This year’s Nobel Prize in Economic Science was awarded to Oliver Hart of Harvard University and Bengt Holmström of MIT for their contributions to contract theory. Contracts play an important role in many economic relationships between employers and employees, firms and consumers, and etc. Contract theory studies the optimal way to design contracts to ensure that both parties take mutually beneficial decisions when they have different interests.
Holmström’s theories in the 1970s considered the so-called “principal-agent problem” where a principal (e.g. an employer) hires an agent (e.g. an employee) to perform a work for him, and the agent’s action cannot be observed and performance cannot be perfectly measured. Holmström developed the “informativeness principle” which suggests that optimal contracts should structure compensation based on “all outcomes that can potentially provide information about actions that have been taken.”His later work studied this problem in more realistic setting, for example, when an agent works on many tasks; and when many agents work as a team. He also analyzed this problem in a dynamic setting where the principal can reward the agent not only with current pay but also future potential promotions.
Hart in the 1980s made a major contribution to contract theory in analyzing the “incomplete contracts.” Since the future is uncertain, the contracting parties cannot specify every possible future outcome. Therefore, a contract should also spell out who has the right to decide what to do when an unforeseen event happens. The research went on to develop new theoretical tools for 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.”
Hart and Holmström’s work provides us the tools to analyze the designing of contracts’ financial terms, the allocation of control rights, property rights, and decision rights between parties. These tools can be applied to the design of many contracts in practices, from CEO compensation to the level of pay for workers overall.Their research “lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions,” as the Academy states.
Dr Yaping Shan
School of Economics
University of Adelaide