The Nobel Prize in Economics

Oliver Hart and Bengt Holmström will share this year’s award for their contributions to contract theory.

TT News Agency / Reuters

This year’s Nobel Prize in Economics was awarded Monday to Oliver Hart and Bengt Holmström for their work on contract theory, the Royal Swedish Academy of Sciences announced.

Hart, a professor at Harvard University, and Holmström, one at the Massachusetts Institute of Technology, created theoretical tools that are “valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design,” the academy said.

Here’s more:

Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analyzing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatization of public-sector activities.

Holmström, in the late 1970s, put forth the informativeness principle that showed how a principal—for instance, a company’s shareholders—should design an optimal contract for an agent, for instance the CEO, whose action aren’t always observed by the principal. The principle stated how the contract should link the agent’s pay to performance-relevant information. Using this model, he showed how the optimal contract carefully weighs risks against incentives.

Hart, in this work in the mid-1980s, contributed to a new branch of contract theory that deals with incomplete contracts. Here’s more:

Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law.

“I woke at about 4:40 and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang,” Hart said. “My first action was to hug my wife, wake up my younger son ... and I actually spoke to my fellow Laureate.”

The duo will share the 8 million Swedish krona ($923,973) prize equally.