Contract Theory: Nobel Prize in Economic Sciences

The 48th Sveriges Riksbank Prize in Economic Sciences was awarded to Oliver Hart, an economics professor at Harvard University and Bengt Holmstrom, also an economics professor at MIT, for their exceptional work on Contract Theory. Contracts can be of various types but their purpose is to uphold trust and cooperation between the 2 or more concerned entities.

In https://www.nobelprize.org/…/popular-economicsciences2016.p… , the contributions of Holmstrom have been highlighted through rigorous analysis of Principal (Employer, who may not be able to observe the manager’s performance directly) Agent (Employee/ manager) model since 1970s under the following heads: Informativeness principle, Multitasking, Moral Hazard in teams, Dynamic contracts and Career concerns. For instance, performance based incentives to compensate the employees may not be the most efficient way to reward them because it doesn’t take into account external factors in the economy (Informativeness principle). The CEO may get faulty incentives for high profits of an oil company which may not be based on CEO’s contributions at all but merely due to rising oil prices in market. If a teacher is rewarded based on performance of students in tests, then it will prevent her from accomplishing her other duties as a teacher. She might not encourage creative thinking or engage in class discussions but only focus on completing the syllabus (Multitasking model).

Oliver Hart’s contribution lies at the heart of Incomplete Contracts and decision rights, ownership rights and property rights. It is reasonable to assume that contracts cannot anticipate all possible future events and give a set of predetermined methods to proceed in every case. So, instead contracts focus on allocating decision making power to the respective entities. An important application of this is in the debate about when to privatise public services like schools and prisons? This would involve a trade off between cost reduction and maintaining quality of the service.
The announcement and subsequent explanation of the Contract theory for Nobel Prize is here https://www.youtube.com/watch?v=XlUBxV39Kkw.

 *The post was originally published on FISCUL, LSR facebook page.
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