Contracts & Behavioral Economics

I'm always interested in the way in which compromises are reached, especially in terms of doing deals and putting that language into the contract. If we could do whatever we wanted without consequences,  we'd all write contracts that pushed all burdens, obligations and risks to the other party while handing ourselves all the upside. Since that's not the way things work, we end up making compromises that end up shaping our behaviors with respect to the other party.

In the post, Contract Terms as a Driver of Behavior, Tim Cummins marvels over how little attention is paid by the legal community to the field of behavioral economics. This is primarily due to the way in which contract principles are presented in most law schools: You do something wrong, the contract has a way of punishing that behavior. The question posed by Tim is whether that's really all that helpful in terms of a real-world business contract. Do you want to punish failure or encourage full disclosure in order to attempt to mitigate the consequences of failure. Not an easy line to draw on the page.


It's fairly obvious that negative consequences do not always deter bad behavior. According to the prevalent work in economic theories most parties will breach a contract when it's possible to pay the appropriate damages and still make a profit. So, the question in my mind is how to reward or at least encourage "good" behavior between two contracting parties. For some interesting reading on the subject, check out this interview with Harvard Business School associate professor Nava Ashraf. One of the issues raised in the interview discusses the issue:

"... we trust managers to carry out the interests of shareholders: We can build contracts to align manager incentives with those of shareholders, but we are never able to completely contract on all the things we care about and want to enforce. Implicitly, then, we hold a belief that managers have internalized the values we care about, and trust them to act on those, particularly when they might come in conflict with their own interests."

Without getting into the nitty gritty of Behavioral Economic Theory (which I am woefully unqualified to do), what many researchers are looking at now is what a breach of contract costs outside of the four corners of the contract. That is, what is your reputation, brand, trust, etc., worth in economic terms.