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And Now It Is The Nobel Committee That Recognizes Contracting …

October 27, 2009

The recent award of the Nobel Prize for Economics to Elinor Ostrom and Oliver Williamson should be a source of excitement and pride to those in the world of contract management. It endorses the critical importance of good contracting in the delivery of business value – and confirms the need for professionals to focus more on finance and economics.

Both of this year’s winners drew their inspiration from the work of Ronald Coase, oft-cited by IACCM for his contribution to understanding the economics of trading relationships. Williamson in particular has continued that work, by seeking to understand when it makes sense for companies to in-source versus outsource.

Professor Coase established that economic logic would suggest that companies should be less efficient than markets – and therefore purchasing goods and services would cost less than providing them through internal resources. However, this theory depended on the costs associated with determining the market price and engaging an external supplier. At the time he was writing (in the 1930s) these costs could be prohibitively high.

The growth of networked technologies changed the cost equation. Searching and transacting has become much simpler and quicker, leading to two massive changes in recent years. One of these is the dramatic growth of outsourcing (and the resulting break-up of traditional enterprise organization); the other is the drive towards ‘commoditization’ and the endless search for lowest cost sources of supply, regardless of geography.

Professor Williamson’s work has sought to define the limits of this new efficiency and he has confirmed that the savings from a ‘spot trade’ mentality are steadily lost when transactions become more complex and when they depend on the parties forming a meaningful relationship. These findings are important for several reasons:

  1. We must become better at recognizing when it is more efficient to use an external contracted relationship than to do something internally.
  2. We must understand the limits of ‘auction’ behaviour and the extent to which a focus on the market price may obscure the true cost of acquisition.
  3. As The Economist recently observed (Reality Bites, October 17th), “writing and enforcing contracts which take every possible eventuality into consideration (is) difficult, or even impossible”.

Contracts (and therefore the jobs of those who create and manage them) exist to bring discipline to trading relationships. Smart contracting understands the nature and the scope of the contract required and also its limits in defining and managing the required relationship. For our job to bring value, we must be adroit at shaping the relationship with an appropriate form of contract and then applying the right resources to its management, to deal with the level of uncertainty.

Most importantly, this Nobel award confirms the fundamental economic importance of contracting decisions and the need for contracts professionals to focus primarily on economic value and only then on the containment of business and legal risk. If we ignore the economic imperative, we will frequently end up in the wrong relationship.

3 Comments
  1. Carol Leutner permalink

    This statement confirms the fact that a contract is only as good as the relationship between the parties. Creating and keeping that relationship healthy can be a time consuming and costly proposition. If lawyers have the communication expertise and experience to bring to a firm in keeping contract/contract parties “healthy” they should be engaged to do it. Just because they are lawyers or recognized in any other discipline should not be a bar. Rather it is more a matter of the skill to keep the parties and the contract on track.

  2. Alx&ra permalink

    A contract is a legal, not a social relationship document, since it is enforceable by law. Should anything go wrong, it’s the lawyer(s) who feet are held to the fire.

    It is incumbent on the attorney(s), and common sense, to create a good relationship with the other party (ies) to the agreement. Otherwise, we all find out very quickly that agreements forged in an adversarial atmosphere do blow up in everybody’s face, usually sooner than any time later.

    I would hold that an economic aspect to the agreement should be considered a super close second to the legal consideration. After all, and as above, if one party feels it has been forced to accept unfair terms, exercising the terms becomes a nightmare for everybody involved.

    It is the job of a good contract manager, whether a lawyer or paralegal, to ensure an amicable, prompt and mutually acceptable atmosphere in which the terms are executed. It goes without saying that maintaining and mediating a good relationship between the parties makes all the difference. They are the two inseparable sides of the same coin.

    • Your comment regarding the legal significance of a contract is of course correct. But perhaps this overlooks tthree key points.
      1) The decisions that are made over the legal terms do have impacts on a relationship and its outcome – so there is a cost associated with those term and negotiation decisions that perhaps too few lawyers appreciate.
      2) In reality, much legal advice is around the principles of drafting and how the law will view certain business principles or practices, rather than making the underlying business decisions. This is often a point of confusion – and many lawyers find themesleves being pushed to make business decisions, rather than legal decisions. It is not right – nor my intent – to criticize lawyers for the frequent failings of business people t be clear over what they are really trying to achieve.
      3) In my expereeince, there are many areas of ‘the contract’ in which lawyers often have little involvement. For example, service level agreements and statements of work are key documents which are often prepared and drafted by non-lawyers.

      Contracts – and the process by which they are preared – are often complex. My point is that they exist first and foremost to assist successful economic outcomes – and that includes (but is not dominated by) the need to offer protection from negative economic outcomes (such as lawsuits).

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