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Oliver Hart and Bengt Holmström, 2016 economics Nobelists, explained

Contracts — legally binding agreements about who will do what in exchange for what under what circumstances — are the lifeblood of a functioning market economy. Outside of an extraordinarily oversimplified schematic model of a market, there’s simply no other way to do things. On-the-spot exchanges of cash for goods do happen, of course (I bought a banana that way over the weekend), but most economic relationships are considerably more complicated than that.

Everything from a credit card transaction to an employment agreement to deals with landlords and suppliers and investments involves contracts. Without them, you would have economic activity and a crude form of market exchange but nothing remotely resembling the vast sophistication of modern industrial and post-industrial activity.

But in the eyes of a lot of economic modeling, the contracts that constitute the binding connective tissue of the entire economy operate like a magic box that simply and seamlessly reconciles conflicting interests. The 2016 Nobel Prize in economics was awarded to Oliver Hart and Bengt Holström, two foreign-born economists who now teach at Harvard and MIT, respectively, for the compatible though not collaborative work on building out the theory of contracts into something more robust and informative.

The key idea stretching across both men’s work is that there’s no such thing as a perfect contract. In some sense, it might be ideal to have a document that specifies every possible situation and every possible remedy, complete with perfect and immediate information about exactly who did what when.

Real contracts are, of course, nothing like that. In part that’s because trying to draft such a contract would be costly, and in part it’s because the monitoring and information required to do complete contracting would itself by costly and impossible.

It matters who owns what

Much of Hart’s most interesting research centers on the ways in which contracting imperfections mean that it ultimately does matter who owns what. There is a meaningful difference, he argues, between a government that operates a prison directly and a government that contracts out prison management to a private operator. The private prison operator, unlike the government, has a strong financial incentive to invest in new methods and processes for cutting costs. In this particular case, an incentive that is too strong and will lead to dismal outcomes!

In other arenas, by contrast, contracting out to incentivize cost cutting is probably a good idea. As Tyler Cowen writes, common sense says you wouldn’t want Air Force One to be owned and operated by a private contractor that the government hires on a fee-for-service basis, but it does make perfect sense for the government to buy the plane from a privately owned airplane building company rather than to try to do plane manufacturing in house. These questions of where to draw the line between public provision and public payment are crucial for many political debates, and Hart’s research offers theoretical tools to help understand the question.

That research builds on earlier work he did in the 1980s that deals with purely private cases. When does it make sense for a company to own elements of its own supply chain versus contract with other companies for supplies?

This is often treated as a pure question of financial engineering where the right answer is to own as little as possible to maximize the paper return on equity. But Hart argues that it actually makes a substantive difference. The entity that owns the underlying asset has an incentive to invest in its improvement — and incentives to invest in particular ways.

This helps explain, for example, why as mapping software became more and more central to the smartphone experience, the contracting relationship between Apple and Google collapsed. Apple severing ties with Google and developing its own in-house maps was costly and full of friction, but ultimately the contracting relationship itself had become so laden with frictions and conflicts of interest that it was impossible for Apple to pursue its core interests through that route.

It’s hard to design the right rewards for managers and workers

Holmström’s best-known research focused on a different aspect of the contracting relationship — the complicated interplay between owners, managers, and workers.

It’s clear that in some sense it would generally be desirable to “pay for performance,” thus encouraging people to do their best work. But accomplishing this requires some kind of definition and monitoring of performance, possibly in areas where this is hard to do.

Holmström’s main idea is that you can’t just financially reward people for outcomes; you need to make sure your reward system is genuinely based on all the relevant information. CEO pay schemes often fail to meet this standard, in effect paying executives a bonus when share prices rise regardless of what was happening to other stocks. If shares in McDonald’s rise but shares in every other fast-food company rise more, then the CEO is probably lucky — managing a company during good times for the industry or the market as a whole — rather than skilled. Conversely (though in practice this happens less often), blaming an executive for being in charge during a generalized stock market crash makes very little sense.

Holmström’s paper on moral hazard and observability applies ideas about uncertainty to insurance contracts where, in practice, deductibles are often used to make sure the insured party’s incentives are not unduly undermined by the existence of insurance.

An interesting paper on “Moral Hazard in Teams” combines the insurance ideas and compensation ideas to provide a speculative account of why worker-owned co-ops have not, in practice, been a very successful corporate form in the marketplace. Holmström’s answer is, essentially, that teams by their nature have a difficult time adequately punishing themselves for failure. This ends up rewarding not workers as a whole, but specifically the least diligent and least conscientious workers. Separating ownership from work creates a group of dedicated punishers who ultimately drive superior performance.

Economic theory that informs everyday decision-making

Macroeconomics — the study of business cycles and long-term growth — is a minority of academic economic work but tends to be unusually salient in the media. Many recent trends in media coverage of economics have focused on a dichotomy between abstract, unrealistic, model-driven macro and newer efforts to ground economic research more clearly in empirical data.

This is an important contrast, but the Hart/Holmström prize is a reminder that there is more to economic theory than totally abstract whole-economy models. Doing empirical studies of how contracts are written and enforced, of what kinds of insurance products people buy, and of who works for what kind of company is interesting and important.

But practical people making these decisions are facing difficult questions. It would be utopian and fairly unrealistic to simply assume that existing practices are optimal.

Hart and Holmström use the tools of economic theory to investigate concrete, difficult problems in the design of market structures. Few people get into the management of a private or public sector enterprise because they abstractly want to “do economics.” There is typically something they actually want to do — build a smartphone or get the president a plane or a form a new kind of company that empowers workers — but abstract economic ideas are still relevant to doing this kind of work as well as possible.