The work in microeconomic theory for which Oliver Hart and Bengt Holmström have received this years Nobel Prize goes back to the 1970s and 1980s when the foundations of contract theory were being firmed up.
Their work has provided economists the tools to understand interactions between entities in a range of fields, such as the design of performance incentives in firms and schools, corporate governance, privatisation, constitutional law, and entrepreneur-investor relationships.
The Royal Swedish Academy of Sciences highlighted that their contributions to understanding “real-life contracts and institutions, as well as the pitfalls when designing new contracts” were crucial.
Mr. Holmström, in 1979, published a theoretical model and result that significantly enhanced the understanding of risk and incentives in employer-employee relationships.
This was called the informativeness principle, which said performance should be linked to all variables or outcomes that provide information on the actions taken by an agent, such as a firm’s manager, and not just the outcomes she can effect.
Remunerating a manager based on just the share price of her firm will reward and punish her for factors beyond her control, and a better contract would therefore link managerial compensation to the firm’s share price relative to the share prices of other comparable firms.
Mr. Hart’s key contribution to contract theory has been the notion of incomplete contracts. Not all information is available ex ante; how does a contract allow principals (such as employers) and agents (such as employees) to negotiate unforeseen situations?
The work by Mr. Hart and his colleagues in this area was cited by the Academy for its breakthrough nature.
The Economics Nobel raises larger questions given the high-profile nature of the subject and the fact that it is the only social science for which a prize is awarded. Analysis from The Economist and the Nobel organisation shows that of the 77 laureates who shared the 48 economics prizes awarded between 1969 and 2016, all of 38 were U.S. residents and 10 were British.
Economic historians Avner Offer and Gabriel Söderberg recently pointed out that while the prize may not have a significant liberal or conservative bias, only one person has been awarded a prize for ‘social democracy’ — how governments provide for their people — as opposed to ‘hard economics’ despite social democratic principles governing how 30 per cent of GDP is allocated in developed countries.
Why this has happened is perhaps less important than pointing out that it has happened, so there is an awareness of what the economics prize is, and what it is not.
Contract theory is not merely the study of legally binding contracts. Broadly defined, it studies the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions. Contract theory guides us in structuring arrangements between employers and employees, shareholders and chief executives, and companies and their suppliers.
In essence, contract theory is about giving each party the right incentives or motivations to work effectively together.
Previously, general equilibrium theory had already shown how efficient outcomes can be achieved under ideal circumstances, through detailed contractual agreements. In fact, research in this area has already led to a number of other economic science prizes.
However, this research ignored two potential issues: informational problems and incomplete contracts. By studying these two issues, Hart and Holmström developed what has become modern contract theory.