REUTERS | David Bebber

The times they are a-changin’

Earlier this week, economists Oliver Hart and Bengt Holmström came close to a Nobel prize for law when the Royal Swedish Academy of the Sciences awarded them the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (strictly speaking not a Nobel prize; Nobel’s will included only five prizes and this was not one of them) for their work on the theory of contracts.

The Academy announced the awards saying that: “Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.”

Dr. Holmström is a professor at the Massachusetts Institute of Technology with a focus on insurance and incentives. He has had a particular influence on executive pay practices and the impact of his work can be seen in the framing of best practice around performance related pay in the UK corporate governance code.

His first major insight, published in 1979, related to the difficulty of an employer measuring the performance of its employees when it could only ever have imperfect information about what the employees had done. He concluded that:

“An optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken”.

This requires a potentially vast amount of information to be considered in determining performance: he also concluded that the harder it is to observe an employee’s actions (or their impact), the less their pay should be based on performance, a topic we recently touched on in an article by Dan Cable and Freek Vermeulen of London Business School.

Holmström went on to discover insights into how career concerns influence performance, even where pay is not explicitly performance-linked, because organisations indirectly reward good performance by increasing future pay. In addition, his work on multi-tasking showed how fixed pay can help ensure a balanced allocation of effort across a mixture of tasks, some of which are easy to measure and others not.

Curiously, his award may not come as a surprise to keen viewers of The Simpsons. Soon after the announcement, MIT tweeted that his win had in fact been predicted in a 2010 episode of the show, according to an article in The Hollywood Reporter.

Dr. Hart, a professor at Harvard, has contributed to the debate about the outsourcing of public services such as prisons. His major breakthrough related to the incomplete nature of contracts.

The main idea is that a contract 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 output has materialised.

Hart built on this research to consider questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.

In the context of privatisation, Hart showed that while publically-owned service providers had little apparent incentive to invest in either quality or cost reduction, private contractors typically had too strong an incentive for cost reduction, suggesting that certain public services could not be successfully privatised. Moves by the US to end private ownership of prisons affirm his insights in this area.

In its announcement, the Academy concluded:

Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.

Earlier this year I blogged about research based on a computer analysis of vast numbers of agreements that offers us insights into the use of precedents and how law really works in practice. It will be interesting to see whether the application of this kind of big data analysis yields future contenders in this field; to quote another new laureate this week: “The times they are a-changin’.”

Sara Catley

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