A Nobel for Contract Theory

If I had to sum up in two words what earned Oliver Hart and Bengt Holmstrom the 2016 Nobel Prize in economics, the answer is "contract theory". Contracts are much more important in our day to day lives than we often realize. Contracts play a critical role in the functioning of the modern economy. Contracts define who is allowed to do what with the property they own, the people they employ and the treasures they store. They underpin nearly all of the banking and insurance sectors. Self-interested individuals need often work together to take advantage of economic opportunity and find ways to align or minimize conflicts of interest. That's where contracts come in.
Why do contracts matter? Suppose that you and I are interested in opening a chotpotti stand together. We agree that I will bring the materials we need (chona dal, eggs, potato, tomato and so forth) while you will make the chotpotti. You will do the mixing while I mind the cashbox and at the end we will split the proceeds fairly. A doubt niggles, though. You are worried I might, at the end, try to help myself with the contents of the cashbox. We therefore decide to draw up a contract dictating that the returns to our operation must be split evenly. But then I start to worry: much of the success of our stand will depend on the quality of the chotpotti, over which I have no control. What if you decide to slack off and piggyback on your chotpotti mixing genius, knowing that even after you carefully mix the ingredients, the split is still an even 50-50? We therefore set to haggling over language in the contract setting out precisely how each of us should do our respective jobs.
Contracts make people cooperative and trusting when they otherwise may be unaccommodating and mistrusting.
Employees have employment contracts; borrowers have credit contracts; accident-prone owners of valuable property have insurance contracts. Some contracts are less than a page, while others over hundreds of pages. A major reason for drawing up a contract is to regulate future actions such as stipulating rewards for good performance and conditions for dismissal as well as sharing risk among the parties to the contract.
Contract theory has influenced many fields, ranging from corporate governance to constitutional law. How should companies pay their executives? What types of tasks should government agencies outsource to private contractors? How best to write an auto insurance policy to protect drivers from financial loss without soothing them into carelessness? Thanks to the work of Oliver Hart and Bengt Holmström, we have the tools to analyze not only contracts' financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties. The contributions by these two have contributed to understanding many of the contracts observed in real life.  Their work focuses attention on the necessity of trade-offs in setting contract terms.  It is yet another in a series of recent prizes which explores the unavoidable imperfections in many critical markets.
The trade off between insurance and incentives: A vehicle insurance never fully reimburses the loss due to an accident. Why do such insurance have deductibles and co-pay? Surely it would be better to have insurance contracts that perfectly pool risks and thus relieve the vehicle owners of all the losses associated with a particular accident if they happened purely by chance. Holmstrom's analyses of insurance contracts describe the unavoidable trade-off between the completeness of an insurance contract and the extent to which that contract encourages moral hazard. If the vehicle is fully insured their drivers may become more careless. This tension between insurance and incentives is due to a combination of two factors. The first is a conflict of interests: if we were all equally careful, full insurance would be unproblematic, but we are not. The second is measurement: not all our actions can be perfectly observed. If an insurer could see every careless action, an insurance contract might fully cover all losses caused by true accidents, but not those caused by reckless behaviour. Unfortunately, not all careless actions are observable and hence even true accidents cannot get full insurance coverage.  In case of health services, from an insurance perspective, the co-payments that patients must sometimes make when receiving treatment are a waste.  It would be better for people to be able to insure fully. Unfortunately, insurers cannot know that all patients are receiving only the treatment they need and no more.  Co-payments are used as a way to lean against the problem of moral hazard: that some people will choose to use much more health care than they need when the pool of all those being insured picks up the bill.
Paying for performance does not always work: The problem of providing incentives for employees had been known for a long time without any clear answer. Holmström and Shavell argued in 1979 that an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This came to be known as the informativeness principle, which says that payments should not only depend on outcomes that can be affected by agents but also relative to those of others. Holmstrom's work suggested that performance-based pay should be linked as much as possible to measures of managerial performance such as the price of a company's share relative to those of its peers rather than the share price in isolation. However, the more difficult it is to find good measures of performance, the closer a pay package should get to a simple fixed salary. Thus, in industries with high risk, payment should be relatively more inclined towards a fixed salary, while in more stable environments it should be based on performance. Contract should link the agent's pay to information relevant to his or her performance while carefully weighing risks. Likewise, companies fare best when they establish pay packages that incentivize executives to prioritize the long term as much as the short term, to avoid focusing too much on quarterly profits.        
