This week, Oliver Hart and Bengt Holmström won the highly coveted ‘Nobel Prize’ in Economics for their contributions to contract theory, joining the ranks of other economic superstars John Nash (known as the inspiration for the Hollywood blockbuster A Beautiful Mind), Paul Krugman (known for his sometimes amusing New York Times weekly op-eds) and Leonid Kantorovich (ok, so not all Nobel Laureates become household names).
The Royal Swedish Academy of Sciences awarded Hart and Holmström the prize as recognition for their contribution to helping establish contract theory as a “fertile field” of research and for proving that “no take backs” was a legally-binding contract (that last claim might not be true).
What is the relationship between contract theory and economics?
Contracts are a type of relationship that are vital to a functioning economy and facilitate the formation of economic associations despite the presence of future uncertainty, as well as the existence of human malice and greed. As modern society progresses, economic relationships become more complex and comprehensive and this has increased the significance of contract theory. In other words, the relationship between quid and pro is becoming more complex and mystifying.
The level of analysis of contracts has increased dramatically since the 1970s. Today, contract theory helps us to understand and explain economic theory as well as real world outcomes. For example, the theory of the firm is a useful concept for understanding competition and market prices. But in reality no firm can operate in the market without the existence of contracts. From securing investment to buying and selling goods and services, contracts mediate and dictate firm behaviour. The theory of the firm also highlights another important issue in contract theory: agency. Since ‘the firm’ is not a single thinking person, contracts are commonly created and acted on by agents – employees – on behalf of a principal – the firm.
Applying contract theory to economic concepts
Internal organization of institutions, such as firms, also relies on contracts. One of the first applications of contract theory was the relationship between firms and their workers. Contract theorists use theory to explore the relationship between workers, who are risk-adverse and favour constant salaries, and firms, who are willing to take on risk in order to earn a profit.
Contract theory highlights issues that might arise from this relationship. How do firms and employees create mutually beneficial agreements when there is some possibility that the firm will go out of business and the worker will lose their job, or alternatively, the worker will prove to be unproductive or reckless? One conclusion is that workers usually enter into fixed salary agreements that set their wage at a level that is lower than their marginal product, because they are risk-adverse. This explains why wages are not ordinarily tied to performance and tend to remain stagnant even when a firm’s overall productivity increases.
Holmström and the implications of CEO employment contracts
Holmström drew on his own experience as a long-term director of Nokia to provide valuable understanding of a special case of the employer-firm relationship, CEO remuneration. Because a CEO is the most important agent of a firm, the board is highly interested in incentivising innovative and productive behaviour. This line of reasoning leads to the mega-bonuses and generous share options that are commonplace in some industries. However, it can also incentivise recklessness and deceptive behaviour if a contract is not well thought-out.
Holmström’s work emphasised the importance of formulating CEO employment contracts that correctly balance risks and incentives. To do this, companies should adhere to the “informativeness principle” and link indicators of CEO performance to pay. Companies don’t always execute this principle very well. For instance, share price movement is still commonly used as a performance indicator. However, rises and falls in the share price can often be result of factors outside of a CEO’s control, such as trader speculation or sheer luck. Therefore, it is not a good performance indicator.
Hart and incomplete contracts
Hart looked at the performance of incomplete contracts. Many contracts, such as a construction contract to build a skyscraper, create a long-term relationship and it is not feasible to articulate contract terms that cover all possible contingencies. Instead, contracts are usually relatively rudimentary and employ certain strategies such as giving certain parties decision rights, the option to do certain things when a situation arises. For instance, in the context of a construction contract, a decision right might allow investors to pull the plug on a project if construction takes too long. Hart and others demonstrated that features of incomplete contracts, such as decision rights, negatively impact their efficiency.
Hart applied the theory of incomplete contracts to the issue of privatisation of government services. Hart found that in some instances, privatisation leads to lower quality services due to the limitations of incomplete contracts. One example which Hart cited almost two decades ago was the issue of privatised prison contracts, which he believed would lead to lower quality incarceration. This was put down to the tendency for companies to cost-cut and the difficultly of preventing this contingency in a long-term service contract. This analysis may have struck a chord with U.S. policymakers, recently the Federal Justice Department announced that the use of privately owned prisons would come to an end.
Image source: The Nobel Foundation
 Bloomberg. 2016. “Harvard and MIT Economists Share Nobel for Contract Theory.” Bloomberg News. October 10. Accessed October 12, 2016. http://www.bloomberg.com/news/articles/2016-10-10/hart-and-holmstroem-awarded-2016-nobel-prize-in-economics
 Hart, Oliver, and Bengt Holmstrom. 1987. “The Theory of Contracts.” In Advances in Econoimc Theory Fifth World Congress, by Truman Bewley. Cambridge: Cambridge University Press.
 2016. Popular Science Background: Contract Theory. The Royal Swedish Academy of Sciences. https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular-economicsciences2016.pdf
 2016. Popular Science Background: Contract Theory. The Royal Swedish Academy of Sciences.
 BBC. 2016. “US to end federal use of private prisons.” BBC News. August 18. Accessed October 12, 2016. http://www.bbc.com/news/world-us-canada-37124183