Student Blogger - Contracts as Reference Points

In a recent article (Contracts as Reference Points), Professors Oliver Hart and John Moore argue that parties use contracts as a reference point for their expectations of others’ behavior. Since a party agreed to the contract—perhaps through a competitive bidding process—they will not be aggrieved when their counterparty fulfills the terms of the contract. That is exactly how the party expected the counterparty to behave.

But not all contracts completely specify the obligations of the parties. Some terms of a contract are flexible, such as the exact employment tasks, or the specific quality of a product being produced. When a term in a contract is not specific, it allows parties to deviate and still meet the obligations of the contract. If a party sees their counterparty deviating, that party may become aggrieved and feel cheated. This may cause the aggrieved party to “shade”—or not adequately perform their part of the bargain—as a means of retaliation. Thus, parties may choose to adopt rigid contracts to avoid potential shaving.

Hart tested the prediction that parties may prefer rigid contracts in a recent empirical paper that was presented at the Law and Economics Workshop. In the experiment, “buyers” chose whether to offer rigid or flexible contracts. Then the contracts were auctioned off to sellers. The flexible contracts had the advantage of allowing the parties to adjust the final purchase price for the goods. The seller’s production costs were either “high” or “low.” If the costs turned out to be “high” and the contract was rigid, then the seller walked away from the contract because the costs would be greater than the rigid purchase price. But if the contract was flexible, the price could be adjusted so that both parties gained from the trade. Thus, one would expect parties to choose flexible contracts so that there would always be beneficial trade. The downside to choosing flexible contracts is that the seller may become aggrieved by the buyer’s choice of price and subsequently shade, producing low quality goods.

The experiment appeared to confirm Hart’s hypothesis: Parties will prefer rigid contracts because of the potential for shading in flexible contracts. The buyers often chose rigid contracts to ensure that the seller would not engage in shading. And as hypothesized, the sellers very rarely shaded in rigid contracts. Presumably this was because the sellers “agreed” to that contract and received exactly what they expected; the contract was a reference point. As a result of very little shading in rigid contracts, the buyer received a higher profit with rigid contracts than flexible contracts. Also, when the buyer did choose to offer a flexible contract, the buyer often paid a higher price than necessary so that the seller would not become aggrieved and produce low quality goods.

One puzzle presented by this experiment—and the reference point hypothesis in general—is why the parties choose the contract as the reference point. It seems a party could just as easily fix any other part of their dealing, such as the bargaining process, as a reference point. An explanation may be that the deal struck in the contract has some special significance because it resulted from a competitive bidding/bargaining process. That competition leads the parties to believe the contract is legitimate and that they have not been “cheated.”

But looking at Hart’s experiment, the flexible contract was also the result of a competitive bidding process. Multiple sellers bid on a flexible contract (thereby setting the minimum purchase price). This competition should arguably legitimize the terms of the flexible contracts. The sellers knew when they bid on flexible contracts that the buyer was free to pay any amount above the minimum. Why would a seller be aggrieved when the buyer did the best thing for themselves and paid the minimum?

Furthermore, it seems that the buyer’s original choice to offer a flexible or rigid contract could also serve as a reference point. As already explained, the flexible contract is the superior contract for both parties. (And in fact, the sellers did receive a greater average profit if the buyer offered a flexible contract.) Thus, the buyer’s unilateral decision to offer a rigid contract could also have been the source of aggrievement. That choice—just like a buyer selfishly paying the lowest amount possible—benefited the buyer at the expense of the seller. In this case however, the seller may not be aggrieved because no matter how selfish the buyer behaved in choosing a rigid contract, the seller still agreed to those terms and entered into the contract. Still there is the puzzle why sellers would ever be aggrieved in flexible contracts because the seller also agreed to the terms of those contracts thereby allowing the buyer to pay the lowest price possible.