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Economics Nobel for Contribution in Contract Theory
Oct 14, 2016

For their groundbreaking work on how to make contracts fairer and more effective, Oliver Hart of Harvard University and Bengt Holmstrom of the Massachusetts Institute of Technology won the 2016 Nobel Prixe for economics.

  • They will share the 8 million kronor ($930,000) award for their contributions to contract theory.
  • Hart, 68, is a London-born U.S. citizen who has taught at Harvard since 1993.
  • Holmstrom, 67, is an academic from Finland who formerly served on the board of the country's mobile phone company Nokia.
  • For decades, the two men have studied practical problems involving the countless kinds of contracts that underlie modern commerce: How should companies pay their executives? What types of tasks should government agencies outsource to private contractors?

The work in microeconomic theory for which Oliver Hart and Bengt Holmstrom have received Nobel Prize goes back to the 1970s and 1980s when the foundations of contract theory were being firmed up.

  • Their work has provided economists the tools to understand interactions between entities in a range of fields, such as the design of performance incentives in firms and schools, corporate governance, privatisation, constitutional law, and entrepreneur-investor relationships.
  • Their contributions to understanding ‘real-life contracts and institutions, as well as the pitfalls when designing new contracts’ were crucial.

Holmstrom, in 1979, published a theoretical model and result that significantly enhanced the understanding of risk and incentives in employer-employee relationships. This was called the informativeness principle, which said performance should be linked to all variables or outcomes that provide information on the actions taken by an agent, such as a firm’s manager, and not just the outcomes he/she can effect.

Remunerating a manager based on just the share price of the firm will reward and punish for factors beyond control, and a better contract would therefore link managerial compensation to the firm’s share price relative to the share prices of other comparable firms.

Hart’s key contribution to contract theory has been the notion of incomplete contracts. How does a contract allow principals (such as employers) and agents (such as employees) to negotiate unforeseen situations?

  • Through their initial contributions, Hart and Holmstrom launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications.
  • Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.

The laureates who shared the 48 economics prizes awarded between 1969 and 2016, 38 were U.S. residents and 10 were British.

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