12/10/2016

Contracttheory,2016NobelPrizeineconomicsBusinessInsider

Bonuses,risk,andmoralhazardan8
pointexplainerofcontracttheory
BENMOSHINSKY
OCT.10,2016,8:39AM

OliverHartfromHarvardandMIT
professorBengtHolmstrmwonthis
year'sNobelMemorialPrizeinEconomic
Sciencesfortheirstudyofcontractsand
humanbehaviourinbusiness.
Thefieldisknownascontracttheory.
Itis,partlyatleast,anattempttofindout
howcontractsbetweenfirmsand
employeescanleadtoshorttermismand
howthosecontractscouldbebetter
constructed.
Thetwoeconomistsprovideda
comprehensiveframeworkforanalysing
manydiverseissuesincontractualdesign,
likeperformancebasedpayfortop
executives,deductiblesandcopaysin
insurance,andtheprivatisationofpublicsectoractivities."

Nobelprize.org

Ithasbecomeespeciallyrelevantintheyearssincethe2008financialcrisis,whichwasblamedontheshortterm
riskencouragedbyhugecashbonusespaidtoinvestmentbankers.Italsotouchesonthemesofmoralhazard,
whichariseswherethosethattaketherisksdon'tshareinthecostsoffailure.
TheRoyalSwedishAcademyofSciencespublishedapaperoncontracttheoryandtheworkthatwonHartand
Holmstromtheirprizethisyear.
Hereisaquickbreakdownofthekeyideas:
1.Contracttheoryhasitsrootsinthe1700s,whenAdamSmitharguedthatsharecroppingcontractsdidnot
incentivisetenantstoimprovetheland.Thetheorywasrevisitedinthe1930swhenAmericanbusiness
executiveChesterBarnardconsideredhowtogetemployeestoputmoreeffortintotheirworkinbig
companies.Barnardisconsideredthepioneeringauthorrelatedtomanagementtheoryandorganisational
studies.
2.Thetheorylooksatthedifficultyoftyingpaytoperformance.AcompanymightpayaCEObasedonan
increaseinstockmarketvalue,butthiscouldendupbeingjustluck.Inthelate1970sandearly'80s,work
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12/10/2016

Contracttheory,2016NobelPrizeineconomicsBusinessInsider

byHolmstrmonthe"InformativenessPrinciple"helpeddevelopmodelsofperformancethat
counterbalancedexternalfactorsbeyondthecontrolofmanagers.
3.Contracttheoryalsolooksatshorttermincentivesandtheproblemthatmanagersmightprioritisequick
gainsoverfuturestability.Inthe1990sHolmstrmdevelopedthe"MultitaskingModel,"whichprovideda
wayofmeasuringthiseffect.
4.Themodelhasbeenexpandedtocapturethemoralhazardofteamwork,wherebysomemembersofateam
canpiggybackonthehardworkofothers,aswellasfuture"careerconcerns,"whichmightmotivate
someonetotakemoreorlessriskthantheircontractwiththeircurrentemployersuggests.
5.OliverHart'sworkfocusesontheideaof"incompletecontracts"andtheirrelationshiptopropertyrights.
6.Thetheorygoesthatalmostallcontractsareincompletebecauseperformanceistohardtomeasure
accurately.Evenifyoucouldmeasureitaccurately,itwouldbetoocomplextoreflectinacontract.
7.Hisworkhasbeenappliedtostudiesofthecompetinginterestsofcompanyshareholdersandmanagers,
andtherightsofinvestorsinbankruptcy.
8.Theworkisimportantandhasfarreachingapplications.HereiswhattheAcademysaid:"Itgenerates
precisehypothesesthatcanbeconfrontedwithempiricaldataandlaysanintellectualfoundationforthe
designofvariouspoliciesandinstitutions,frombankruptcylegislationtopoliticalconstitutions."
OliverHartistheAndrewE.FurerProfessorofEconomicsatHarvardUniversity,wherehehastaughtsince
1993.BengtHolmstrmisthePaulA.SamuelsonProfessorofEconomicsatMassachusettsInstituteof
Technology,wherehealsowasheadoftheeconomicsdepartmentfrom20032006.
UnlikeNobelhonoursinothersciencesandareas,theeconomicsawardisacollaborationbetweenSweden's
centralbank,ortheSverigesRiksbank,andtheNobelFoundation.
TheprizehaspreviouslygonetosuchmajornamesasMiltonFriedman,PaulKrugman,andFriedrichvon
Hayek.Politicalscientistswhoseworkhasinfluencedeconomicsasadisciplinehavealsobeenhonouredinthe
past.
LastyearitwenttoDeatonwasgiventheprizeforhisworkon"consumption,poverty,andwelfare."

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