Contract theory: For which he was given the Nobel prize in Economics in 2016

Oliver HART and Bengt Khol’mstrem

Monday, October 10, the names of the Prize winners of the Swedish national Bank for economic Sciences in memory of Alfred Nobel (also referred to as the Nobel prize in Economics). They were American scientists Oliver HART and Bengt Khol’mstrem – theory of contracts. Here is a translation of the explanation of the Nobel Committee, what exactly is the importance of their work.

Contracts are of great importance for the normal functioning of modern society. Research by Oliver HART and Bengt Holmstrom shed light on how contracts help us to cope with conflicting each other’s interests.

Contracts help us to interact and trust each other in situations that may lead to default and cause mutual distrust. As employees, we sign labor contracts. As borrowers – loan agreement. As the owners of fragile or valuable property – insurance contracts. Some contacts are less than a page, for other not enough and hundreds of worksheets.

One of the reasons for drawing up contracts is the settlement of future action. For example, the employment contract may provide for a reward for good work and to describe the conditions of dismissal. But, at the same time, it is important to note that contracts have other purposes – for example, the sharing of risks between the parties to the contract.

Contract theory gives us a General understanding of how to compile such documents. One of the goals of theory is to explain why contracts exist in different forms and designs. Another goal is to help us decide how best to make the contract, and thereby to improve public institutions. Should organizations that provide such services as schooling, medical treatment or detention, to be public or private? Should teachers, health workers, employees of the penal system to a fixed fee or receive a reward, depending on the quantity and quality of the work done? To what extent the managers should be paid bonuses or securities of the company where they work?

Contract theory does not necessarily provide satisfactory answers to these questions, because in each case, the best contract will still depend on the specific situation and circumstances. However, the strength of this theory is that it allows you to soberly assess possible problems. Contribution of Nobel laureates in Economics for 2016 Oliver HART and Bengt Holmstrom in understanding of the actual contracts and institutions, as well as the risks in their compilation, is invaluable.

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The tension between insurance and compensation or damages

Even if you have insurance for your car, it is unlikely that you will receive full compensation for their losses in the event of an accident. So what is the motivation for the payment of insurance premiums and co-payments? If an accident occurs by chance, of course it is better to have a valid insurance contract, which is a perfect combination of risks and thus eases the load of your damage that is associated in particular with the accident. But full insurance leads to moral hazard: the insured person may behave more carelessly.

The tension between insurance and compensation of damages caused by the combination of two factors. The first is a conflict of interest, because nobody is perfect. If we were all equally careful, regardless, we will have to bear the full burden of responsibility for the consequences of their own behavior or not, full insurance would not be a problem. The second factor is the calculation: not all actions can be perfectly traced. If the insurer could see every careless action of the insured, and this case, the contract of insurance would fully cover the damages, the cause of which was really an accident. However, he does not cover those caused by reckless behavior.

The same type of voltage can be represented in many other contractual terms, for example, in employment contracts. In most cases, the employer is better prepared for the risks than the employee. If the employee acted in the interests of both parties and would not be required counter measures the voltage between the insurance and the reward would have lost its relevance. For the employer in this case, it would be optimal to offer employees a guaranteed xed wage. But if the interests of the employee come into conflict with the interests of the employer and his behavior is hard to trace, the more preferred it becomes, the contract of employment linking pay to productivity.

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The dependence of wages from productivity

Although the problem of creating incentives for workers have long been known, to analyze this issue began in the late 1970s, when researchers come to more accurate answers to the question how to construct the optimal incentive contract. The first significant findings were made in the context of employment contracts that include risk-averse agents (employees) whose actions could not be directly traced by the leaders (employers). Instead, leaders could only in some measure to observe the performance of the agents.

The Central result, which separately and independently published in 1979 Bent Khol’mstrem and Stephen Shavell, the conclusion was that the optimal contract is to bind the payment to all results that have the potential to provide information on actions taken. This principle of informativeness is not just talking about the fact that payments should depend on the results that can be influenced by agents. For example, suppose that an agent is a Manager whose actions affect the stock price of his company, but it does not affect the stock price of other companies. Does this mean that the salary of the Manager should depend only on the share of private enterprise? The answer is no. Since the stock price reflects other factors of the economy that the Manager is not able to control. Thus, a simple relationship of wages with the cost of securities of the company will lead to the fact that the Manager will reward the happy coincidence of circumstances in the market and punish bad. It is better to tie the wage of the Manager to the shareholder value of the enterprise in comparison with other similar enterprises (for example, working in the same field).

A related result is the conclusion that, the harder it is to trace the efforts of the Manager (possibly because of the many confounding factors that blur the relationship between his work and performance of the company), the less the salary of Manager should be based on performance. In areas with a high risk of payment should also be on fixed salary, whereas in more stable industries, they should shift closer to the results.

These early works, especially the article Holmstrem of 1979, gave accurate answers to basic questions concerning salaries, performance-related. However, it soon became clear that important aspects of the reality was missed when building the base model. However, these works have stimulated further research as Holmstrom and other scientists.

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Strong incentives against balanced incentives

In an article published in 1982, Khol’mstrem analyzed the dynamic situation in which the current employee’s salary does not depend explicitly from its performance. Instead, the employee is motivated to hard work, concern for their career progression and future salary. In a competitive labor market, a company needs to reward current performance of higher jobs in the future, while the worker simply change employer. Although this may seem an effective system of remuneration and motivation of employees, the system has one significant drawback: the concern of the career might be fast enough for novice workers that they will be working too intensely at that time, as specialists are older will take time off from work. This model Holmstrem associated with career concerns, has also been applied in a different context for the relationship between politicians and those who voted for them.

