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Why this Nobel prize for economics is so well deserved

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Most people have probably never even heard of “contract theory,” but that’s the specialty that has won Finland’s Oliver Hart and Bengt Holmström this year’s Nobel prize in economics. And as the theory’s name implies, their work helps us understand the contractual relationships between, for example, workers and firms, shareholders and management, businesses and suppliers, and health insurance companies and their customers. 

When should workers be paid a bonus based on performance? What’s the best way to structure the contract specifying the terms for paying a bonus? Should managers have stock options as part of their contracts, or is some other arrangement preferable? When should insurance companies require co-payments, and what’s the best co-pay schedule?

Here’s a way to think about contract theory. People often find themselves in situations in which they must trust that someone else will act in their best interest, so contracts are a way of creating incentives that avoid conflicts of interest and specify how to share any risks inherent in the contractual relationship.

For example, shareholders in a company must trust that its managers will make choices that maximize the value of their investment rather than acting in their own interests (e.g. spending lavishly to decorate their offices or spending time pursuing projects that make them look good but aren’t what’s best for the firm). In these situations, the problem becomes one of writing a contract that creates incentives for the manager to put shareholder interests first.

The optimal construction of these “pay for performance” contracts is a harder problem than it might appear at first glance. In this example, it seems clear that tying the manager’s income to some measure of firm performance -- profits and stock values are common choices -- will help overcome the manager’s incentive to place his or her interests above those of shareholders.

But how should other factors, such as luck, be accounted for? What if people work in groups so that the contribution to the final product by each member is difficult to identify? That could lead some members to shirk and get free ride on the effort of others.

What type of contract would discourage this type of behavior? What if some tasks are easy to monitor and evaluate, and hence easy to write into a contract, but other important parts of the job aren’t? In this case, a “pay for performance” contract would focus too much on the tasks that can be monitored and rewarded, and too little on the others. That might be worse than not paying a bonus at all.

Holmström’s contribution was to analyze all these cases (and more), identify the economic incentives that are at play and work out the best contractual arrangements. 

For example, when luck is a important factor in a manager’s performance, paying bonuses based on how well the manager does relative to an industry average is one possible way to separate luck from effort and skill. Consider: If all firms have the same good luck -- say, an unexpected fall in oil prices that increases profits -- then performance will go up across the board. So only those managers who did better than average, presumably due to their skill and effort rather than luck, would be rewarded.

Unlike much of what theorists in economics produce, Holmström’s work has wide application in the real world -- and the Nobel prize was well deserved. This theory is useful whenever contracting arrangements between people or firms are needed. 

Hart’s work is equally praiseworthy, but his main contribution is more difficult to describe. It begins with the idea that it’s not possible to specify all possible contingencies in a performance-based contract. Some unforeseen factor can always arise and affect the ability to fulfill the contract’s terms. 

In such a case, it’s very possible that the parties in the contract will disagree about the best course of action, and this leads to perverse economic incentives. Because it’s impossible to write a contract that details every possible contingency, the problem is how to design the best contract based upon what can be foreseen, measured and written into the agreement. This is known as “incomplete contracting” theory.

Hart and his co-authors show how to solve this problem. The Nobel Committee explains it well:

“The main idea is that a contract that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree. The party with this decision right will have more bargaining power, and will be able to get a better deal once output has materialized. In turn, this will strengthen incentives for the party with more decision rights to take certain decisions, such as investing, while weakening incentives for the party with fewer decision rights. In complex contracting situations, allocating decision rights therefore becomes an alternative to paying for performance.“

Since decision rights and ownership rights go hand in hand, Hart’s contributions also deliver a theory of property rights that has wide applications. For instance, how should financial contracts should be constructed, and when should government services should be privatized? Also, when should a firm be highly vertically integrated (i.e. the produce the inputs needed for production itself instead of purchasing them in the marketplace, often accomplished by merging with suppliers)?

In commercial loan contracts in which it’s not possible to observe and measure all aspects of the borrower’s effort and performance (resulting in an incomplete contract), it’s generally best if the borrower retains a great deal of decision-making control so long as its performance is good, but control (property rights) should revert increasingly to lenders as performance deteriorates. This is how many contracts in the real world work, such as those between entrepreneurs and venture capitalists.

These are just a few examples of contract theory’s broad range of real-world applications. Hart and Holmström have contributed greatly to the development of the theoretical tools needed to understand the many and diverse contractual relationships we observe. And they’ve helped us understand how contracts allocate property and decision rights between parties. 

Just as important, their work serves as a guide to people in both the public and private sectors on how to design contracts that produce the best possible outcomes. No wonder they’ve received such a high honor.

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