Contract Design Research Articles

Dynamic Contract Design in the Presence of Double Moral Hazard

We consider a stylized incentive management problem over an infinite time horizon, where the principal hires an agent to provide services to customers. Customers request service in one of two ways: either via an online or a traditional offline channel. The principal does not observe the offline customers’ arrivals, nor does she observe whether the agent exerts (costly) effort that can increase the arrival rate of customers. This creates an opportunity for the agent (i) to divert cash (that is, to under-report the number of offline customers and pocket respective revenues) and also (ii) to shirk (that is, not to exert effort), thus leading to a novel and thus far unexplored double moral hazard problem. To address this problem, we formulate a constrained, continuous-time, stochastic optimal control problem and derive an optimal contract with a simple intuitive structure that includes a payment scheme and a potential termination time of the agent. We enrich the model to allow the principal to either (i) dynamically adjust the prices for the services in both channels or (ii) monitor the agent. Both tools help the principal to alleviate the double moral hazard problem. We derive respective optimal strategies for using those tools that guarantee the highest profits. We show that the worse the agent’s past performance is, the lower the prices should be set and the more the principal should monitor the agent. This paper was accepted by Ilia Tsetlin, behavioral economics and decision analysis. Funding: The work of F. Tian is financially supported by the Hong Kong RGC Funding [RGC General Research Fund 2023/24 17502023], HKU Seed Fund for Basic Research for New Staff (2022), and the HKU Business School Shenzhen Research Institute [SZRI2023-BRF-04]. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.01169 .

How incentive alignment along the supply chain fosters incremental innovation: evidence from defence performance-based contracts

PurposeTo investigate how providers of product-service bundles design and manage their contracts with upstream suppliers to incentivise incremental innovation for the benefit of their downstream customers, who contract the provider based on performance.Design/methodology/approachAn embedded multiple-case study was conducted to examine elements of a European jet fighter’s manufacturing and after-sales supply chain. The embedded cases concern provider contracts with first-tier suppliers of product and service offerings. Data collection involved 21 semi-structured interviews, documents and other secondary data sources. Data analysis was informed by agency theory to assess the effectiveness of contract design and management in delivering incremental innovation and to identify related contracting strategies.FindingsWe identify four strategies for fostering incremental innovation in contracts between providers and their first-tier suppliers. These include two contract design strategies, i.e. reducing goal incongruence and addressing information asymmetry; and two contract management strategies, i.e. reducing outcome uncertainty and promoting inter-firm integration between providers and sub-suppliers.Practical implicationsThe research offers managerial guidelines regarding how providers can design and manage their tier-one supplier contracts to achieve incremental innovation. These include encouraging early supplier involvement, using focussed KPIs in contracts, and managing product and service-offering suppliers differently.Originality/valueThe research shows the contingent effect during contract design and management of a sub-supplier’s product vs. service offering, which, in turn, impacts incremental innovation. We also find that using focussed key performance indicators in sub-supplier contracts can be effective in improving product and service quality.

The use of cash flows metrics in CEO compensation and the design of loan contracts

The use of cash flows metrics in <scp>CEO</scp> compensation and the design of loan contracts

The Impact of Employee Stock Ownership Plans on Capital Structure Decisions: Evidence from China

The determination of the capital structure is a critical component of a company’s financial decision-making process. The question of how to optimize a firm’s capital structure to increase its value has been a significant topic of interest within the financial community. The employee stock ownership plan (ESOP) has developed rapidly in China’s capital market over the past decade, providing a suitable context for studying the impact of employee equity incentives on capital structure decisions. This paper employs cross-sectional ordinary least squares regression models and unbalanced panel fixed effect models to investigate the impact of employee stock ownership plans (ESOPs) on firms’ capital structure decisions. The analysis is conducted on a sample of Chinese A-share listed companies on the Shanghai and Shenzhen Stock Exchanges. The research considers both static capital structure choice and dynamic capital structure adjustment. We find that the implementation of an ESOP reduces the level of corporate debt and accelerates the dynamic adjustment of capital structure, suggesting that employee equity incentives play a role in optimizing firms’ capital structure decisions. We also find that the impact of ESOPs on the dynamic adjustment of capital structure is asymmetric. Specifically, the implementation of ESOPs markedly accelerates the downward adjustment of capital structure, yet has no impact on the upward adjustment of capital structure. Further analysis demonstrates that the impact of ESOPs on capital structure decisions is contingent upon the macroeconomic environment, industry characteristics, corporate governance, and ESOP contract designs. First, the optimization of ESOPs on capital structure decisions is more pronounced in an economic boom environment, in a poor market climate, or in competitive industries. Second, the reduction effect of ESOPs on corporate debt is more pronounced in non-state-owned companies, high-tech companies and those with lower ownership concentration. In contrast, the acceleration effect of ESOPs on capital structure adjustment is more pronounced in state-owned companies, non-high-tech companies and those with higher ownership concentration. Ultimately, ESOPs financed by loans from a firm’s major shareholders—or with a longer lock-up period, smaller shareholding size or executive subscription ratio—demonstrate a more pronounced optimization effect on capital structure decisions. This paper not only contributes to the existing literature on the relationship between equity incentives and capital structure decisions, but also provides guidance for listed companies on the reasonable design of their ESOPs and the optimization of their capital structure decisions.

