The contractual duo of Economics

Published: October 16th, 2016
Written By : Ronak Pol

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 was awarded jointly to Oliver Hart and Bengt Holmström “for their contributions to contract theory”.

This is precisely what the announcement reads and it is important for many among us to first acknowledge the fact that this is the “Sveriges Riksbank (Bank of Sweden)” Prize in Economic Sciences and not the Nobel Prize in literal sense.

Although the prize has had its fair share of criticism and controversy right from 1974 when Friedrich von Hayek used his Nobel Banquet speech to critique the prize (must read) .“The Nobel Prize confers on an individual an authority which in economics no man ought to possess,” Hayek said. He worried that the prize would influence journalists, the public and politicians to accept certain theories as gospel — and enshrine them in law — without understanding that those ideas have a different level of uncertainty than, say, gravity or the mechanics of a human knee.

This is a very important point as economics as a social science has the power to influence individuals like none other, but economics is still and never will be a pure science meaning all the theories should be taken with a grain of salt and should be used and updated with changing times.

But with this out-of-the-way we can go ahead and look at this years winners and join hands in congratulating the Harvard – MIT duo and briefly understand their contribution to growing  literature in economics.

As the press release by The Royal Swedish Academy of Sciences notes

“Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest(principle – agent problems) , contracts must be properly designed to ensure that the parties take mutually beneficial decisions.

This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities. In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal.

Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.

In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights : which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law.

His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned. Through their initial contributions, Hart and Holmström 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.”

An interesting article by Niranjan Rajadhyaksha from mint explains why contract theory matters and would be an interesting read for people who have not studied contract theory or want a simple exposition of the same.

Conclusion

As we congratulate this years winners we must not forget what Alfred Marshall wrote: “Students of social science, must fear popular approval: Evil is with them when all men speak well of them”.

And remember that no social science theories are beyond the realm of criticism irrespective of what award is bestowed upon them.

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