The art of contracts

malin arve speilbilde
Malin Arve at the Department of Business and Management Science recently had her paper `Dynamic Procurement under Uncertainty: Optimal Design and Implications for Incomplete Contracts´ published the American Economic Review.

The art of contracts

The Nobel Prize in Economics was recently awarded to two researchers who had studied contract theory. Malin Arve at NHH has recently contributed to the field at the very highest level.

‘The field is called information economics,’ explains Malin Arve, postdoctoral fellow at the Department of Business and Management Science, NHH.

She believes this to be a fitting name. It is all about what information exists and who has access to it.

Act as you want

The basic concept of contract theory is to get someone who has private information, about themselves or something else, to act as you want them to. This is always the key issue, and you can build on it from there, Arve says about her field.

Arve recently had an article published in one of the world’s most prestigious economic research literature journals, the American Economic Review.

It is obviously a big deal. It couldn’t get much better.

Malin Arve

REFERENCE

Dynamic Procurement under Uncertainty: Optimal Design and Implications for Incomplete Contracts by Malin Arve and David Martimort. Published in American Economic Review.

The journal publishes the best articles from the whole field of economics. She wrote the paper together with David Martimort, who is a leading name in the field.

A big deal

‘It is obviously a big deal. It couldn’t get much better,’ says Arve about the publication, which was celebrated with a cake.

This kind of publication is not something you manage to achieve that often and when you do, it means a lot, according to Arve.

Her colleague Øystein Foros from the same department also had an article accepted for publication in another prestigious journal, along with Professor Hans Jarle Kind.

Pricing in the age of diversity

Both articles trigger NHH’s bonus of NOK 80,000 (per article).

Allowing for risk

Arve’s study is about how contracts should be designed, such as contracts for public procurement between the authorities and a road construction company. The innovative aspect of Arve’s article is the idea of taking the changing world into consideration and that the parties may find it necessary to amend or extend contracts at a later point in time.

‘Earlier, we have talked about contracts as very static, but in reality, things might happen that mean you have to revaluate the situation. We have tried to take this into consideration,’ says Arve.

Earlier, we have talked about contracts as very static, but in reality, things might happen that mean you have to revaluate the situation. We have tried to take this into consideration.

Malin Arve

Let’s say a municipality is going to procure a library service. Since the service is intended to be long-term, they will probably offer a fairly long contract for the assignment. It is then reasonable that certain circumstances change during the contract period – perhaps they should offer internet to the users or introduce a new borrowing system, or other unpredictable circumstances. This unpredictable additional factor can be described as a risk, which the parties should allow for when negotiating the service contract.

‘It turns out that, if you have a world containing a certain degree of risk in the form of future unpredictable incidents, it is very important to spread out payments. If you do, you are not as vulnerable to a shock in the future,’ says Arve.

Relevant to others

She initially only had public procurements in mind, such as roads, schools and hospitals, but the public sector is not alone in making large purchases.

‘I received an enquiry from Telenor, who wanted to know if I could present my findings to them. I really wondered what they were intending to do with this, but after the presentation, they said that “this is actually what we do as well”,’ says Arve.

As a producer of telephony services, Telenor needs a mobile network to transmit on. The network comprises both a spectrum for radio waves, which they buy on auction from the authorities, and physical base stations to transmit the signals with. Arve explains that, if you have greater spectrum, you need fewer stations.

‘Telenor puts out construction and maintenance of the physical network to tender, and thereby encounter exactly the same problem as I have described in my study. They can suddenly be given access to more spectrum or lose some, entailing the need to build an extra base station. This must then be included in the contract. It was nice to see that my abstract model could be applied to a situation I hadn’t considered,’ says Arve.

An up-and-coming field

The two researchers who received the Nobel Prize in Economics this year have made contributions to different aspects of the contract field. Bengt Holmström of MIT has, among other things, studied how businesses should pay their managers. Oliver Hart of Harvard has worked a great deal on privatisation of public services and how the authorities can gain as much as possible from their investments.

Arve is part of the latter tradition.

‘This field is very big at the moment, but a lot remains to be done. When we allow for risk in a world that is dynamic, it sells very well. Another article in the same journal I published in also concerns dynamic contracts and the value of private information, but in a slightly different context,’ says Arve.

Arve also says that allowing for risk and amendments to contracts may sound matter-of-fact, but it can very quickly entail technical and mathematical difficulties.

‘We have managed to formulate this in a model and have gained results that we at least believe are useful. Given that businesses like to minimise risk, this becomes important. It is also something that has not been studied before,’ says Arve. 

There is more of a hierarchy in France and the lecturer is well-respected. Shame on you if you’re late! The lectures are very technical and mathematical.

Malin Arve

French schooling 

Arve has taken her higher education at the University of Toulouse in France, from her bachelor's degree until completing her PhD. She believes that the French approach to economics is more technical, which has been useful as a basis for her own work. However, she believes that Norwegian students think more independently.

‘There is more of a hierarchy in France and the lecturer is well-respected. Shame on you if you’re late! The lectures are very technical and mathematical. In Norway, the students are more critical and they learn to understand and not just to remember,’ says Arve.

Personally, she prefers the Norwegian approach and thinks the students learn more if they are forced to think for themselves. In Arve's opinion, the debate that has taken place here about whether there is too little reflection and diversity in economics education is nothing in relation to how the discipline is practised in France.

‘In Norway, the students are actually encouraged to think more for themselves. If a lecturer in France says that five plus three is nine, you don't argue. I can’t say that to my students here,’ says Arve.

Text: Bendik Støren

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Published: 21 December 2016 12:00, updated: 21 December 2016 12:41