How Supplier Customization Influences Its Performance? A Moderated Mediation Model Based on the Contract Theory

ABSTRACT Purpose This study aims to investigate the underlying psychological mechanism and the boundary conditions of the effects supplier customization (SC) on its performance in supply chain management (SCM). Methodology/approach Based upon the contract theory, the study explores how SC influences its performance by revealing mediating role of customer entitlement (CE), and examines the boundary conditions of contractual governance (CG). The dyadic questionnaire survey data of 111 supplier and customer firms in China were used to validate a moderated mediation model. Findings It is found that SC enhances its performance through the increased CE. Furthermore, the above consequential link is moderated by both contractual completeness (CCP) rather than contractual enforcement (CEF). Specifically, CCP negatively moderates the indirect effect of SC on SP through CE. However, CEF negatively moderates the direct effect of SC on CE. Research implications This research are really limitations, including its focus on single industry; single-country system; its cross-sectional design; and the oversight of the possible impact of relational governance (RG) on the link between buyers and sellers. Practical implications Executives should always attach importance to the development of psychological contract (PC), and managers should identify the underlying psychological mechanisms of a customization strategy in B2B and use contractual design and execution with caution. Originality/value/contribution The study extends the literature of the psychological mechanism and more granular characterization of CG, and provides insights for managers to recognize reasonable governance tactics in the context of SCM.

Coordination contract design for a two‐echelon supply chain considering risk aversion and yield uncertainties

AbstractThis study establishes a two‐echelon supply chain (SC) wherein the supplier and the manufacturer suffer from yield uncertainty, and the supplier has a risk‐averse attitude. The SC members’ optimal input quantity and order quantity are investigated. On this basis, the revenue‐sharing and subsidy contracts are introduced to achieve SC coordination. The findings indicate that the two contracts are valid on SC coordination, and there exists a one‐to‐one relationship between these two contracts. Moreover, the two contracts can achieve the same utility allocation between the SC members under specific conditions. Overall, our findings help the SC members develop more efficient cooperation mechanisms.

Safe design and evolution of smart contracts using dynamic condition response graphs to model generic role‐based behaviors

Safe design and evolution of smart contracts using dynamic condition response graphs to model generic role‐based behaviors

Full Quantity or Full Credit? Choosing the Right Buyback Policy for a Behavioral Retailer

Problem definition: Despite extensive research on buyback contracts in supply chain management, little attention has been given to a direct comparison between a traditional full-quantity, partial-credit (FQ) buyback contract and an alternative full-credit, partial-quantity (FC) contract, especially when considering the behavioral biases of the retailer. This study aims to fill this research gap by exploring how these biases influence contract performance and offer practical guidelines for suppliers. Methodology/results: Through controlled laboratory experiments and structural model estimation, we show that the ordering decisions made by human retailers are jointly affected by three behavioral biases—loss aversion, prospective accounting, and psychological cost of inventory error—and these biases differ in magnitude between the two contracts. Incorporating these biases into a behavioral retailer’s utility function, we then analytically examine which buyback policy the supplier should choose. When the wholesale price is exogenously given, the supplier should adopt the FC contract for high-margin (low-cost) products. Conversely, when the supplier has the power to set both the wholesale and buyback prices, the FC contract is generally more beneficial for low-margin products. Finally, when the product cost is sufficiently high, a wholesale price contract may be advantageous over buyback policies. Managerial implications: The managerial implication of this paper is significant for suppliers who have to choose between different buyback policies. The paper suggests that the supplier should carefully consider not just the economic, but also the behavioral dimensions when making contract decisions, particularly when dealing with a retailer influenced by behavioral biases. Specifically, the choice between FQ and FC contracts is influenced by two key environmental factors: the production cost of the product and the nature of wholesale pricing. Understanding these elements allows suppliers to be flexible in contract choices and design appropriate return policies for their downstream supply chain partners. Funding: P. Yu was supported by the National Natural Science Foundation of China [Grants 72371038 and 72033003] and the Fundamental Research Funds for the Central Universities [Grant 2024CDJSKPT16]. T. Feng was supported by the National Natural Science Foundation of China [Grant 72131004]. Supplemental Material: The online appendix is available at https://doi.org/10.1287/msom.2023.0574 .

