24 June 2008

ND Football 07 & Contract Failures

In economics,there is a topic called "contract theory." One particularly important result of Contract Theory states that when two parties enter into a contract (for example one firm hires the products or services of another firm), if the new relationship requires any relationship specific investment, then there is an optimal contract duration.

For example, if coal-mining firm enters in a contract to supply a coal-burning power plant with coal and the power plant will benefit from investment in its factory to tailor its coal-burning process for the type of coal its new partner is supplying, then the two parties would benefit from specifying that their relationship is guaranteed for some particular duration, and early termination by a party incurs a penalty.

To see why, imagine that the two parties agree to maintain their relationship only for a period of time less than the optimal duration. The power plant will not be incentivized to fully invest in the relationship specific assets needed to get the most from the coal. The power plant will therefore get less profit from each unit of coal and therefore not be willing to pay as much to the coal supplier as if they contracted for a longer duration.

There is still a problem. Suppose that the coal-provider and the power-plant contract for the optimal duration. If relationship specific assets depreciate at all, the second after the contract is initiated, from the power plant's perspective, the remaining duration no longer warrants the same degree of relationship specific investment. The power plant will choose not to invest in replacement of depreciated relationship specific assets.

How do the two parties perpetually stay on the margin, always keeping the optimal contract duration in the future. The answer is a continually self-renewing contract, the Evergreen contract. Instead of contracting for a fixed duration, the parties contract to remain in the relationship until one party calls for termination at which point, after a fixed length of time the contract is over. This way, a sufficient amount of duration always remains on the horizon to justify optimal investment in relationship specific assets.

There are many industries in which Evergreen contracts are prevalent and often the norm. Restaurants hiring wait staff generally require a 2-week termination notice. Some people think that the time is so that the restaurant can find and train replacement (which is partially true), but a major reason is so that the restaurant can be justified to provide the wait staff proper training, development of a special relationship specific, the wait staffs knowledge of the restaurant. Evergreen contracts have also become popular in oil and oil-service contracts.

Perhaps Notre Dame' s Athletic Director could benefit from practicing some contract theory. Kevin White's problem is not contracting for too short a time period, but for longer than optimal duration. Who can really blame Charlie Weiss for looking past the near term, either consciously or sub-consciously? When you are provided with a 10-year contract extension, over investment in relationship specific assets becomes a real problem in the near term. You begin to redecorate your office, make sure your child is in the right school district, you treat your staff more congenially, you revamp your recruitment travel process all because you know you will be benefitting from these actions for the next 10 years. Yeah, these actions should pay dividends in the future, but the near term performance is gonna suffer.

It would be nice if ND football could be awesome today, and awesome tomorrow. Maybe it could be if ND's AD offered Coach Weiss an Evergreen contract. We would be getting that type of season that we will be getting in 5 or 6 years today and every year onward. Let's just hope that our near-term suffering isn't bad enough to drive away recruits for the long-term. Luckily it hasn't appeared so yet. Since NBC doesn't Evergreen contract with ND, we're able to get recruits who want to be seen on tv for the next 5 years even though we were abysmal last year. Two wrongs can sometimes make a right.

There are plenty of other explanations for ND's season last year. Coach Weiss wasn't acclimated to the college scene and ran the program too much like a pro program the first year and never developed his youth… All are probably true, but I just wanted to lend an economic perspective to the discussion. There is a pattern of behavior there. Coach Willingham's contract didn't end up being optimal duration either.

4 comments:

Bobbie said...

So, do you not think investing in the future is a good idea for ND football? Do you think they could be as good in the near term (if Charlie focused on that) as they will be in the long term (as is his current focus)?

Maybe Charlie is just a bad coach period - no excuses or bad planning.

mastro said...

yeah, if you choose to sacrifice the present you can have a really good future. do i think it's a good idea, yeah. do i think that was kevin white's plan, no.

the point is that however willing you are to sacrifice the present for the future , however patient you may be, you could have achieved that same result with an Evergreen contract. Then, instead of good investment in the process today and inadequate investment around year 8, you could get optimal investment continually. Since evergreen continually renew, when the investment starts paying off, we would be able to retain that level, instead of having to offer another 10 year contract and have performance poropoise again.

Anonymous said...

is poropoise a word?

mastro said...

porpoise, yes