The Economics Nobel: A prized contract

The Economics Nobel: A prized contract: The work in microeconomic theory for which Oliver Hart and Bengt Holmström have received this year’s Economics Nobel Prize goes back to the 1970s and 1980s when the foundations of contract theory were...

"Their work has provided economists the tools to understand interactions between entities in a range of fields, such as the design of performance incentives in firms and schools, corporate governance, privatisation, constitutional law, and entrepreneur-investor relationships. The Royal Swedish Academy of Sciences highlighted that their contributions to understanding “real-life contracts and institutions, as well as the pitfalls when designing new contracts” were crucial. Mr. Holmström, in 1979, published a theoretical model and result that significantly enhanced the understanding of risk and incentives in employer-employee relationships. This was called the informativeness principle, which said performance should be linked to all variables or outcomes that provide information on the actions taken by an agent, such as a firm’s manager, and not just the outcomes she can effect. Remunerating a manager based on just the share price of her firm will reward and punish her for factors beyond her control, and a better contract would therefore link managerial compensation to the firm’s share price relative to the share prices of other comparable firms. Mr. Hart’s key contribution to contract theory has been the notion of incomplete contracts. Not all information is available ex ante; how does a contract allow principals (such as employers) and agents (such as employees) to negotiate unforeseen situations? The work by Mr. Hart and his colleagues in this area was cited by the Academy for its breakthrough nature."


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