The science of the deal Oliver Hart and Bengt Holmstrom win the Nobel prize for economic

sciences
The pair helped the field understand how contracts work
Oct 10th 2016
SUPPOSE that you and I are interested in opening a lemonade stand together. We agree that I will bring the
materials we need (cups, stand and so forth) while you will make the lemonade. I’ll do the pouring while you
mind the cashbox and at the end we will split the proceeds fairly. A doubt niggles, though. I am worried you
might, at the end, try to hog the contents of the cashbox. We therefore decide to draw up a contract (common
practice in the lemonade-stand industry) dictating that the returns to our operation must be split evenly. But then
you start to worry: much of the success of our stand will depend on the quality of the lemonade, over which I have
no control. What if I decide to slack off and piggyback on your lemonade-brewing genius, knowing that after you
pour your sweat into the lemonade (not literally), the split is still an even 50-50? We therefore set to haggling over
language in the contract setting out precisely how each of us should do our respective jobs.
Contracts play a critical role in the operation of the modern economy. They set out who is allowed to do what
with the land they own, the people they employ and the songs they store on their smartphones. They underpin
nearly all of the banking and insurance sectors. Individuals are self-interested, but to take advantage of economic
opportunity people must often work together and find ways to align their interests (or minimise conflicts of
interest). That’s where contracts come in. This morning, The Swedish Riksbank awarded this year’s Nobel
prize for economic sciences to Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a
Finnish economist at MIT, for their work improving our understanding of how and why contracts work, and when
they can be made to work better.
Their work focuses attention on the necessity of trade-offs in setting contract terms; it is yet another in a series of
recent prizes which explores the unavoidable imperfections in many critical markets. Mr Holmstrom’s analyses
of insurance contracts describe the inevitable trade-off between the completeness of an insurance contract and the
extent to which that contract encourages moral hazard. From an insurance perspective, the co-payments that
patients must sometimes make when receiving treatment are a waste; it would be better for people to be able to
insure fully. Yet because insurers cannot know that all patients are receiving only the treatment they need and no
more, they employ co-payments as a way to lean against the problem of moral hazard: that some people will
choose to use much more health care than they need when the pool of all those being insured picks up the bill.
Mr Holmstrom applied a deeper analysis to the issue of performance pay, where hard work cannot always be
observed properly. His work suggested that performance-based pay should be linked as much as possible to
measures of managerial performance (such as the price of a company’s share relative to those of its peers rather
than the share price in isolation). But the more difficult it is to find good measures of performance, the closer a
pay package should get to a simple fixed salary.
Mr Hart’s complementary work explored cases in which contracts were necessarily incomplete because not all
outcomes could be specified. In such cases, he reckoned, the allocation of decision rights became hugely
important. In our lemonade stand contract, for instance, we might not specify what happens when a rival stand
opens across the street, but we might agree that the chief executive is empowered to decide what to do in such
cases and then choose one of us to fill that position. Decision rights often go hand in hand with ownership rights.
Mr Hart’s work on the subject noted that who owns what is not simply important in determining what happens in
various unexpected scenarios, but also matters in shaping day-to-day incentives. A scientist working in an R&D
department will spend her time in different ways if promised an ownership share in whatever valuable intellectual
property she generates than if her firm has full ownership rights to the innovations.
This work has had important applications. Work co-authored by Mr Hart compared the incentives to owners in
public and private prisons, for example. In publicly owned prisons, managers might underinvest in quality-
improving measures, but private owners face too strong an incentive to cut costs, leading to conditions for
prisoners that are worse than those in public prisons. This research has informed recent public debates about
private prisons in America.
A common and important thread in work by Messrs Hart and Holmstrom is the role of power in planning co-
operative ventures. Individuals or firms with the ability to hold up arrangements—by withholding their service or
the use of a resource they own—wield economic power. That power allows them to capture more of the value
generated by a co-operative effort, and potentially to sink it entirely, even if the venture would yield big gains for
all participants and society as a whole. Contracts exist to shape power relationships. In some cases, they are there
to limit the exercise of hold-up power so that a venture can go forward. In others, they are intended to create or
protect certain power relationships in order to encourage good behaviour: workers or firms with the right to exit
a relationship, for instance, force other parties to that relationship to take their interests into account. The broader
lesson—that power matters—is one economics too often neglects. Hats off to the Nobel committee for awarding
a prize that puts power dynamics front and centre, and reveals the many, often unappreciated, ways in which they
affect our lives.