Insights into Editorial: Why the 2016 economics Nobel for contract theory really matters
The Nobel Memorial Prize in Economic Science has been awarded to Oliver Hart and Bengt Holmstrom for building the foundations of contract theory.
What is contract theory all about?
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.
Contracts are signed mainly for the following reasons:
- A contract helps the two sides of the deal work together over a long period of time.
- The contract creates rules that allow agents with different interests to cooperate to achieve some goal. No market economy can work without such cooperation premised on trust but also backed by the law.
What are the main concerns?
There are various nuances in our contracts. They could be formal or informal, depending on whether they are enforced by law or social norms. They could be complete or incomplete, which is based on whether they take into account all possibilities that lay in the future.
- One side of a contract may know more than the other because of information asymmetry, so insurance companies, for example, may end up covering people with health problems rather than the healthy, through what is called adverse selection.
- There are also agency problems—as when managers who are under contract with shareholders actually try to maximize their own earnings rather than those of their shareholders.
Significance of contract theory:
Contract theory helps us understand these problems. And helps us solve them through better contract design. Hart and Holmstrom have developed elegant and powerful methods that are taught to all students in economics. Their work forms the fundamental building blocks of many areas beyond economics, such as finance, law, public policy and management. They have studied two potential issues: informational problems and incomplete contracts. By studying these two issues, Hart and Holmstrom developed what has become modern contract theory.
Holmstrom’s work focuses on informational problems in which some parties do not observe what others are doing. He has published three papers in this regard.
- Moral Hazard and Observability:
His 1979 paper, “Moral Hazard and Observability”, shows how employers should optimally link employee rewards to performance outcomes. One key insight is that a CEO’s pay should not depend only on his or her company’s share price. Such a scheme would unnecessarily penalize the CEO for factors beyond his or her control, such as commodity prices.
A better reward scheme would seek to eliminate such factors by, for example, linking the CEO’s pay to the company’s share price relative to competitors in the same industry.
- Moral Hazard in Teams:
Another paper, published in 1982 and titled “Moral Hazard in Teams”, extends his 1979 analysis to settings in which a team of employees contributes individual efforts towards a collective output, such as a team of inventors working together to develop a new product.
A partnership scheme that simply shares profits amongst team members creates a free-rider problem: Each team member is insufficiently motivated by his or her share of profits and thus exerts too little effort. Holmström shows that the free-rider problem can be resolved by introducing a “budget-breaker”, a third party such as a venture capitalist who assigns rewards and penalties to the team members and keeps what is left for herself.
- Multitask Principal Agent Analyses:
Holmström’s 1991 paper with Paul Milgrom, “Multitask Principal Agent Analyses – Incentive Contracts, Asset Ownership and Job Design”, considers situations in which the employee allocates effort amongst multiple tasks. The employer only observes the outcome of some tasks. For example, a teacher may devote effort towards improving test scores or towards inculcating student creativity.
One insight is that the school should not make teacher pay too sensitive to observable outcomes. Rewarding teachers for high test scores may distort teacher effort away from hard-to-measure tasks such as developing student creativity.
Hart developed foundations for the theory of incomplete contracts. The basic idea is that it is impossible to write a contract that anticipates every potentially relevant future contingency. Consequently, the allocation of control rights becomes a powerful tool for creating incentives. This perspective enables the analysis of fundamental questions such as whether companies should outsource or integrate production, which assets they should own and how they should choose between equity and debt financing.
- Hart’s 1986 paper, “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration”, studies incomplete contracting in which various parties invest to increase the productivity of an asset. When unforeseen contingencies arise, the parties have to bargain over what to do. Crucially, asset owners have stronger bargaining power, which motivates them to invest. Therefore, the asset should be owned by the party whose investment is most important.
- A paper Hart published in 1990 with John Moore, “Property Rights and the Nature of the Firm”, extends his 1986 analysis to study optimal ownership of multiple assets. It shows that highly synergistic assets – whose values are enhanced when used together – should be owned by a single party, rather than separately by multiple parties.
- Concentrating bargaining power in the hands of one party is more effective than diffusing bargaining power across multiple parties. This paper paints a compelling picture of large integrated firms where all physical and intellectual assets are owned by a single corporate entity.
Contracting As An Art, Not A Science:
Hart and Holmstrom have developed contract theory as a term of art.
- A key reason contracting can be considered an art—noted the Nobel Prize Committee—is because “relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions.”
- A second reason contracting can be seen as an art instead of science is the complex nature of many of today’s business relationships. Hart’s work has focused on an area of economics called “incomplete contracts,” the fact that agreements often don’t specify actions and payments for all possible contingencies.
Contracts have governed the workings of the economy since ancient times. As technology improves and organizations become more complex, the theory and practice of contract design will only increase in importance. Hart and Holmstrom’s work lays the foundation for thinking more strategically about how to design contracts for optimal outcomes.