1. The Nobel Prize for Economics for 2016 has been awarded to Dr Oliver Hart from Harvard University and Dr Bengt R Holmstrom from the Massachusetts Institute of Technology for their valuable contributions to the contract theory.
  2. Contract theory is the study of the ways individuals and businesses construct and develop legal agreements.
  3. Consider the following scenario: an shoe company undergoes a management change. It offers a ‘per piece’ rate pay to employees rather than a fixed pay. How would the output per worker be affected by this decision?
  4. So the theory analyses how different parties make decisions to create a contract with particular terms.
  5. Dr Hart and Dr Holmstrom developed a comprehensive framework for analyzing many issues in contract design, like performance based pay for top executives, the privatization of public sector activities etc.
  6. The fundamental question the contract theory aims to address is the principal-agent problem.
  7. The principal-agent problem in political science and economics occurs when one person (the Agent) is able to make decisions on behalf of another person (the Principal).
  8. For example : In corporate management (Agent) and shareholders (Principal) or Politicians (agent) and voters (Principal).
  9. Holmstrom’s informativeness principle states that the principals should design a contract which links the agent’s pay to its performance.
  10. Humans fundamentally have different interests, which are often mitigated by contractual arrangements.
  11. However, it is impossible for contracts to specify and cater for every eventuality and this is where Dr Oliver Hart stepped in with his work on incomplete contracts.
  12. Hart’s analysis on incomplete contracts has provided academics and policymakers theoretical tools to study questions such as what kind of companies should merge, what is the proper mix of equity and debt financing and when should institutions such as prisons and schools be publicly or privately owned.
  13. Understanding contracts does not only have implications in the financial domain for understanding bankruptcy reforms and investor rights, but has wider implications for governance.