Every year, at around this time, I end up doing some background reading to try and find out why the Nobel committee chose to award a Nobel prize to some obscure professor(s) for their work in some even-more-obscure area of economics:

A lot of it is boring.

But this year… I’m not sure how the Academy managed to stay awake long enough to make their decision.


Spoiler alert: Oliver Hart and Bengt Holmström won the prize for their academic study of contracts.

I’ll just pause here to let that bit about ‘study’ and ‘contracts’ settle in a bit.

Let me try and summarise what they’re being recognised for:

Once upon a time, we lived in a world where people earned a paycheck and that was that. They shook hands, and a gentleman’s word meant something. It wasn’t always clear what it meant, but it definitely meant something, and you could take a chap at his word.

Then people got more lazy.

So a man called Mr Holmström did some studying and declared that henceforth, we should all have salaries tied to some measure of job performance. And thus, we started to spend time setting ‘achievable’ goals with ‘measurable’ outcomes that were ‘within our control’, and carefully detailing these in not-so-tightly-worded contracts that we would never read.

But at least we were less lazy – because better work was linked to better pay, and hooray.

But then Mr Holmström did some more thinking, and decided that there was more to this story. Some people would work hard for reasons other than a bonus – sometimes, they would work hard to get lots of promotions (which would then come with higher pay)! And he observed that you could pay an old person and a young person the same performance-related pay, but the older person would be more lazy because they lost all desire for promotion!

From there, we developed a get-ahead culture, where the young work for less and the elderly get shunted into early retirement.

But then Mr Holmström did even more thinking, and realised that linking pay to what can be measured might mean that what can’t be measured will be neglected. And so he said that the solution to this was to take multiple steps backward, and pay a fixed salary!

Some might call that argument circular – but at least we have some options now for setting employee salaries.

Then along came Mr Hart, who noticed that there are other problems with contracts, like not knowing the future. It means that the contract is always incomplete, because it cannot possibly cover everything. But he had a solution: appoint a decision-maker in the contract, and let them decide when something unknowable comes along!

*drops mic*

If that sounds facetious, it’s because it is.

But in real life, their theories have some…unexpected outcomes.


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 or not? According to the theory, 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 provide 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 reduc- tion are stronger. A 1997 article by Hart, together with Andrei Shleifer and Robert Vishny, showed that incentives for cost reduction are typically too strong. The desirability of privatisation therefore depends on the trade-off between cost reduction and quality. In their article, Hart and his co-authors were particularly concerned about private prisons. Federal authorities in the United States are in fact ending the use of private prisons, partly because – according to a recently released U.S. Department of Justice report – conditions in privately-run prisons are worse than those in publicly-run prisons.

In case you’re wondering, why yes – you did read an argument that went “state-sponsored services are inefficient – but they’re a lot less bad than the free market alternative”.

*drops mic again*

For more, here’s the Academy’s summary for this year’s prizewinning work: Contract Theory.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.