual goals
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Individuals and Resource
Flows
Type of Agent
contribution
entitlement
Shareholder
Manager
Employee
Vendor
Customer
Lender/creditor
Government
Auditor
equity capital
Skills
Skills
goods, services
Cash
Loan capital
public goods
Services
dividend
salary, bonus, benefits
salary, wages, benefits
cash
goods, services
interest, principal
taxes
fees
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How Firms Work
• Contract is mutual expectation or
understanding
– Not necessarily explicit
– Role of social conventions
• Emphasis on symmetry
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Individual vs. Organization
Goals
• Firm is like an arena or game
– In which individuals seek their goals
• Applicable to All Organizations
–
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Focus Here on Business Firm
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Conditions Necessary for
Firm to Work
• Individual condition
– Each individual must expect to receive
more than the opportunity cost of his
contribution
– Otherwise individual has no incentive to
continue his participation
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Conditions Necessary for
Firm to Work
• Aggregate Condition
– Firm’s production function should be
able to produce enough output from
resource contributions to satisfy all the
individual expectations
• Otherwise, expectations of some people will not be
fulfilled, and they will quit the firm.
• If these people are necessary for the firm’s contract
set to function, their departure may result in collapse
of the firm
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Questions for Reviewing
Decisions and Events
• Will it make any individual contracts
infeasible?
• Will it make the contract set as a
whole infeasible?
• Common element in organizational
failures
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Example 1: Feasible Contracts
• Six contracting parties
• Opportunity cost of 60 for customer
• Opportunity cost of 10 for other five for a
total of 50
• Total available surplus = 10; feasible in
aggregate
• Many individually feasible allocations of
the surplus possible
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Feasibility of Contracts
Shareowner
Manager
Creditor
Employee
Vendor
Subtotal
Customer
Net
Surplus
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Opp.
Cost
Share
Rent
(1)
10
10
10
10
10
50
(2)
11
12
11
12
10
56
(3)
1
2
1
2
0
6
60
10
56
0
4
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Two Complications
• Agents’ opportunity costs are private
– Manager does not know agents’ costs
– Except in special case of perfect market
– Agents have reasons to keep them private
during negotiations
– Market imperfection means error in manager’s
estimate of agent cost
– Agent does not know the total surplus
– Negotiation under veil of mutual uncertainty
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Privacy of Costs
– Uncertainty renders outcome less
certain
– Uncertainty makes success in
negotiation more likely
– Post-negotiation boasts or complaints
leak information for the next round of
negotiations
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Negotiations are Sequential
– Manager negotiates with agents, one at
a time, in sequence
– Each deal brings new information,
changes the remaining surplus
– This may change the negotiating
strategy and even the production plans
– Picture changes continually
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Changing Feasibility of
Contracts
• Internal and external events affect
feasibility of contracts
• Senior management must anticipate
these changes, adjust contracts and
renegotiate them
• Long-term planning or business
policy or strategic management
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Sources of Change
• Changes in factor and product
markets
– Capital
– Labor
– Technology
– Product, customer preferences
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Managing in Changing
Markets
• Pitfalls of relying on history and
experience
• False confidence
• Wrong kinds of commitments
• Old contracts may become infeasible
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Effect of Changes
• Contracts of some agents become
infeasible
• If the contract is still feasible in
aggregate, management may try to
renegotiate with some or all agents
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Effect of Change on Contracts
Old
Opp.
Cost
Old
Share
Old
rent
New
Opp.
Cost
Shareowner
Manager
Creditor
Employee
Vendor
Subtotal
(1)
10
10
10
10
10
50
(2)
11
12
11
12
10
56
(3)
1
2
1
2
0
6
(4)
11
9
12
9
8
49
Customer
Net Surplus
60
10
56
0
4
55
6
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Min/ A Feasible
Max
Revised
New
Contract
Share
(5)
(6)
11/17
12
9/15
10
12/18
13
9/15
10
8/14
9
49/55
54
55/49
54
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Strategic Management?
