The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2016 has been awarded to Oliver Hart and Bengt Holmström \”for their contributions to contract theory.\” So what is contract theory, why does it matter, and what did Hart and Holmstrom do? The Nobel committee each year posts some background information about its choice, both a \”Popular Science Background: Contract Theory,\” and a more technical \”Scientific Background\” paper called \”Oliver Hart and Bengt Holmström: Contract Theory.\”

In the most basic model of supply and demand, the buying and selling takes place at a moment in time. But in the real world, what is bought and sold often takes place in the context of an ongoing relationship. A company signs a long-term contract with a supplier. A bank makes a loan that will be repaid over some years. Workers at some firms and executives at many firms do their jobs expecting that if the firm makes higher profits, they will receive a bonus. Sales people at many firms expect to be paid according to how much revenue they generate. Some organizations operate on an up-or-out principle, where a time comes when you are either promoted or asked to leave. When a market exchange takes place over an extended period of time, a contractual relationship is at work. Sometimes the contract is mostly explicit, and sometimes large parts of it are implicit (or are part of a broader legal framework). But understanding contracts–both what goals they seek to achieve and how they can go wrong–is fundamental to understanding markets.

Just to be clear, the economic analysis of contracts are not an arithmetic problem with a clear cut answer. Amidst the complexities of the real world, there is no all-purpose perfect contract. But researchers like Hart and Holmström can still make considerable progress by spelling out the issues and identifying the key tradeoffs. For example, here is the Nobel committee on some of Holmström\’s insights about pay-for-performance contracts. As you read it, you may wish to consider  how it differs from that is actually observed in contracts for top executives at many firms.

\”A central result, published separately and independently by Bengt Holmström and Steven Shavell in 1979, is that an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This informativeness principle does not merely say that payments should depend on outcomes that can be affected by agents. 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 (such as those in the same industry).

\”A related result is that the harder it is to observe the manager’s effort – perhaps due to many distorting factors blurring the relationship between her effort and the company’s performance – the less the manager’s pay should be based on performance. In industries with high risk, payment should thus be relatively more biased towards a fixed salary, while in more stable environments it should be more biased towards a performance measure.\” 

Related problems arise in jobs that involve a high degree of multi-tasking. With many interlocking tasks, trying to create an explicit pay-for-performance is very difficult, and it may be better to have an overall performance evaluation which leads to promotions or raises over time. Another issue arises with jobs that involve a high degree of teamwork. As the Nobel committee writes: \”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 in an article from 1982, showing that when the firm’s entire income is divided among team members (as in a worker-owned firm), effort will generally be too low.\”

The award to Hart focused on a different set of contracting issues, in the area of what are called \”imcomplete contracts.\” The issue here is that in a number of settings, it is impossible to anticipate all of the possible issues that might arise. For example, imagine a city that hires a contractor to build a bridge. The contractor submits a bid. But what if there are dramatic changes in the price of materials, or bad weather, or a quality problem with a subcontractor, or a flu epidemic that knocks out half the workforce, or an unexpected environmental review that leads to delays, or any number of other issues? When it is essentially impossible to write a contract covering all eventualities, the other option is to write a contract that specifies who will get to make the decisions when an unseen eventuality arises. Here is discussion from the Nobel committee with a sampling of some  implications:

\”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 materialised. 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. 

\”In several studies, Hart – along with different co-authors, such as Sanford Grossman and John Moore – analysed how to allocate the ownership of physical assets, for example whether they should be owned by a single firm, or separately by different firms. Suppose a new invention requires the use of a particular machine and a distribution channel. Who should own the machine and who should own the distribution channel – the inventor, the machine operator, or the distributor? If innovation is the activity for which it is most difficult to design a contract, which seems realistic, the answer could be that the innovator should own all the assets in one company, even though she may lack production and distribution expertise. As the innovator is the party that has to make greater non-contractible investments, she also has greater need of the future bargaining chip that property rights bring to the assets. …

\”Another application of Hart’s theory of incomplete contracts concerns the division between the private and public sectors. Should providers of public services, such as schools, hospitals, and prisons, be privately-owned or not? According to the theory, this depends on the nature of non-contractible investments. Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to provide either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger. A 1997 article by Hart, together with Andrei Shleifer and Robert Vishny, showed that incentives for cost reduction are typically too strong. The desirability of privatisation therefore depends on the trade-off between cost reduction and quality. In their article, Hart and his co-authors were particularly concerned about private prisons. Federal authorities in the United States are in fact ending the use of private prisons, partly because – according to a recently released U.S. Department of Justice report – conditions in privately-run prisons are worse than those in publicly-run prisons.\”

\”Contract theory\” is one of those terms that may sound irredeemably theoretical and academic. But when thinking about the benefits and tradeoffs of contracts in a wide array of different situations–workers, innovation, production, finance, even government constitutional arrangements–you soon notice that this is a branch of economic theory which is applying analytical precision and rigor to gain insights into the messy real-world issues of day-to-day economic and political life.

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