Balancing incentives: Holmström analyzed a dynamic situation in which an employee's current salary does not explicitly depend on his current performance. Instead, the employee is motivated to work hard due to concern about his career and future salary. In a competitive labour market, a company has to reward current performance with higher future earnings, otherwise the employee will switch employer. While appearing to be an efficient system for rewarding and motivating workers, this has one drawback: career concerns may be strong for people starting their working lives when they work excessively hard, while older people without this incentive tend to slack off.
In Holmström's original 1979 article, the worker was assumed to be responsible for a single task. Holmström and Paul Milgrom extended the analysis in 1991 to a more realistic scenario where an employee's job consists of many different tasks, some of which may be difficult for the employer to monitor and reward. Their analysis concluded that it may be best to offer weak overall incentives to deter the employee from concentrating on tasks for which performance is easier to measure. For instance, if teachers' salaries depend on student pass rates, then teachers might spend too little time teaching equally important, but harder to measure, skills such as creativity and independent thinking. A fixed salary, independent of any performance measures, could lead to a more balanced allocation of effort across tasks. The results of this multi-tasking model changed how economists think about optimal compensation schemes and job design.
Team work also modifies the original pay-for-performance framework. If performance reflects the joint efforts of a group of individuals, some members may be tempted to shirk, free-riding on the efforts of their colleagues. Holmström addressed this issue showing that when the firm's entire income is divided among team members, effort will generally be too low. Compensation needs to be more flexible such that the total compensation for the team members no longer needs to add up to the total income they generate.  
Incomplete contracts: Hart explored a fundamental shortcoming of contracts: no one can predict the future and there are too many future variables to possibly codify them all in a contract. So, when the unforeseen inevitably happens, who decides how to deal with it? This is the domain of "incomplete contracts". Hart emphasized that a contract should identify who has the right to make future decisions - a significant kind of power. However, parties are frequently unable to realistically articulate detailed contract terms in advance. The problem then becomes how to design the best rudimentary contract. Contracts that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree. The party with this decision right will have more bargaining power, and will be able to get a better deal once the outcome has materialized. In turn, this will strengthen incentives for the party with more decision rights to take certain decisions, such as investing, while weakening incentives for the party with fewer decision rights. In complex contracting situations, allocating decision rights therefore becomes an alternative to paying for performance.  
Hart explored cases in which contracts were necessarily incomplete because not all outcomes could be specified. In such cases, he reckoned, the allocation of decision rights is hugely important. In our chotpotti stand contract, for instance, we might not specify what happens when a rival stand opens across the street, but we might agree that the manager is empowered to decide what to do in such cases and then choose one of us to fill that position. Decision rights often go hand in hand with ownership rights. Hart's work on the subject noted that who owns what is not simply important in determining what happens in various unexpected scenarios, but also matters in shaping day-to-day incentives.
Financial contracts: Suppose, in the case of a manager, that true performance is difficult to use in a contract because the manager is able to divert the firm's profits. The best solution may be for the manager to become an entrepreneur and own the firm himself. An entrepreneur can freely decide how to run the firm and make the appropriate trade-off between actions that raise profits of the company and actions that increase his private benefits. The limitation of this solution is that the manager sometimes cannot afford to buy the firm, so that outside investors have to finance the purchase. But if profits cannot be contracted on, how can investors be sure they will get their money back? One solution is to promise them a fixed future payment (regardless of profits) with collateral: if the payment is not made, ownership is transferred to the investors, who can liquidate the firm's assets. This is actually how most bank loans work. More generally, incomplete-contract theory predicts that entrepreneurs should have the right to make most decisions in their firms as long as performance is good, but investors should have more decision rights when performance deteriorates.  
Property rights: The importance of property rights for reducing externalities, improving incentives, and achieving more efficient outcomes has been noted for centuries. The subject of property rights received renewed attention following the work of Hart and his co-researchers who discovered that property rights over assets can be used to define boundaries of firms.
Every organization, whether a firm, a nonprofit organization, or a society, must confront two basic problems: the creation of incentives for efficient behaviour among its members and the efficient allocation among those members of the resources available to and produced by the organization. These problems are closely related, because the rule for allocating resources generally affects individuals' incentives. Organizations have many ways of trying to achieve these goals. Sometimes they use contracts which may explicitly specify behaviour or attempt to indirectly encourage desirable behaviour through incentive pay. Other times they allocate decision rights to parties and leave them considerable discretion.
