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Duo win the Economics Nobel for Contract Theory

  • Image Credit: @NobelPrize

Image Credit: @NobelPrize

The Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel 2016 has been awarded to Oliver Hart and Bengt Holmström for their contributions to “contract theory”. Both the laureates will share the prize money of 8 million Swedish Krona for the 48th prize, which was instituted in 1969.

Oliver Hart, a professor of Economics in Harvard University in the USA, was born in 1948 in London. He received his Ph.D. in economics from Princeton University in 1974, and has been a professor at the Harvard University since 1993. Bengt Holmström is the Paul Samuelson Professor of Economics at the Massachusetts Institute of Technology, USA. He was born in 1949 in Helsinki, Finland, obtained his Ph.D. from Stanford University in 1975 and has been at MIT since 1994.

In a society of self-interested individuals, contracts help us to be cooperative and trusting. They also regulate future actions. A clearly charted out employment contract tells the employee which actions and behaviours are in the interest of the employer or the firm and which are detrimental. Consequently there are rewards and punishments to incentivise and de-incentivise those actions. Contracts serve other purposes too - like sharing the risk due to external factors which neither party can affect. However, there is an inherent tension between insurance from risk and incentives; if the damages are fully covered in a vehicle insurance, owners tend to be careless!

Although the problem of providing incentives to workers has been known for a long time, the level of analysis was raised dramatically in the 1970s. A central result published by Holmström states that an optimal contract should link payment to all outcomes. A related result is that if performance is harder to measure, payment should be based less on performance. Thus, a high-risk industry should lean more towards a fixed salary and a stable industry towards a performance-pay. He later extended the analysis to the case where the agent performs many tasks, some whose outcomes are not easy to measure. In such a case, it is better to divide the incentives across the tasks than to concentrate on the task whose outcome is easier to measure. For example, if teachers are rewarded based on the test scores of the students alone, the teacher has an incentive to focus on tests, even at the cost of teaching - an equally important task whose outcome cannot be measured easily.

Oliver Hart’s contribution is in the theory of incomplete contracts. More often than not, a contract cannot be specified to the tiniest detail; it is necessarily incomplete. The challenge then is to design the best rudimentary contract, and specify who has decision-making rights should there be a disagreement in the future. The party with these rights also has a higher stake in the firm, thus a stronger incentive to act in in the interest of itself and of the firm. In complex contracts, allocating decision making rights becomes an alternative to paying for performance.

A major application of Hart’s theory is about the division between the public and the private sectors in running public services like education, healthcare, etc. An economically rational firm is interested in both quality improvement and cost-reduction. Hart’s theory found that the incentives for cost-cutting are typically too strong. Privatisation is desirable only when the outcomes of innovation and cost-cutting are welcome, and when lapses do not incur large costs. In particular, Hart studied the conditions of privately-run prisons in the USA and found that living conditions there are worse than those in publicly-run prisons.

Thanks to the work of Hart and Holmström, we now have tools to analyse not only financial contracts but also property and ownership rights. The current theory is remarkable in that it is both positive and normative - it can both explain the observed data and make policy recommendations for smooth functioning of institutions.

 

References:

1.      Official site of the Nobel Prize in Economic Sciences 2016 https://www.nobelprize.org/nobel_prizes/economic-sciences/

2.      Popular information on the Nobel Prize in Economic Sciences 2016 http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular-economicsciences2016.pdf