2016 Nobel Prize in Economics – Contracts are everywhere in society

Oliver Hart of Harvard University and Bengt Holmström of the Massachusetts Institute of Technology (MIT) have been jointly awarded this year’s Nobel Prize in Economic Sciences ‘for their contributions to contract theory’.

‘Contract theory has greatly influenced many fields, ranging from corporate governance to constitutional law’, said Per Strömberg, chairman of the Economic Sciences Prize Committee, in his announcement of this year’s laureates. ‘Thanks to the work of Oliver Hart and Bengt Holmström, we now have the tools to analyse not only contracts’ financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties.’

He went on: ‘The contributions by the laureates have helped us understand many of the contracts we observe in real life. They have also given us new ways of thinking about how contracts should be designed, both in private markets and in the realm of public policy.’

‘Oliver Hart and Bengt Holmström win a long overdue Nobel Prize for founding the field of Contract Theory. An unarguably splendid pick’, commented University of Michigan economist Justin Wolfers. He added: ‘The Hart-Holmström Nobel is all about economic theorists who re-engaged with the real world and all its imperfections. The old joke “it works in practice, but does it work in theory” no longer applies. Hart and Holmström’s work is all about our messy reality.’



The long and the short of contracts

The Nobel citation explains how contractual relationships are essential to the functioning of modern societies. Examples include contracts between shareholders and top executive management, between an insurance company and car owners, and between a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions.

This year’s laureates have developed contract theory as a comprehensive framework for analysing many diverse issues in the design of contract, such as performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public sector activities.

In the late 1970s, Bengt Holmström demonstrated how a ‘principal’ – for example, a company’s shareholders – should design an optimal contract for an ‘agent’ (the company’s chief executive), whose actions are partly unobserved by the principal. Holmström’s ‘informativeness principle’ stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives.

In later work, Holmström generalised these results to more realistic settings: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can ‘free-ride’ on the efforts of others.

In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with ‘incomplete contracts’. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances?

Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. His research provides new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.

Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.



Oliver Hart and Bengt Holmström

Born in London in 1948, Hart earned his BA in mathematics at King’s College, Cambridge in 1969, his MA in economics at University of Warwick in 1972, and his PhD in economics at Princeton University in 1974. He then became a fellow at Churchill College, Cambridge, and a professor at the London School of Economics. In 1984, he returned to the United States, where he taught at MIT and, since 1993, at Harvard University.

Born in Finland in 1949, Holmström received his BS in mathematics and science from the University of Helsinki, and his MSc in operations research and PhD in economics from Stanford University. He has been on the faculty of MIT since 1994. Prior to that, he was at Northwestern University and Yale University.

Speaking by telephone to the press conference in Sweden shortly after the announcement, Holmström was asked what he makes of large bonuses awarded to senior executives under modern-day contracts. He responded, ‘My personal view is they are too complicated today’.

Oliver Hart remarked, ‘Contracts are just an incredibly powerful way of thinking about parts of economics. They’re just fundamental to the whole idea that trade is a quid pro quo and that there are two sides to a transaction.’

The Lindau Nobel Laureate Meetings offer sincere congratulations to the new laureates and hope to hear from them in person about their research at the 6th Lindau Meeting on Economic Sciences taking place from 22 to 26 August 2017.

Romesh Vaitilingam

About Romesh Vaitilingam

Romesh Vaitilingam is a writer and media consultant, and a member of the editorial board of Vox. He is the author of numerous articles and several successful books in economics, finance, business and public policy, including The Financial Times Guide to Using the Financial Pages (FT-Prentice Hall), now in its sixth edition (2011). As a specialist in translating economic and financial concepts into everyday language, Romesh has advised a number of government agencies and international institutions, including the European Central Bank, the European Bank for Reconstruction and Development and the UK's Department for International Development. His work also involves consultancy for the economic research community, notably advising the Royal Economic Society, the Centre for Economic Performance at LSE and the Centre for Economic Policy Research on the management and development of their public profile; and training economists in communication skills. In 2003, he was awarded an MBE for services to economic and social science.

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