Oliver Hart and Bengt Holmstrom: Contract Theory Won Nobel

Dr. Bengt Holmstrom, 67, a Finish Economist, working as Professor at the Massachusetts Institute of Technology since 1994 and Dr. Oliver Hart, 68, a British Economist working as Professor at Harvard since 1993 were awarded the Nobel Memorial Prize in Economics for 2016 for their work on improving the design of contracts for performing the specified promise. Announcing the Prize, the Royal Swedish Academy of Sciences observed that the “modern economies are held together by innumerable contracts” and the analysis of contractual arrangements by Holmstrom and Hart jointly and independently, “lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.”

Under most of the economic transactions what is traded is money with a promise to deliver what has been asked for. For instance, a bank lends money today against the promise of the borrower to repay it as per the agreed upon repayment schedule. These transactions call for a mechanism that ensures fulfillment of promises. And thus emerged contracts. In common parlance, “Contract” means an undertaking, promise or agreement made between two or more parties, whereby rights and obligations are created which are enforceable under law. This in turn introduced a mechanism for verification of the performance by the parties concerned and a legal system for penalizing the failed parties. However, commonsense says that the more complex the transaction, the harder it is to evaluate the performance. And it is equally difficult even for a third-party to ensure compliance as per the contract. In the same vein, it is not always possible to make a perfect contract. Which is why a certain amount of sacrifice has to be made by the parties to the contract just as it happens in the case of a company that chooses share capital over a debt capital or a landlord choosing a fixed rent contract over sharecropping contract or vice versa. This phenomenon reveals that there exists in every contract a trade-off between risk-exposure and incentives.

Precisely, it is this ‘trade-off’ between risk-exposure and the incentives that the early research work of Holmstrom and Hart had identified as the decider of contract choice. In addition to this, Holmstrom has identified unidirectional high-powered incentives as another key factor in contract choice. His work identified giving high-powered incentives on the more easily measurable dimensions—such as a landlord granting fixed levy contract obviously inducing a sharecropper to maximize current yield ignoring the upkeep of soil-quality—as another key factor in contract choice. Holmstrom’s work was focused on employment contracts. It revealed that paying for performance does not always encourage employees to work their hardest, because managers cannot always keep monitoring what everyone is doing. Further, he has also shown how it makes sense to offer employees fixed salaries instead of variable bonuses in situations where it is difficult to measure the job performance, which incidentally is what commonly encountered in work situations. His ‘multi-tasking model’ had shown that performance-pay to a CEO can backfire, for it encourages the CEO to work for short-term gains at the cost of the firm’s long-term sustainability.

In addition to these constraints embedded in measurement and enforcement, contracts also suffer from another inadequacy: Contracts by their very nature are incomplete. For, it is not possible always to specify every conceivable contingency that real-life situations throw up. This factor obviously makes economic decisions discretionary. And it is here that ownership of assets makes a great difference in calling the shots, which obviously enhances the owner’s incentives, while diminishing the returns for those who work for the owner. Working on this premise—property rights theory of the firm—Hart highlighting the problems of incomplete contracts, offered “theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and which institutions such as schools or prisons ought to be privately or publicly owned.”

Thus, the work of Holmstrom and Hart enhanced our understanding of real-life contracts and aided businesses, governments and individuals in avoiding potential pitfalls in drafting contracts. One may however wonder that some of this research sounds conventional wisdom, but it must be appreciated these two economists using mathematics rigorously examined the hitherto foggy notions about incentives and contracts and offered ideas for real-world applications to ensure harmonious outcomes.

Intriguingly, in the recent past, the Academy, perhaps wondering, “Is there anything at all left to be awarded under the grand economic theories that are broadly concerned about fiscal and monetary policies?”, has shifted its attention to identify the economists who have been developing careful insights, albeit about smaller questions but with greater certainty, which is “really thinking about economics from the ground up”, and thus is laudable.