Predicting costs of local public bus transport services through machine learning methods

The present study developed several machine learning-based cost models to predict an efficient total economic cost per vehicle revenue-mile of urban public bus transport. The models were trained on a built-in dataset from 269 transit agencies providing urban services in the United States from 2015 to 2019. A feature selection strategy was implemented, finding that, for each proposed model, a subset of features determined a large impact on unit cost. These “core” features included commercial speed, average salary expenses per employee, vehicle productivity, and fleet ownership cost per vehicle. Machine learning techniques outperformed the linear regression method in terms of predictive power and robustness (understood as the dispersion of predictive power measures over the training sets). Based on SHAP values, the sensitivity analyses showed that the proposed models could be used to predict the impact of changes in some critical features on corresponding unit costs. The results may be useful for: (i) introducing regulatory constraints to the allocation of national public resources to local public bus transport services, aimed at minimizing the resources needed to provide a given level of service; (ii) defining the maximum economic compensation required by firms involved in competitive tendering for the allotment of service concessions, or firms with monopoly rights (by political choice and/or local public ownership); and (iii) improving service contract management and design by identifying key cost drivers of transit services.

Competition, Product differentiation and Crises: Evidence from 18 million securitized loans

RMBS sponsors contributed to the rise of new product features in securitized mortgages prior to the 2008 financial crisis. Using a regulatory shock to sponsor competition , we show securitization influences the design of mortgage contracts, empirically demonstrating a unique, feedback loop of product differentiation from the derived security (MBS) to the underlying asset (loans). Product differentiation in Prime MBS collateral rises faster than that of non-prime in the early boom period (2000–2004), a strategic choice by MBS sponsors in the face of increasing competition. At very high levels of competition, product differentiation targets non-prime (marginal) borrowers. We develop a theoretical framework for sponsor-induced product differentiation that explains these empirical findings.

Directional aspects of crop yield correlation: Implications for insurance rating and contract design

AbstractWe estimate directional anisotropic models of linear correlation for crop yields. We find that directional distances (i.e., the degree to which yield correlation decays depending on direction) tend to differ from one another, with east to west distances being “longer” than north to south distances (i.e., correlation tends to decline slower in the east to west direction), at least for the major crops of corn and soybeans. Results for wheat are somewhat ambiguous. However, in all cases, average yield aggregates made up of east to west linked counties tend to be more accurate than is the case for north to south linkages. Implications for rating and contract design in the US area yield federal crop insurance program are offered.

Electricity contract design and wholesale market outcomes in Australia's National Electricity Market

AbstractThe emergence of variable renewable energy (VRE) technologies has created a range of different energy contracting techniques. Within Australia's National Electricity Market (NEM), Run‐of‐Plant (RoP) Power Purchase Agreements (PPAs) became the most common form of contract with purchasers of wind and solar energy agreeing to pay a fixed price for energy irrespective of when it is produced and, therefore, its actual value to the market. In November 2023, the Commonwealth Government adopted a 32 GW RoP PPA Contract‐for‐Difference (CfD) underwriting policy that aims to effectively shield the generator from market price risk. This article discusses different contract structures and their impact on participant behaviour during periods of material oversupply and negative prices. We find that embedded solar PV exports into the distribution network, which are not required to dynamically participate in the wholesale market, have increased wholesale energy supply, enabling profit maximising vertically integrated renewable firms to drive prices lower in a manner that partially strands the output of RoP PPA CfD generators with a $0/MWh price floor. A key conclusion from our analysis is that requiring embedded solar PV to effectively participate in the wholesale market appears to be a pre‐condition for the efficacy of government‐initiated RoP PPA CfDs.

