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

2. (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

3. (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
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(c) Copyright 2004 Shyam Sunder

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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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5. 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
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(c) Copyright 2004 Shyam Sunder

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

7. Firm as a Set of Contracts
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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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9. Individuals and Resource Flows
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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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11. 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
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12. 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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(c) Copyright 2004 Shyam Sunder

13. 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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(c) Copyright 2004 Shyam Sunder

14. 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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(c) Copyright 2004 Shyam Sunder

15. 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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(c) Copyright 2004 Shyam Sunder

16. Feasibility of Contracts
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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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(c) Copyright 2004 Shyam Sunder

19. 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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(c) Copyright 2004 Shyam Sunder

20. 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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22. 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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24. Effect of Change on Contracts
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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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(c) Copyright 2004 Shyam Sunder

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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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(c) Copyright 2004 Shyam Sunder

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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, , 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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(c) Copyright 2004 Shyam Sunder

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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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(c) Copyright 2004 Shyam Sunder

29. 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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(c) Copyright 2004 Shyam Sunder

30. 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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(c) Copyright 2004 Shyam Sunder

31. Example of Aggregate Infeasibility
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32. 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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(c) Copyright 2004 Shyam Sunder

33. 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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(c) Copyright 2004 Shyam Sunder

34. 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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(c) Copyright 2004 Shyam Sunder

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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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(c) Copyright 2004 Shyam Sunder

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

37. 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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(c) Copyright 2004 Shyam Sunder

38. 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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(c) Copyright 2004 Shyam Sunder

39. (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

40. Thank You. Please write to: shyam. sunder@yale
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