The basic concept of a property right is relatively simple: A property right gives the owner of an asset the right to the use and benefits of the asset, and the right to exclude others from them. It also, typically, gives the owner the freedom to transfer these rights to others. The owner is allowed to exclude all, and is accountable to no one but herself. In other words, property rights are a bundle of decision rights involving the asset, which provide rights of access and the rights of exclusion, including the right to take the profit generated by use of the asset and to prevent others from doing so.
Suppose a new invention requires the use of a particular machine and a distribution channel. Who should own the machine and who should own the distribution channel - the inventor, the machine operator, or the distributor? If innovation is the activity for which it is most difficult to design a contract, which is realistic, the answer could be that the innovator should own all the assets in one company, even though she may lack production and distribution expertise. As the innovator is the party who has to make greater non-contractible investments, she also has greater need of the future bargaining power that property rights bring to the assets. The work of Hart, teaming with many other frontier researchers, has been an inspiration for the development of various theories of the organization of production, locally and globally, based on the concept of property rights.
After extending the property-rights theories to explain multinational firms' boundaries, the literature acknowledged that contracting institutions are not only important for understanding vertical integration decisions, but they also constitute a source of comparative advantage. By formalizing the idea of power in market and non-market economic transactions, the ideas of Hart and his co-researchers have proven to have new and interesting implications for how the process of globalization affects different groups in society depending on their assets and access to information, and also how the effects of trade policies are transmitted across countries, with implications for the efficacy of rules that currently govern negotiations at the World Trade Organization.
Public versus private provision: Another application of Hart's theory of incomplete contracts concerns the division between the private and public sectors. Should providers of public services, such as schools, hospitals, and prisons, be privately-owned? This depends on the nature of non-contractible investments. Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to do either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger. But Hart, together with Andrei Shleifer and Robert Vishny, showed that incentives for cost reduction are typically too strong. The desirability of privatization therefore depends on the trade-off between cost reduction and quality. Hart's work showed that cost reduction and improvements to quality are the two conflicting forces at work when a government decides whether it should privatize a service or run it on its own. Private contractors have a strong incentive to reduce cost, which can result in a drop in quality.
This work has had important applications. Hart was concerned about private prisons: would profit-seeking contractors emphasize cost-cutting more over maintaining quality? Work co-authored by Hart compared the incentives to owners in public and private prisons. In publicly owned prisons, managers might under invest in quality-improving measures, but private owners face too strong an incentive to cut costs, leading to conditions for prisoners that are worse than those in public prisons. His concerns proved perceptive: After discovering that private prisons were marred by more safety and security problems than government-run prisons were, the Justice Department ordered the Bureau of Prisons to reduce and eventually end the use of private prisons.
The theory of incomplete contracts provides a way of thinking about which government services can benefit from being privatized, and which are better off under government control. Hart and Holmstrom's work suggest that the case for in-house provision is generally strong when non-contractible cost reductions have large adverse effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatization is strong when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government. Thus, the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatization is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools. In some other services, such as provision of health care, an analysis of the efficiency of alternative arrangements is a great deal more complicated and requires deep understanding of competition, contracts, and regulation.            
The holdup problem:  A common and important thread in work by Hart and Holmstrom is the role of power in planning co-operative ventures. Individuals or firms with the ability to hold up arrangements-by withholding their service or the use of a resource they own-wield economic power. This has come to be known as the holdup problem -- a situation where two parties may be able to work most efficiently by cooperating but refrain from doing so because of concerns that they may give the other party increased bargaining power, and thereby reduce their own profits. This problem is central to the theory of incomplete contracts and shows the difficulty in writing complete contracts. That power allows them to capture more of the value generated by a co-operative effort, and potentially to sink it entirely, even if the venture would yield big gains for all participants and society as a whole. Contracts exist to shape power relationships. In some cases, they are there to limit the exercise of hold-up power so that a venture can go forward. In others, they are intended to create or protect certain power relationships in order to encourage good behaviour: workers or firms with the right to exit a relationship, for instance, force other parties to that relationship to take their interests into account. The broader lesson-that power matters-is one economics too often neglects.
The author is Lead Economist, The World Bank Dhaka Office.  Opinions expressed in this article are the author's own.