EXPRESS: Monitoring Technologies in Industrial Systems

Monitoring technologies, which are at the heart of the industrial Internet of Things (IOT) ecosystems, promise significant transactional efficiencies by making it easier to track product performance and contract compliance. These efficiencies are particularly compelling in industrial multi-vendor, multi-component systems, where complex component interdependencies often cause disputes around liability in the case of product failures. Drawing on transaction cost theory, fieldwork, and a national survey of industrial original equipment manufacturers we estimate how product performance contracts are specified in these contexts, and how these monitoring technologies can impact ex-post exchanges between OEMs and their suppliers. We find that systems architecture associated with the multi-component systems, as well as the presumed efficiencies of monitoring technologies, drive the contract designs through their potential impact on the disputes, monitoring, and contract writing costs faced by the OEM. However, we also find there are clear limits to the benefits offered by these monitoring technologies. The greater monitoring facilitated by these technologies appears to exacerbate disputes. This counterintuitive finding comports with the view that, when unforeseen interdependent failures occur, detailed data from monitoring may trigger a spate disputes over new and unexpected information, as well as over the appropriateness of existing protocols for failure metrics and remedies.

Constructal design of cross‐flow heat exchanger with concave/convex fins

AbstractA contractual design of cross‐flow heat exchanger with concave/convex fins under fixed pressure drop is presented in this paper. An array of heated concave and convex fins are placed in a fixed area, and they are cooled by incoming cross flow, which is moving towards the fins due to constant pressure drop. The distances from fin to fin, the fin base, and the fin surface curvature (concave and convex) are free to morph and are constrained by the fin length and the height of cross flow. Bejan's number ranges from 105 to 107. The ratio of fin base‐to‐fin length is changed from 0.1 to 0.3. The dimensionless mass, momentum, and energy equations for two‐dimensional, steady, and incompressible flow are solved based on the finite volume numerical method. Also, the scale analysis method is used to compare heat transfer densities from concave and convex fins. The numerical results showed that the maximal convective heat transfer density for convex fins is higher than that of the concave fins for all Bejan numbers. The augmentations in the maximal heat transfer density are 2.1% at Be = 105, 4% at Be = 106, and 12.5% at Be = 107. Also, this is confirmed by the scale analysis method.

Does carbon emission trading scheme inhibit corporate executives' pursuit of excess compensation? Evidence from a quasi-natural experiment in China

Carbon regulation, which affects corporate management's carbon reduction and related decisions, has the potential to influence corporate executives' pursuit of excess compensation. Using the pilot policy of the carbon emissions trading scheme (CETS) in China as a quasi-natural experiment, we examine the impact of this policy shock on corporate executives' excess compensation through data from listed manufacturing companies from 2007 to 2020. Our findings show that the executives' excess compensation of manufacturing companies in the pilot regions shows a significant decline owing to the policy shock of CETS, which is supported by a rich set of robustness tests. Furthermore, the mechanism tests indicate that reducing agency costs and stimulating employment demand are two channels for CETS to inhibit excess compensation of corporate executives, and that the factor marketization and the nature of firms' property rights play moderating roles in this inhibitory effect. Heterogeneity analysis indicates that the inhibitory effect of CETS on the excess compensation of corporate executives also varies depending on the differences in corporate governance characteristics. Overall, these findings provide evidence for the regulatory effect of CETS in the contract design of corporate executives' compensation and also provide empirical support for emerging economies to alleviate income inequality by achieving carbon equality.

The problems of adapting Antitrust Law to the digital economy

In connection with the Fifth Antimonopoly Package, the author analyzes the effectiveness of new competition law. The aim of the research is to identify the legal and economic consequences of including the term “network effect” and special legal structures for abuse of a dominant position in digital markets in Russian legislation. The study is based on Russian and foreign legislation, materials from judicial practice, and scientific research. The new rules make it possible for the existing legal regulation on the protection of competition to be applied to the phenomena of the digital economy. However, in the digital sectors, prohibiting the abuse of a dominant position contributes to strengthening the dominance of platform operators and the formation of a digital monopoly. This is not entirely consistent with the goals of antitrust regulation. With the consolidation in the provisions of Russian law of the principle of technological neutrality, as well as the design of a public contract, the strengthening of the dominance of platform operators may be restricted. A consequence of the lack of unified terminology in the Fifth Antimonopoly Package and legislation on digital platforms is the unreasonable limitation of the subject composition of the prohibition of abuse of a dominant position in digital markets. The Fifth Antimonopoly package applies to the activities of marketplaces and aggregators, but does not extend to digital ecosystems and digital services in the format of applications, cloud storage, social networks, search engines, streaming services, among others. This limitation will be overcome by applying the general rules on the prohibition of monopolistic activities and unfair competition to digital ecosystems and digital services. The author draws attention to a number of practical problems in applying dominance criteria to the activities of digital intermediaries, focusing on their business model. Conclusions are drawn about the advisability of expanding the subject composition of relations regulated by the new special rules of the Fifth Antimonopoly Package. Legal means are also proposed aimed at ensuring a balance of interests of the dominant digital platform operators and users.

