The Science of Contracts Behind the 2016 Economics Nobel

SMITH BRAIN TRUST — Contracts help human beings do what at times seems impossible. They help us cooperate and trust each other. It’s not that we fundamentally don’t trust one another. It’s just that trust is a freer-flowing currency when agreements are backed by a contract. And that’s why contract theory is so important, and why on Monday it became the premise for the 2016 Nobel prize for economics.

Harvard University’s Oliver Hart and the Massachusetts Institute of Technology’s Bengt Holmström were awarded the prize for developing contract theory and for “helping us understand real-life contracts and institutions, as well as the potential pitfalls when designing new contracts,” the Royal Swedish Academy of Sciences wrote in a statement. 

With contract theory, British-born Hart and Finnish-born Holmström blueprinted a framework for analyzing diverse contractual issues — from performance-based pay for top executives, to deductibles and copays in insurance, to the privatization of public-sector entities. "Their work is so seminal that this pick had an air of inevitability to it," said Kislaya Prasad, research professor at the University of Maryland’s Robert H. Smith School of Business. "The only question had been 'When?'"

He said the theory filled a huge gap in people's understanding of transactions that require the signing of a contract. "Their elegant solutions to this problem are among the most aesthetically satisfying in all of economic theory,” said Prasad, executive director for Smith’s Center for International Business Education and Research (CIBER).

Should schools, hospitals and prisons be public or privately owned? Should teachers, healthcare workers and prison guards receive fixed salaries or performance-based pay? Should high-level managers receive bonuses or stock options? With so many variables involved, contract theory can’t answer all those questions. “However, the power of the theory is that it enables us to think clearly about the issues involved," the academy wrote in its announcement. Contract theory helps explain why contracts come in varied forms and designs, and helps stakeholders draw up better contracts, “thereby shaping better institutions in society.”

Prasad said most economic relationships are governed by some kind of contract. Company employees are hired to serve the interests of the executives, while executives are hired to serve the interests of shareholders. "Here in the Washington, D.C. area, many local companies supply goods and services to the federal government and bid for contracts," Prasad said. "Indeed, one may view the U.S. Constitution as a contract between citizens and the branches of government."

He said poor contract design can take a toll on individuals, companies and entire countries. "It will come as no surprise that the terms of a contract affect how people will behave," Prasad says. "For instance, during the 2007-08 financial crisis, there was much discussion of whether the design of executive contracts led companies to take on too much risk."

Smith School finance professor Michael Faulkender, director of the school's Master of Finance program, says contract design also explains what went wrong more recently at Wells Fargo. The San Francisco-based bank has been rocked by revelations that its employees opened as many as 2 million checking, savings and credit card accounts without their customers' permission to meet sales quotas. The scandal led to an $185 million fine from regulators and sanctions for the chief executive from the bank’s board of directors.

Faulkender links the scandal to incentives built into executive contracts. "Today, salary makes up a small portion of executive compensation, compared to the type of performance-based pay that Hart emphasized in his work," Faulkender says. What Holmstrom added was that you need to be careful in designing those contracts. "Incentive pay comes with risks, such as higher pay, increased income inequality," Faulkender said. "And employers who use incentive programs should take care that the things that you are rewarding are really what should be rewarded."

Hart told the academy that he awoke around 4:40 a.m. Eastern time Monday in the United States, thinking it was too late for a Nobel call. "But then fortunately the phone rang,” he said. Via the Nobel Prize Twitter account, he wrote that contracts, when done correctly, protect win-win solutions in business. "Contracts are just an incredibly powerful way of thinking about parts of economics," he wrote. "They’re just fundamental to the whole idea that trade is a quid pro quo and that there are two sides to a transaction.”

Holmstrom, in an interview with the Nobel committee, said of Hart, "I’m so glad that I won it with him. He’s my closest friend here."