Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016
OLIVER HART AND BENGT HOLMSTRÖM: CONTRACT THEORY
The Committee for the Prize in Economic Sciences in Memory of Alfred Nobel
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Contract Theory
1 Introduction
An eternal obstacle to human cooperation is that people have different interests.
In modern societies, conflicts of interests are often mitigated - if not completely
resolved - by contractual arrangements. Well-designed contracts provide incen-
tives for the contracting parties to exploit the prospective gains from coopera-
tion. For example, labor contracts include pay and promotion conditions that
are designed to retain and motivate employees; insurance contracts combine the
sharing of risk with deductibles and co-payments to encourage clients to ex-
ercise caution; credit contracts specify payments and decision rights aimed at
protecting the lender, while encouraging sound decisions by borrowers.
The idea that incentives must be aligned to exploit the gains from cooper-
ation has a long history within economics. In the 1700's, Adam Smith argued
that sharecropping contracts do not give tenants sufficient incentives to improve
the land. In the 1930's, Chester Barnard considered how employees could be
incentivized to contribute effort within large organizations.(1) This year's laure-
ates have approached these old ideas using theoretical models that have given us
new insights into the nature of optimal contracts. The models have also allowed
researchers to sharpen existing arguments and pursue them to their logical con-
clusions. As a result, contract theory has made major strides during the last few
decades. Today, incentive problems are almost universally seen through its lens.
The theory has had a major impact on organizational economics and corporate
finance, and it has deeply influenced other fields such as industrial organization,
labor economics, public economics, political science, and law.
A classic contracting problem has the following structure. A
principal en-
gages an
agent to take certain actions on the principal's behalf. However, the
principal cannot directly observe the agent's actions, which creates a problem
of
moral hazard: the agent may take actions that increase his own payoff but
reduce the overall surplus of the relationship. To be specific, suppose the prin-
cipal is the main shareholder of a company and the agent is the company's
manager. As Adam Smith noted, the separation of ownership and control in a
company might cause the manager to make decisions contrary to the interests
of shareholders.(2)
To alleviate this moral-hazard problem, the principal may offer a compensa-
tion package which ties the manager's income to some (observable and verifiable)
performance measure. We refer to this as
paying for performance. The com-
pany's profit or stock-market value are frequently used performance measures,
but they have well-known drawbacks. They may depend largely on factors be-
yond the manager's control, so that the manager would be rewarded for luck.
Intuitively, it would be desirable to filter out as much of the luck component as
possible, perhaps by measuring the firm's performance relative to other firms in
the same industry. But any performance measure is likely to be imprecise and
noisy, so in the end the optimal compensation schedule must trade off incentive-
provision against risk-sharing.
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https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/advanced-economicsciences2016.pdf
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