Insight letter – Contracting in the New Economy
Do you think about the Ultimatum Game when you negotiate your contracts?
Insight letter on Contracting in the New Economy
In an economy characterised by increasing volatility, uncertainty, complexity and ambiguity (VUCA), businesses and not least lawyers need to think in new ways when drafting and negotiating contracts. Success in contracts regarding e.g. outsourcing, supply chain or joint ventures, lies in the parties’ ability to jointly work towards common goals in a VUCA environment, while keeping friction in the relationship low.
To keep friction low, organisations need to learn from what in behavioural economics is called the Ultimatum Game, an experiment run on thousands of people all over the world. On Wikipedia, the Ultimatum Game is described like this:
One player, the proposer, is endowed with a sum of money. The proposer is tasked with splitting it with another player, the responder. Once the proposer communicates his decision, the responder may accept it or reject it. If the responder accepts, the money is split per the proposal; if the responder rejects, both players receive nothing. Both players know in advance the consequences of the responder accepting or rejecting the offer.
Say the proposer is endowed with 100 EUR. How should the proposer split the money with the responder? A proposer – acting like traditional economists often assume – would propose a, say, 99,99/0,01 split. The proposer would maximise the “profit”. And the responder would accept: 0,01 EUR is better than 0 EUR, right?
Of course, this is not the outcome in these experiments. Proposers often propose 50/50 splits and at 70/30 splits, the responders often get angry and rejects the proposal. That is, the responders walk away from money because they think the proposal is so unfair that it is more important that the proposer gets nothing than getting the 30. The Ultimatum Game and other similar experiments show the strong sense of fairness that humans have.
In traditional contract negotiations, the results from the Ultimatum Game are often ignored. The first draft often is like the 70/30 split or worse when it comes to obligations and transfer of risks. Of course, this triggers strong negative reaction for the other party, which not necessarily leaves the negotiations but responds in anger and long mark-ups. Which then makes the original proposer upset (how dare they?!). The parties end up in a negative tit-for-tat game that many would recognise but few remember as value creating.
There is an irony here: Contracts are partly written to prevent the other party from acting opportunistically against the interest of the first party. But sending the “70/30 contract proposal” makes the other party want to retaliate and act against the proposer’s interest. The risk that the proposer (i.e. contract drafter) wants to avoid is actually created by the proposer.
When writing and negotiating contracts in a VUCA environment, it is critical that the learnings regarding humans’ sense of fairness taught to us in the Ultimatum Game are taken into consideration. To be clear, this often requires much more than just sending a traditional contract which is more balanced. When the purpose is (which it should be) to lay the foundations for a commercial relationship where friction is low throughout the term, the traditional, transactional contract must often be abandoned. Instead, a relational contract and the process for entering into such contract should be used. With its focus on creating continuously aligned interest and expectation and basis in strong social norms of fairness, the relational contract is often a better commercial instrument for doing business in a VUCA environment.
Questions for you to think about
- Do you and your organisation think about the learning’s from the Ultimatum Game when you write and negotiate your more complex and strategically important contracts?
- How do you yourself react when you receive a draft or proposal which is very unbalanced to the proposer’s advantage?
- What actions can you begin doing today to start to integrate the learning’s from the Ultimatum Game in your contract drafting and negotiation?
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