Nobel Prize in Economic Sciences 201

- Yashdeep Singh Dahiya , Economics Association

2017-02-19

Technical

This year the Nobel Prize for Economic Sciences was jointly awarded to Oliver Hart and Bengt Holmstrom for their contributions to contract theory.

Oliver Hart, born in 1948 in London, completed his Ph.D. from Princeton University in 1974. He is currently Professor of Economics at Harvard University, Cambridge, USA.

Bengt Holmstrom, born in 1978 in Helsinki, Finland, completed Ph.D. from Stanford University. Presently, he is Professor of Economics, and Professor of Economics and Management at MIT, Cambridge, USA.

Contract Theory

We all like getting rewarded. This is not the case only with individuals but also corporates and governments. Everyone who constitutes an economy wants to get benefited to the best of one’s own interest- be it shareholders, employees or employers. To make sure that all the participants involved in a commercial transaction are satisfied, we need contracts that define clauses acceptable to all parties. Contracts are bound legal agreements that both the parties agree upon before beginning a transaction.

We often see different types of contractual relationships around and each contracting party tries to exploit prospective gains from cooperation. For example: labor contracts include pay and promotion conditions that are designed to retain and motivate employees; credit contracts specify payments and decision rights aimed at protecting the lender while encouraging sound decisions by borrowers.

While contracts have been there for a long time, this year’s laureates have developed the existing contract theory with a comprehensive framework that analyzes many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatization of public-sector activities.

Let’s have a look at the significant contributions of Hart and Holmstrom to the contract theory.

Laureates’ Contribution to the Contract Theory

Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmstrom are valuable to the understanding of real-life contracts, as well as their pitfalls in design.

Paying for Performance

The problem of providing incentives for employees had been known for a long time and it was only in the late 1970’s that researchers arrived at exact conclusions on how to design an optimal incentive contract. It explains how a fixed salary may not drive employees to work for outcomes desired by the firm.

Holmstrom’s informativeness principle stateshow a contract should link an agent’s pay to his performance– by using relevant information about outcomes that are affected by agent’s behavior. But does it mean that the payments should depend on outcomes alone?

For example, suppose the agent is a manager whose actions influence her own firm’s share price, but not share prices of other firms. Does that mean that the manager’s pay should depend only on her firm’s share price? The answer is no. Since share prices reflect other factors in the economy – outside the manager’s control – simply linking compensation to the firm’s share price will reward the manager for good luck and punish her for bad luck. It is better to link the manager’s pay to her firm’s share price relative to those of other, similar firms.

Strong incentives vs Balanced incentives

Holmstrom also analyses situations where pay does not depend on performance alone but on other objectives.

Holmstrom’s career concerns model is about compensating employees not only on the basis of their performance but also higher future earnings, otherwise the employee will simply switch employers.

In the multitasking model, he also analyses how contracts can deter the employee from concentrating on tasks for which performance is easier to measure, it may be best to offer weak overall incentives. For instance, if teachers’ salaries depend on (easy to measure) student test scores, then teachers might spend too little time teaching equally important (but harder to measure) skills such as creativity and independent thinking.

Team work also modifies the original pay-for-performance framework. If performance reflects the joint efforts of a group of individuals, some members may be tempted to shirk, free-riding on the efforts of their workmates. Holmström addressed this issue by analysing the role of an outside owner in changing the incentives. An outside owner for the firm can boost individual incentives because compensation can be more flexible: total compensation for the team members no longer needs to add up to the total income they generate. Thus he also discusses the role of ownership and control on incentives.

Incomplete Contracts

In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts.

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.

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.