You don’t think about it, but what makes you a law-abiding citizen with a job and a home is a long list of contracts. These agreements, which could be as simple as a few words uttered under certain conditions or documents hundreds of pages long, help to ensure that you and most of the people you interact with work together on a set of agreed terms.
Today the Nobel Prize in economics was awarded to Oliver Hart of Harvard University and Bengt Holmström of the Massachusetts Institute of Technology, for explaining a lot of what we know about how contracts work and why we make them the way we do. “Contracts are just an incredibly powerful way of thinking about parts of economics,” said Hart. “They’re fundamental to the whole idea that trade is quid pro quo and that there are two sides to any transaction.”
The theory behind contracts dates all the way back to the 1700s and Adam Smith’s research on sharecropping contracts. Hart’s and Holmström’s work has helped explain how contracts are designed to overcome issues of trust and conflicts of interest. It applies to all types of contracts, from the one that ties you to your employer to the one you sign when you buy a house. The purpose these contracts serve is to share risk among all the parties.
For example, if accidents occurred purely by chance, wouldn’t it be better to have an insurer who covers all the cost? That would work only if all humans always did their best to avoid accidents, which we don’t. If we were fully insured, we would have an incentive to be more careless. Contract theory helps us understand why in such cases insurance companies charge deductibles and co-payments.
The theory also tackles something known as the principal-agent problem. It works like this: A principal (for example, an employer) hires an agent (an employee) to do some work and pays her according to an agreed contract. The dilemma arises because the agent can make decisions that benefit herself at the expense of the principal. And the principal doesn’t have perfect knowledge of what the agent is doing all the time or even a good measure of her performance. So how do you decide what to pay her?
For example, should a CEO’s pay only be linked to her own company’s share price, not that of other companies? You might think yes, because she doesn’t have control over other companies. But Holmström says no, because share prices can be moved by other factors in the economy. If pay is only linked to the company’s share price, the CEO might be rewarded for good luck and punished for bad economic factors outside of her control. Instead it should be linked to the share price relative to other, similar firms. A good contract should take into account all factors that measure performance.
The problem, as both Hart and Holmstrom have shown, is that contracts are not perfect. They cannot, for instance, specify exactly what each party must do in every future eventuality. Instead, one solution is that contracts should be written to give one party the right to decide when both parties cannot agree. “The party with this decision right will have more bargaining power, and will be able to get a better deal once output has materialized. In turn, this will strengthen incentives for the party with more decision rights to take certain decisions, such as investing, while weakening incentives for the party with fewer decision rights,” as the press release about the prize explains.
Though contracts have existed for a long time, Hart and Holmstrom’s work helps us design better contracts in many fields.
For instance, who should own a machine and who should own the distribution channel for what it produces—the inventor, the machine operator, or the distributor? Answer: it depends. If innovation is the most difficult step to contract, then perhaps the inventor should own all the assets.
Or, if a business’s profits aren’t guaranteed, how can investors be reasonably sure of getting their money back? One solution is to promise future pay regardless of profit or loss, or offer collateral in terms of the firm’s assets.
Or should public services, such as schools, hospitals, and prisons, be privately owned or not? The answer depends on many factors, but ultimately it’s down to how the contracts for privatizing them balance the incentives between improving quality and reducing cost. Hart and some colleagues have shown that often—specifically in the case of private prisons—the incentives to reduce costs are too strong. Contract theory, in other words, is key to making a lot of decisions about public policy. Shame the policymakers don’t always use it.