Why the 2016 economics Nobel for contract theory really matters

Contracts design defines our incentives in various situations in the real world. The works of Nobel laureates Oliver Hart and Bengt Holmstrom provide valuable insights

Members of the Nobel committee and the Royal Swedish Academy of Sciences announce Oliver Hart and Bengt Holmstrom as the winners of the 2016 Nobel Prize in economics. Photo: AFP
Members of the Nobel committee and the Royal Swedish Academy of Sciences announce Oliver Hart and Bengt Holmstrom as the winners of the 2016 Nobel Prize in economics. Photo: AFP

The decision to award the Nobel Prize in economics this year to Oliver Hart and Bengt Holmstrom for their work in contract theory is further proof that some of the best work in economics is being done to understand the rules of the game—and the contracts that determine our actions in the real world.

Most of us sign contracts. Why do we do so? Take the contracts we enter into with our employers, for example. There are two main reasons.

First, a contract helps the two sides of the deal work together over a long period of time. Think of what would happen if each company would have to search for new employees at the start of every day, or vice versa.

Second, 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. How contracts are designed defines our incentives in various situations in the real world.

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.

Contract theory helps us understand these problems. And helps us solve them through better contract design. Take a simple informal contract. A harried mother has to leave the house for a couple of hours. She is worried her two children will bring the house down by fighting over a large piece of cake in the refrigerator.

The mother leaves a simple instruction—the elder child will cut the cake while the younger one will choose which piece to eat. Now, the elder child cannot cheat. The mother has aligned their interests—or achieved incentive compatibility—through an informal contract.

Contract theory is not just about such parlour games. In two landmark papers written in 1979 and 1991, Holmstrom provided the principles that can help companies draw up contracts to ensure that managers do not sacrifice the long-term health of the firm in pursuit of bonuses linked to short-term performance.

This was precisely the problem in Wall Street before the 2008 financial crisis — investment bankers took excess risks to earn their annual bonuses while those very risky bets almost destroyed the financial system.

Hart has similarly written seminal papers on using contract theory in mergers, acquisitions, corporate ownership and vertical integration. One of his most cited papers was written with Sandy Grossman in 1986. Once again, think of the recent controversy over the non-compete clause for Analjit Singh in the merger between HDFC Life and Max Life. There is contract theory at work again here.

It is with good reason that the Royal Swedish Academy of Sciences has said on the official Nobel website: “The contributions by the laureates have helped us understand many of the contracts we observe in real life. They have also given us new ways of thinking about how contracts should be designed, both in private markets and in the realm of public policy.” The use of contract theory in public policy is something that the Indian government needs to learn, be it the design of telecom auctions or the public distribution system.

The fact that the 2016 Nobel Prize in economics has gone to two giants of contract theory tells us something else as well. Most of the public attention is lavished on macroeconomics and the related dark art of forecasting. This is where the crisis of economics is the deepest.

Since 1991, 22 economists have been awarded Nobel Prizes for their work in the overlapping fields of new institutional economics, game theory, industrial organization, contract theory and information asymmetry. Let us start counting: Ronald Coase, Douglass North, John Harsanyi, John Nash, Reinhard Selten, James Mirrlees, William Vickrey, George Akerlof, Michael Spence, Joseph Stiglitz, Robert Aumann, Thomas Schelling, Leonid Hurwicz, Eric Maskin, Roger Myerson, Elinor Ostrom, Oliver Williamson, Alvin Roth, Lloyd Shapley, Jean Tirole—and now Hart and Holmstrom.

Their combined work helps us understand our interactions with others—and design better rules so that social outcomes are better than before.