Chains and Contracts

Chains and Contracts

As students of economics, one of the first things we learn about is Adam Smith’s invisible hand  as described in The Wealth of Nations. This invisible hand basically states that the best interests of a society are realized through individual self interest and freedom of consumption and production. Now, this hand which is obviously invisible in theory, was also a bit of a mystery to actual economists. For the longest time, microeconomics has tried to study the economic institutions upon which the  working of the invisible hand rests, specifically upon contracts. Oliver Hart and Bengt Holmström, who won the Nobel prize in Economics in 2016 won it for their work on contract theory.

Why do contracts matter?

“Contract theory provides us with a general means of understanding contract design. One of the theory’s goals is to explain why contracts have various forms and designs. Another goal is to help us work out how to draw up better contracts, thereby shaping better institutions in society.“

(Source: Popular Information – The Prize in Economic Sciences 2016 )

The most basic model in economics is the supply-demand model, where buyers and sellers decide how much is traded and what goods are traded, in response to the prices of the goods. Now you could use examples as simple as apples and oranges, or consider examples that are relatively more complex such as construction labourers. The assumption remains that once you pay the ‘price’ for something, you immediately have your goods in perfect condition and the seller has their income-there is an instant verification. However, a lot of transactions aren’t spot trades like this, in which there is near-immediate exchange. In more complex scenarios, transactions are fulfilled over time- for example, getting insurance, in which you pay premiums and receive payment in case of unfortunate circumstances or when your policy matures, or getting a loan, in which a lender gives out money that is to be repaid with interest at some point in the future. These transactions cannot be verified immediately, which can lead to a series of issues. This is where contracts step in. Contracts ensure that all parties involved stick to the agreed upon conditions of the trade. In a perfect world, contracts would be complete- a 100% guarantee that all parties would uphold their part of the deal, come rain or shine. The seller gets their money and the buyer gets their goods in mint condition.
Contract theory has provided brilliant insights for kinds of transactions, be it trading in cryptocurrency, transactions between businesses or even governance systems. 

Okay this sounds brilliant but what’s the catch

Since we do not live in a perfect world, there is no such thing as a  “complete contract”. Some of the most obvious reasons for this are the following-

1. Moral hazards

Take the example of car insurance. On paper, I can state that I will obey every traffic rule and be a responsible driver, and the insurance can check some records to see if I have been a fan of road rage in the past. However, there is no way for the insurer to ensure my responsibility in real time. The driver’s carelessness could incur a cost upon the insurer, even if the insurance contract requires the driver to be careful at all times.

2. There is no way for any person, or even a bunch of people, to account for every single future circumstance in the realm of possibility, and even if one could somehow list down each possible predicament, it would be inefficient to account for all. Contracts would account for events with a higher chance of happening. In theory, the earth could split open right where my car is parked right now, but my insurance contract would account for relatively more possible circumstances, such as theft. 

Clearly, the problem with contracts is what they don’t account for, not what they do.

The silver lining that blockchains can find

In rather simple terms blockchain can be defined as a chain of records stored in blocks that are not managed by any single authority, in effect ensuring security, transparency and decentralization. An extremely simple analogy might be a Google Doc you share with your friends to edit together- everyone can make their changes, and all of it is recorded and visible to everyone and is thus transparent.

Blockchains record information ranging from financial transactions, identity records, ownership records, agreements between parties or even how many hours do electrical appliances run in a household. The process to store something on the blockchain requires most computers (nodes) of the blockchain network to reach a consensus. Once stored, the record cannot be altered or removed without the permission of the node that made the record, or again, a consensus.  The consensus is a set of rules (so pretty much a contract) amongst stakeholders that regulate how data will be accepted, which ensures the effective working of the blockchain.

Blockchain startups could possibly put the incompleteness of contracts to use- by improving the quality of information so as to include as many terms as possible in contracts. For example, with the advent of technology, car insurance providers could provide lower premiums to people who agree to use devices that monitor their driving, thereby decreasing the unverifiable information and possibly creating efficiency gains. Technology, especially Big Data and AI can be used to account for more contingencies and possibilities where contracts fail.

Devangee Halder

SY B.Sc Economics