The Nobel Prize is widely considered one of the highest honors available in the science, literature and philanthropic communities. The prizes are awarded every year, with some exceptions, to people who publish or perform outstanding work in their given field. The awards span over six categories: physics, chemistry, medicine, literature, peace and economic sciences.
Handed down earlier this month was the award in economic science. It was awarded to Oliver Hart and Bengt Holmstrom for their, “contributions to contract theory.” Contract theory is the economic analysis of contracts. The pair specifically dealt with the contracts between CEOs and shareholders. Specifically, the Nobel Prize Committee states, “We now have the tools to analyze not only contracts’ financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties.”
The important factor here is they are not referring to legally analyzing contracts. The pair is referring strictly to the economics behind contracts, why they have certain clauses, bonus packages, or even why we make them. The theory revolves around basing compensation on how well the company as a whole is doing so that a worker is not punished for what might have been bad luck. Contracts are an extremely powerful thing, and not only when there is a lot of money on the line. People are legally bound to the contracts, both boss and worker. A main factor in Hart’s research specifically is the inclusion of a clause that lets one party choose when an agreement cannot be reached due to uncertainty or inability to agree.
The main kind of contract the pair focused on were government contracts. These are some of the most complex contractual agreements out there. The amount of incentives and trade-offs that exist create a unique dynamic within this subgroup of contracts. Government workers tend to take less pay than any of their private sector counterparts. So, in order to keep workers and attract them in the first place, incentives need to be great. Things like pensions, annuity plans and intellectual property rights are highly debated when contracts come up.
Holmstrom specifically focused on how government contracts could be more efficient if public entities, like hospitals and jails, were to be made public. Taking into consideration contract theory reformed how whole industries work.