In the original article Holmstrem during 1979, it was assumed that the agent performs one task. In 1991 Khol’mstrem and Paul Milgrom broadened the analysis to a more realistic scenario where the employee consists of many different tasks. Some of them can be difficult to track the employer for the amount of compensation. In order to prevent the employee to focus on task, performance in which is easier to measure, it is better to offer overall weak incentives. For example, if the salary of a teacher depends on (legkozelebbi) progress of the student, then the teacher will probably devote too little time teaching the same important (but more difficult to measure) skills, such as creativity and independent thinking. Fixed salary, not depending on any performance parameters, in this case, it will probably lead to a more balanced distribution of effort between tasks. The result of such multitasking model has changed the approach of economists to the optimal payment schemes and work organization.

Work within a team is also making adjustments to original scheme “payment for performance”. If the performance displays the joint efforts of a group of people, some of the participants may demonstrate a tendency to shirk its responsibilities and moonlight through the efforts of its employees. Khol’mstrem considered this issue in the article of 1982, demonstrating that when the entire income of the company is distributed between team members (as in the company, owned by the workers themselves) that their efforts will be fairly low. Foreign owner may increase individual incentives because the salary can be more flexible: total remuneration for team members is no longer calculated from the total income they generated. This example hints at another important issue, which can be considered within the framework of contract theory. Is possession and control.

Incomplete contracts

Inaccurate measurements of performance is not the only obstacle in drafting effective contracts. Parties often are not able to advance realistic to formulate detailed terms of the contract. Thus arises the problem of compilation of the best elementary of the contract. This is an area of incomplete contracts.

A major breakthrough happened here in the mid-1980s in the works of Oliver HART and his colleagues. The main idea consisted in the fact that the contract may not explicitly define what parties have to do with further random events, instead, you have to determine who will own the right to determine what to do when the parties cannot come to an agreement. The party holding the right solutions will also have the right to dictate the conditions, and the ability to get a better deal, when you have a tangible result. In turn, this will strengthen the incentives for strong parties with voting rights on decision-making about, for example, capital investment, whereas for parties with a smaller voting incentives will be weaker. In a difficult contract situation, the transfer of the right solution becomes an alternative to paying for performance.

Property rights

A number of studies HART, together with various co-authors such as Sanford Grossman and John Moore, they analyzed how to allocate property rights for tangible assets. For example, should they be owned by the same company, or different. Suppose that a new invention requires the use of a machine, and your distribution channel. Who should own the machine and who is the distribution channel? Inventor? The operator? The distributor? If innovation is the activity which is particularly difficult to make realistic contract, the answer to this question lies in the fact that the innovator is to collect ownership of all assets in one company, even if it will lead to the shortage of production and distribution. Because the innovator is the party that needs to make more nectarivory investment, it also needs more advantage for future negotiations, which, apparently, will transfer property rights in the assets.

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Financial contracts

One of the important applications of the theory of incomplete contracts the financial contracts. Suppose in example about the Manager’s true performance is difficult to apply the contract because the Manager is able to withdraw the profit of the company. The best solution for the Manager can go into the category of entrepreneurs and owners of companies an entrepreneur can freely decide how to manage your company and appropriately allocate resources between actions that enhance the profitability of the company, and actions that increase his personal gain.

The limitation of this solution is that the Manager sometimes cannot afford to buy the firm, so to Finance the purchase needs for external investors. But if profit can’t be spelled out in the contract, how can investors be sure that they will get their money back? One solution is to promise them a fixed payment (independent of profit) making. If payment is not made, title passes to the investor can liquidate the assets of the company. This is how Bank loans – and the theory explains why. More generally, the theory of incomplete contracts predicts that businesses should have the right to make most decisions in their firms as long as business is good. And the investors the right should go when performance degrades. This feature is typical of actual financial contracts, such as complex contracts signed by entrepreneurs and venture investors.


Another application of the theory of incomplete contracts HART for distribution between the private and public sectors. Should organizations that provide such services as schooling, medical treatment or detention, to be public or private? According to this theory, it depends on the nature nectariferous investment. Suppose that the Manager who manages the service for the provision of household services may make two types of investments: one is to improve the quality, reduce the cost at the expense of quality. Moreover, we assume that such investments are difficult to stipulate in the contract. If the service is owned by the state and hires for its management of the Manager, the Manager will have little incentive to implement any of these investments, because the state does not clearly promise to reward those efforts. If the service provider provides private incentives to invest in quality, and in reducing the cost much stronger. The article 1997 HART, Andrei Shleifer and Robert Cherry has demonstrated that incentives for cost reduction are usually very strong. Therefore, the appropriateness of privatization depends on the tradeoff between cost reduction and quality. In his article, HART and his coauthors expressed special concern over private prisons. The US Federal government actually reduce the number of private prisons. Partly because of the report of the Ministry of justice, according to which the conditions in private prisons is worse than in the state.

The value of the works of Nobel laureates

Contract theory has a great impact on many fields – from management to organizations of constitutional law. Thanks to the work of Oliver HART and Bengt Holmstrom we now have the tools to analyze not only financial contracts but also the contractual allocation of control rights, property rights and the right to decision to the parties to the contract. The contribution made by the current winners, helped me understand a lot of contracts that we observe in the real world. They also gave us new ways of thinking about how things should be written contracts – as in the private market and the public sphere.