We’ve come a long way in how we do business. From handshakes and verbal agreements, today’s business owners have moved on to using automated contract management systems to solidify relationships, fulfill promises, and reach the goals of an organization.
However, although contracts seem pretty simple to understand and easy to do thanks to the tools available today, they are quite complex, as explained by Professors Oliver Hart and Bengt Holmström. Awarded the Nobel Economic prize in 2016, they analyzed the optimal construction of contracts, eventually building the foundations of contract theory.
The Relevance of Contract Theory Today
While Hart and Holmström studied different kinds of contracts such as employment contracts, insurance contracts, and shareholder contracts, this is not all the process involves.
Rather than merely examining different legally binding contracts, contract theory involves the review of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions. With contract theory, we can structure deals that give each party the right incentives to work together effectively.
Indeed, the methods developed by Hart and Holmström have become the fundamental building blocks of various areas, such as finance, law, and public policy.
Learning About Contract Theories
Of course, it’s crucial to understand how automated contract management systems and other advanced tools can help you throughout every stage of the contract lifecycle. However, it’s also your responsibility to learn about the theories explaining why we do what we do as career professionals.
The more you learn about the theories justifying why we have contracts, the better you’ll be able to navigate the complexities involved in working with different kinds of agreements. Read on below to understand the theories surrounding contracts and gain a deeper knowledge of why contracts are crucial to every sector of society.
1. Agency Theory
The agency theory states that parties act for the sake of their own interests—the agent works to increase margin and/or revenue while the principal takes advantage of opportunities to minimize costs.
The difference in interests and interests between gents and principals often leads to moral hazard where one party maximizes its own interests despite the detriment it brings to others. To avoid the principal-agent problem, contract regulations have been put in place to avoid the principal-agent problem, protecting each party’s rights.
2. Transaction Cost Economics (TCE)
Transaction cost economics is an essential economic theory to study for those who want to write complete contracts. This contract theory goes beyond the sticker price—it considers the total cost of the agreement to help understand when it’s more efficient for a transaction to occur within the market or an organization.
To determine the total costs of a contract, TCE considers the following factors:
- Search and information costs
- Bargaining costs
- Policing and enforcement costs
3. Relational Contract Theory
Unlike TCE that fixates on a complete contract, the relational contract theory suggests that business relations should be prioritized instead of economic deals. According to this theory, the contract is a device for facilitating economic exchange and including possible legal consequences in the event of a breach.
Conclusion
With knowledge comes power. Looking forward to the future of contract management and investing in the most innovative automation tools are crucial to contract management. Still, you must also remember to look back at the contract theories introduced over the years that have contributed to managing contracts today. The more you understand the different contract theories, the better you’ll manage various agreements!
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