Who won it?
- Oliver Hart from Harvard and MIT professor Bengt Holmstrom won this year’s Nobel Memorial Prize in Economics for their study of contracts and human behaviour in business.
What is Contract Theory?
- How contracts are designed defines our incentives in various situations in the real world. Contracts can be
- formal or informal, depending on whether they are enforced by law or social norms
- complete or incomplete, which is based on whether they take into account all possibilities that lay in the future
- Contract theory is, partly at least, an attempt to understand the nuances in our contracts and how those contracts could be better constructed.
- The two economists provided “a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.”
- It has become especially relevant in the years after the 2008 financial crisis, which was blamed on the short-term risk encouraged by huge cash bonuses paid to investment bankers.
- It also touches on themes of moral hazard, which arises where those that take the risks don’t share in the costs of failure