Nobel economics prize awarded for work on contract theory

Nobel economics prize awarded for work on contract theory
17 Oct 2016

On the 10th of October 2016, British-American Oliver Hart and Finnish Bengt Holmström were awarded the Nobel economics prize (including $922 000) for their transformative work on contract theory. According to the Nobel jury, the professors developed theoretical tools which provide “…a comprehensive framework  for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.”

The pair’s work advises parties on how to identify important issues such as contract design and potential contractual pitfalls in order to achieve an outcome which is favourable to all relevant parties. Their theories have been instrumental in advancing our abilities to analyse and draft contracts and to understand institutions and policies in areas as diverse as bankruptcy legislation, insurance, and political constitutions.

The professors’ studies on contracts have revealed the necessity for trade-offs with a view to achieve the right balance of risk and incentive. Insurance contracts for example require a balance between full cover and moral hazard, even though it may seem more convenient to simply pay for comprehensive insurance. Contract theory reinforces the practice of excess payments in order to prevent a situation whereby the insured abuses the insurance system by, for example, driving recklessly or utilising excessive health care benefits.

The theory further examines the efficacy of performance based bonuses to motivate employee performance. Professor Holmström demonstrated how optimal contracts link payments to outcomes, with salaries tending more towards fixed remuneration where performance is more difficult to measure. He elaborated that shareholders should ideally reward managers by comparing the relative performance of their company to other companies in the same sector.

Professor Hart’s contribution to contract theory examined the complexities involved in writing contracts which cover eventualities that cannot be specified in advance. Contracts record and determine the power relationships of the relevant parties and must be formulated to encourage good behaviour. Hart alleges that when outcomes cannot be specified, it is important to allocate in advance the respective parties’ rights to make decisions concerning various unexpected scenarios. This approach is especially useful in financial contracts where entrepreneurs could gain or lose control of their companies as against their lenders, depending on the performance of the business.

The theory has been pivotal in understanding the pros and cons associated with the provision of public services by public and private providers. Hart’s work revealed that while public prisons in America provide a manager with little incentive to improve efficiency, “incomplete contracts” enable private prisons to cut costs at the expense of quality thus resulting in unacceptable conditions. These findings induced a shift towards a prison system run by the public sector.

Leonardo Felli, head of the economics department at the London School of Economics praised the work of Holmström and Hart, claiming that “Their analysis of the contractual relationship between individuals has enhanced our understanding of the inner functioning of modern firms, corporations and organisations, as well as providing a key insight into the basic contractual relationships between economic agents, the building block of all economic activities”.

For a list of previous winners, see the following link:

(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)

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