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Economics Nobel and how contract theory influences our lives

Contracts are ubiquitous in everyday our lives – from our personal relationships, to the one with our employers and insurance agents. Research by these Nobel laureates tries to make sense of them

business Updated: Oct 11, 2016 17:35 IST
MIT Professor Bengt Holmstrom during a press conference at MIT announcing his shared Nobel Prize in Economics with Harvard Professor Oliver Hart on October 10, 2016 in Cambridge, Massachusetts.
MIT Professor Bengt Holmstrom during a press conference at MIT announcing his shared Nobel Prize in Economics with Harvard Professor Oliver Hart on October 10, 2016 in Cambridge, Massachusetts. (AFP)

If you have ever wondered why you are being paid a performance-linked bonus or why jails are run by the government and not a private company, this year’s economics Nobel winners have some answers

Who won this year’s economics Noble and for what?

The economics Nobel – in reality the Sveriges Riksbank Prize in Economic Sciences – was given to US-based professors Oliver Hart of Harvard University and Bengt Holmstrom of MIT for their contributions to contract theory.

Why do contracts matter?

Contracts are ubiquitous in our lives – from our personal relationships, to the one with our employers and insurance agents, and many more. Contracts similar to the last two fall within the ambit of what is called economic contract theory. According to Hart, whenever there is a transaction, be it trade or simple buying and selling, there is a contract involved.

In case of a work contract, you (agent) are selling your skills to your employer (principal), who in turn pays you for it. The work that is required of you and amount of money you will get among other things (such as leaves) is generally specified in a written contract.

Contract theory helps us understand how to better design and analyse such contracts.

How does it explain the performance bonus in a contract?

Incentives (the general term for a performance bonus) have long been considered the motivation for people to undertake effort.

Generally, in big organisations it difficult for the employer to observe the performance of the employee. Holmstrom observed that the best contract would be such the salary is linked to all actions of the employee that are observable.

This was termed by Holmstrom as the informative principle. Since it is tough to gather information about what the employee is doing it is better to link a part of the salary to his performance, which in most cases is appraised once a year.

This saves the employer effort and keeps the employee motivated.

READ | US profs Holmstrom, Hart share economics Nobel

But is it always about the money?

No it is not. As Holmstrom told Nobelprize.org, “It is very much about structuring jobs or structuring the organisation in a way that motivates.”

Since the primary motivator is money and “it is effective too often”, it takes the central place in contract theory. Though according to Holmstrom, “sometimes no financial incentive is the best incentive.”

Apart from money, career concerns and team work also play a part. In Holmstrom’s models an employee who performs well has the ability to do and thus is attractive to other employers, who will pay more. Thus there is an incentive to perform well even on less pay.

How does one decide who gets the incentive in a team?

It depends on who owns the output of the team. In most cases it is the promoters of the company, who delegate the responsibility of deciding incentives through a hierarchy of executives (bosses or higher-ups), and specific departments (human resource among others). Sometimes, those low performing employees may free-ride on those performing well.

Since, the organisation has the final say on how to rate your performance, these, according to Hart, are called incomplete contracts. Even though, in most cases, you have the choice to move to another employer.

Why is that the case?

Incomplete contracts arise because it is difficult to specify beforehand how an employee should act in case of an unexpected event in the future. In such cases the decision rights lies with the person who has the ownership.

The concept of ownership is thus linked to incentives through the right to take decisions. This finds huge application in corporate finance and privatisation.

How is corporate finance related to incomplete contracts?

Consider a startup entrepreneur and venture capital firm. While the entrepreneur has an idea but no way to finance it, the VC firm has finances but no profitable idea. When these two parties enter into a contract the key sticking point will be who gets the decision rights as both the entrepreneur – by virtue of having the idea – and the VC firm – by virtue of having the finances – would want to run the company.

Hart and his collaborators (Hart et al.) predicted that in such cases the entrepreneur should have the right when her decisions are good, but the investor in cases her decisions are bad. This how most corporate financing takes place.

What about privatisation?

Privatisation implies that the majority ownership of an asset or an organisation is not held by the government. Private ownership is accompanied by a strong incentive to cut costs through innovations, while this generally not the case under public control.

According to Hart et al. the incentive to cut costs is too strong in case of private ownership and leads to quality reduction. Therefore private ownership is frowned upon when it comes to welfare services such as health care and incarceration.

While in the former competition may help to some extent, in the latter it may not. For instance, in August the US government, which pioneered private prisons, decided to phase them out because they were “not as efficient” as state-run prisons.

Trivia

According to historian Patrick French (@PatrickFrench) Oliver Hart’s grand-uncle was Edwin Montagu of the Montagu–Chelmsford Reforms, which introduced self-government in India. No such connections for Bengt Holmstrom though. https://twitter.com/PatrickFrench/status/785430469827448832

The economics Nobel carries a cash prize of 8 million Swedish krona (Rs 7.69 crore), which is funded not by the Nobel Foundation, but the central bank of Sweden or Sveriges Riksbank. It is also the latest Nobel – instituted in 1968.