How to Nudge a Performance Based Contract (PBC) – Part 2

In the previous article (see How to Nudge a Performance Based Contract (PBC) – Part 1) I described how successful contracts deliver the desired outcomes of both buyers and sellers; the classic “win-win” outcome that we all strive for.  We achieve this outcome by balancing the requirements of both buyer and seller with the consequences (rewards and remedies) that provides both positive (carrot) and negative (stick) incentives.

Examining the relationship between the three areas described in Figure 1 of Part 1 (Buyer Need, Seller Need and Commercial Construct), as illustrated in Figure 1, it is possible to observe the following characteristics:

  • moving horizontally (left / right) changes the nature of the agreement; the left-hand edge is a conventional commercial construct transferring risk from buyer to seller through a prescriptive, written contract whereas the right-hand edge is a highly collaborative (relational) approach that shares commercial risk between the parties with limited formal detail; and
  • moving vertically (up / down) changes the outcome for both the buyer and seller; the top edge meets the Buyer Needs but may be seen by the seller as punitive, “unfair” and a “bad deal” whereas the bottom edge meets the Seller Needs but may be seen by the buyer as risk free providing no assurance of performance; “money for nothing”.

Figure 1 : Relationship between Seller Need, Buyer Need and Commercial Construct

Acknowledging these extreme edges, the ideal PBC is one that balances each of these three areas represented by the overlapping region in the centre of the diagram where the Buyers Needs are delivered by linking these to the Sellers Needs through a fair collaborative Commercial Construct.

So how do we achieve this balance?

A PBC is fundamentally a behavioural economics approach where the buyer is trying to “nudge” seller behaviour to deliver their outcome by applying range of complementary rewards and sanctions.

Those familiar with Thaler and Sunstein’s concept of nudging may disagree with my analogy since they typically refer to nudging in a social engineering context (e.g. influencing the uptake of health insurance) and typically applied with a lighter touch.  However, I believe the intent is same.  Using a range of complementary rewards and remedies within a PBC creates a choice architecture that guides and disables seller choice rather than direct legal consequences of a conventional contract such as contractual breach.

While this type of nudge is more direct than Thaler and Sunstein probably envisioned, perhaps we can call it a “heavy nudge”, I believe the intent is same.  Moreover, I believe those of us involved in developing PBCs should strive to deliver a PMF that allows a seller to self-regulate their own behaviour by defining the consequences of their actions or omissions, including positive rewards (incentives), for delivery of the required outcomes.  One of the ways of achieving this is by designing our Commercial Construct with a range of consequences that scale (escalate) based on significance of performance variation from our requirements, in terms of duration, impact of the variation on the buyer, and whether this represents a continuing / repeating performance issue. This approach can be seen in Table 1.

Commitment
(Disable Choice)
Incentive
(Guide Choice)
Positive Incentive (Carrot)
  • Contract Duration and Extension
  • Incentives
  • Recognition schemes
Negative Incentive (Stick)
  • Stop Payment
  • Termination
  • At-Risk Amount
  • Liquidated Damages

Table 1 : Typology of Incentives and Commitments[1]

Here, commitments represent consequences that are either too good to refuse or too bad to accept. In these cases, the consequences, either positive (carrot) or negative (stick), must be of such significance to disable future choice.  On the other hand, incentives represent consequences that guide rather than disable choice. The difference between commitment and incentive is simply choice; does the consequence disable or merely guide choice.

For organisations that want to minimise the variation between PBC, one approach used with good results is to simplify contract drafting by codifying a default Commercial Construct that includes a range of consequences that scale (escalate) based on significance of performance variation from the buyer’s requirements.  The Australian Standard for Defence Contracting (ASDEFCON) suite of contract templates[2]are one example of this approach.

In summary, when commercial practitioners are developing their contracts they should be mindful of the field of behavioural economics ensuring their “Choice Architecture” delivers a fair and balanced commercial construct that delivers both the buyer’s and seller’s needs.  If commercial practitioners can do this, it should lead not only to positive outcomes, but also to positive and supportive behaviours.  And who wouldn’t want this!

[1]                Adapted from AYRES, I. “Carrots and Sticks”, Bantam, 2010

[2]               http://www.defence.gov.au/casg/DoingBusiness/ProcurementDefence/ContractingWithDefence/PoliciesGuidelinesTemplates/ContractingTemplates/asdefcon.aspx

This entry was posted in Behavioural Economics, Nudging, the What, the Why and tagged , , , , , , , . Bookmark the permalink.

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