• Anticipating change
• Redesigning the contract set to
reestablish individual and aggregate
feasibility if necessary
– Renegotiate with continuing agents
– Negotiating termination of contracts
– Finding new partners and negotiating their
contracts
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Anticipating Change
• Most difficult part of management
• Easy to make others look silly ex
post
• Success may make us less vigilant of
our fallibility
• Mechanical projections from the past
• Value of time gained from foresight
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Famous Words
•
The concept is interesting and well-formed, but
in order to earn better than a 'C,' the idea must be
feasible.“ A Yale professor on Smith's paper
proposing overnight delivery service
• "But what . . . is it good for?“ Engineer at the
Advanced Computing Systems Division of IBM,
1968, commenting on the microchip.
• "There is no reason anyone would want a
computer in their home.“ Ken Olson, founder of
Digital Equipment Corp., 1977
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Famous Words
Who the hell wants to hear actors talk? H.M.
Warner, Warner Brothers, 1927.
We don't like their sound, and guitar music is on the
way out. Decca Recording Co. rejecting the
Beatles, 1962.
Drill for oil? You mean drill into the ground to try
and find oil? You're crazy. Financiers to Edwin L.
Drake, 1859.
Heavier-than-air flying machines are impossible.
Lord Kelvin, president, Royal Society, 1895.
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Dealing with Uncertain Future
• Statistical forecasting to use all
information available in past data
• Delphi Technique to aggregate
information available across
individuals
• Scenario analysis to develop a range
of possibilities to prepare for them
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Redesigning the Contract Set
• No unique solution
• Column 6 in Example 1 shows one
feasible solution
• Interdependence demands
understanding of the whole picture
• An example of aggregate infeasibility
• Requires a redesign
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Example of Aggregate
Infeasibility
Shareown
er
Manager
Creditor
Employee
Vendor
Subtotal
Customer
Net
Surplus
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Old
Opp.
Cost
(1)
10
Old
Share
Old
rent
(2)
11
(3)
1
New
Opp.
Cost
(4)
10
10
10
10
10
50
12
11
12
10
56
2
1
2
0
6
15
12
9
11
57
60
10
56
0
4
45
-12
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Redesigning Contracts
• No obvious algorithm for redesign
• Search for alternative production
technologies, agents, terms of contract
• Cannot assume that all agents will
continue to participate
• Enough slack to deal with uncertainty
during negotiations
• Continually adjust the design through
negotiations
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Renegotiating with Continuing
Participants
• Select who will continue
• Increased O.C. agents will demand
more
• Decreased O.C. agents will be
reluctant to accept cuts (fairness!)
• Asymmetry of information about O.C.
and effect on contracts
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Termination of Contracts
• Some agents may not be a part of the
revised set
• Unhappy agents can impose heavy
costs on the firm
• Value of foresight in gaining time to
deal with them
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New Agents
• Find new agents in respective factor
markets
• Distribution of “free” information to
reduce frictions in factor markets
• Advertising in capital, labor and
product markets
• The cycle never stops
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Summary
• Business unit as a set of contracts
• Agents seek personal goals
• Contracts define resource exchange
relationships
• Individual and aggregate feasibility
• Internal and external changes disturb
feasibility of existing contracts
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Reengineering Contracts
• Managers must anticipate change to
buy time
• Reengineer and renegotiate
contracts to restore feasibility
• Try to improve on design
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Why Reengineering Fails so
Often?
• Over one half of such efforts fail
• Redesign is focused too narrowly to save
costs
• Interests of the people whose cooperation
is necessary for the success is ignored
• Many people see the reengineering effort
as a threat to their jobs
• Deny cooperation, even sabotage the
effort
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Concluding Remarks
• Failure to modify the contract sets to
changing environment causes failure
• A strategic manager scans markets for
changes, reengineers contracts to retain
Individual and aggregate feasibility
• Failures without cooperation of people
adversely affected by reengineering
• Contract model as a framework for
thinking about and reducing such failures
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Thank You.
shyam.sunder@yale.edu