Contract Theory and Strategic Management: Balancing Expectations and Actions Shyam Sunder Yale University Conference on General Accounting Theory, Warsaw, Poland, June 16-18, 2004

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 re- optimization of the firm in changing environment 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder Examples of Failure Enron WorldCom Xerox Barings Bank of London was acquired for $1 by ING Bank Adelphia 12/28/2018 (c) Copyright 2004 Shyam Sunder

Changing Labels for Senior Managers’ Challenge Long term planning Business policy Strategic management Changing paradigms, metaphors, myths, lexicon? The essence of management does not change 12/28/2018 (c) Copyright 2004 Shyam Sunder

Firm As a Set of Contracts Among many individuals Shareholders Customers Employees Managers Suppliers Government Community, etc. 12/28/2018 (c) Copyright 2004 Shyam Sunder

Firm as a Set of Contracts 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Individuals and Resource Flows 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder How Firms Work Contract is mutual expectation or understanding Not necessarily explicit Role of social conventions Emphasis on symmetry 12/28/2018 (c) Copyright 2004 Shyam Sunder

Individual vs. Organization Goals Firm is like an arena or game In which individuals seek their goals Applicable to All Organizations Focus Here on Business Firm 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Feasibility of Contracts 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder Sources of Change Changes in factor and product markets Capital Labor Technology Product, customer preferences 12/28/2018 (c) Copyright 2004 Shyam Sunder

Managing in Changing Markets Pitfalls of relying on history and experience False confidence Wrong kinds of commitments Old contracts may become infeasible 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Effect of Change on Contracts 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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. 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Example of Aggregate Infeasibility 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Reengineering Contracts Managers must anticipate change to buy time Reengineer and renegotiate contracts to restore feasibility Try to improve on design 12/28/2018 (c) Copyright 2004 Shyam Sunder

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 12/28/2018 (c) Copyright 2004 Shyam Sunder

(c) Copyright 2004 Shyam Sunder 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 12/28/2018 (c) Copyright 2004 Shyam Sunder

Thank You. Please write to: shyam. sunder@yale Thank You. Please write to: shyam.sunder@yale.edu Or, visit: http://www.som.yale.edu/faculty/sunder/research/