Data-driven contract design

We propose a prior-free model of incentive contracting in which the principal's beliefs about the agent's production technology are characterized by revealed preference data. The principal and the agent are each financially risk neutral and the agent's preferences are understood to be quasilinear in effort. Prior to contracting with the agent, the principal observes the output produced by a population of identical agents in best response to finitely many exogenously-specified contracts. She views any technology that rationalizes this data as plausible and evaluates contracts according to their guaranteed expected payoff against the set of all such technologies. This paper does four things. First, we characterize the set of technologies that are consistent with the revealed preference data. Second, we show that robustly optimal contracts are either empirical contracts or equity bonus contracts that supplement mixtures of contracts from the data with equity payments. Third, we provide conditions under which these optimal contracts append equity payments to only a single contract from the data. Fourth, and finally, we show that all of our results generalize without complication to a setting in which there might be arbitrary forms of unobserved heterogeneity within the population of agents.

Pay for digitalization: The relationship between digital transformation and payment disparity

AbstractUsing a sample of China's A‐share listed firms from 2016 to 2021, this study empirically examines the influence of digital transformation on the pay gap within firms. Based on the optimal salary contract theory, we posit that digital transformation widens within‐firm pay gap. Conversely, based on the managerial power theory, we posit the competing hypothesis that digital transformation is negatively correlated with the pay gap. Our findings support the optimal salary contract theory, suggesting that digital transformation is positively related to the pay gap, as evidenced by an increase in executive compensation rather than a decrease in the pay of rank‐and‐file employees. These findings are robust to various checks, including alternative measurements, quantile regression model, Heckman selection model, and IV‐2SLS method. Further tests reveal that the positive relationship between digital transformation and the pay gap is more pronounced in labor‐intensive enterprises and those with lower risk‐taking abilities. This study argues that a widening internal pay gap in the digital era is a rational market choice, as evidenced by the positive impact of the within‐firm pay gap resulting from digital transformation on firms' performance. This study extends our understanding of the impact of digital transformation and enriches the literature on compensation contract design.

Contracts rethought and redesigned: A new era with AI

This article discusses the potential of generative artificial intelligence (AI) to revolutionize contract thinking and design. Experience and research tell us that most contracts focus on the wrong things—failure rather than success—and are presented in a way that is inaccessible to many people. Using the principles of proactive contracting and contract design, AI-powered writing assistants such as ChatGPT can help change the contracting paradigm by facilitating the transition from drafting to design and from reaction to proactive action. They can help transform the content, language, structure, and presentation of contracts, simplifying the tedious parts and increasing stakeholder empowerment and choice. This exploratory article presents examples of using AI tools to generate ideas and clauses for commercial contracts and to support contract redesign. This facilitates the creation of easy-to-read explanations, headings, and layered layouts that make contracts more effective, transparent, and sustainable, leading to better business and societal outcomes.

Factors Influencing the Perceived Economic Benefits of Innovative Agri-Environmental Contracts

Continued innovation in contract design may enhance the delivery of agri-environmental climate public goods (AECPG), but barriers to adoption arise in terms of how farmers perceive the economic benefits. Therefore, this paper examines survey data from Ireland and the Netherlands to analyse whether land managers agree that results-based, collective action, value chain and land tenure contracts for the delivery of AECPG are understandable, applicable to their farm and economically beneficial. Using Probit models, we also identify groups of land managers who perceive the different contract types as being economically beneficial, and these findings can inform policymakers of farmer groups who need adequate consideration during the design of agri-environmental contracts. For example, greater incentives could encourage older farmers to enrol in results-based contracts in Ireland and value chain contracts in the Netherlands. We also find a link between contract duration and the perceived economic benefits of collective action contracts in both countries, with land managers in Ireland desiring a longer duration. We highlight that policymakers and land managers in Ireland could apply lessons from the design of agri-environmental contracts in the Netherlands, where they are more common and varied. Greater knowledge exchange between users and non-users of such contracts would also help bridge the gap between theory and practice in both countries.