tag:theconversation.com,2011:/fr/topics/contract-theory-32099/articlesContract theory – The Conversation2022-01-13T19:11:13Ztag:theconversation.com,2011:article/1747742022-01-13T19:11:13Z2022-01-13T19:11:13ZVital Signs. The 3 problems with fines for not reporting positive COVID tests<figure><img src="https://images.theconversation.com/files/440584/original/file-20220113-17-1sgc1b2.png?ixlib=rb-1.1.0&rect=161%2C227%2C3580%2C1682&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><span class="source">Shutterstock/The Conversation</span></span></figcaption></figure><p>The NSW government this week decreed that anyone returning a positive COVID-19 reading using a rapid antigen test must report their result (through the Service NSW app or <a href="https://www.service.nsw.gov.au/transaction/register-positive-rapid-antigen-test-result">website</a>). Failing to do so can result in a $1,000 fine. </p>
<p>The new rule came into effect on January 12 (there will be a one-week grace period). In the first 24 hours more than 80,000 people registered positive tests (recorded since January 1). In one sense that’s a lot. But since we have no idea of the total number of tests taken – let alone the number with a positive result – it’s hard to calibrate.</p>
<p>The fine threat raises a number of questions, with the first being how will the government know if you test positive and don’t record it? On Wednesday, NSW Premier Dominic Perrottet admitted that it would be a hard law to enforce, <a href="https://www.theage.com.au/national/nsw/massive-surge-spike-in-covid-cases-as-nsw-records-rapid-tests-20220112-p59nq2.html">saying</a>:</p>
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<p>there are obviously areas right across the state where there are laws that are harder to enforce than others, this is clearly one that will be harder to enforce, there’s no doubt about it.</p>
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<p>Given this, it’s hard to know what the point of the announced penalty is. Indeed, both the economic theory and behavioural research research suggests it will achieve the opposite of its intention.</p>
<h2>1. Fines act as a disincentive</h2>
<p>Economists view these rules through the lens of the field of “contract theory”. </p>
<p>Rules create incentives that encourage or discourage certain behaviours. In this case, suppose you test positive. If you self-isolate as result, because that’s the right thing to do even without rules, then truthfully reporting the result is of no consequence to you (as long as it’s easy to do, which it is for most people).</p>
<p>But if you wouldn’t isolate, then truthfully reporting the results is of consequence. In NSW you face a $5,000 fine for failing to comply with <a href="https://www.nsw.gov.au/covid-19/stay-safe/rules/legislation-penalties">obligations to self-isolate</a> when diagnosed with COVID-19. Your choice is the low probability of a $1,000 fine for not reporting the result or the higher probability of a $5,000 fine for failing to isolate.</p>
<p>So there’s an individual disincentive to even taking the test at all – which is, after all, optional for most. This means fewer tests will be taken, the opposite of what authorities want.</p>
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Read more:
<a href="https://theconversation.com/its-still-not-too-late-to-fix-the-rapid-antigen-testing-debacle-why-the-national-cabinet-decision-is-wrong-and-must-be-reversed-174391">It's still not too late to fix the rapid antigen testing debacle. Why the national cabinet decision is wrong and must be reversed</a>
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<p>From the perspective of contract theory, therefore, this $1,000 fine is likely to reduce tests by those who are not willing or not able (perhaps because they have to work for financial reasons) to voluntarily isolate. </p>
<p>So you can bet that these folks will be calculating the odds of getting caught. This is the way some people think about parking fines, or thieves think about stealing bicycles. It’s a calculation involving the size of the penalty and the probability of getting caught.</p>
<h2>2. Fines can turn off good behaviour</h2>
<p>Some scholars, such as Harvard philosopher Michael Sandel, argue the very act of putting a dollar value on things causes people to think of them in a transactional way. It’s no longer “wrong” to park in a no-standing zone, there’s just a kind of fee for it. In other words, fines can destroy civic virtue.</p>
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<p>A classic example of this comes from <a href="https://rady.ucsd.edu/faculty/directory/gneezy/pub/docs/fine.pdf">a study</a> by behavioural economists
Uri Gneezy and Aldo Rustichini on ways to encourage parents to pick up their children from child-care centres on time. </p>
<p>Parents being late meant staff had to stay behind. The study involved some centres introducing fines to deter late pickups. But the fines actually led to more late pickups. Parents no longer felt so guilty. Being on time was no longer a social norm but a transaction. They could pay to disregard the expectation.</p>
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Read more:
<a href="https://theconversation.com/what-to-do-with-anti-maskers-punishment-has-its-place-but-can-also-entrench-resistance-143456">What to do with anti-maskers? Punishment has its place, but can also entrench resistance</a>
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<p>So, too, it might be with this week’s $1,000 fine rule. In the unlikely event of getting caught, some might see the fine as just “the cost of doing business”.</p>
<h2>3. Fines can make a mockery of the law</h2>
<p>A final consideration about the $1,000 fine for failing to report a positive RAT tests concerns the problem of laws that cannot be enforced. The NSW government concede the new rule will hard to police and is mostly about <a href="https://www.abc.net.au/news/2022-01-13/sydney-news-rapid-covid-test-fines-hard-to-police-minister-says/100753328">messaging</a>. </p>
<p>“If we didn’t put a fine on it then people would say you’re not taking it seriously,” the minister for customer service said. But this is just turning a law into a bit of a joke. Laws being openly “mocked” damage the rule of law itself. </p>
<h2>Getting rules right</h2>
<p>These three complementary perspectives all point to the $1,000 fine for failing to report a positive rapid antigen test being a bad idea.</p>
<p>It’s good to make it convenient for people to do the right thing (that’s what the Service NSW app does). It’s good to encourage people to do the right thing. It would be really good if there were lots of RATs available (ideally for free or close to it) so people can have the information to empower and protect themselves, their families and their communities.</p>
<p>This does none of these things. It’s bad to enact a rule that makes a mockery of the law and likely to be counterproductive.</p>
<p><iframe id="oHp70" class="tc-infographic-datawrapper" src="https://datawrapper.dwcdn.net/oHp70/3/" height="400px" width="100%" style="border: none" frameborder="0"></iframe></p><img src="https://counter.theconversation.com/content/174774/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Richard Holden is President of the Academy of the Social Sciences in Australia.</span></em></p>The NSW government’s announcement of a $1,000 fine for failing to report a positive voluntary rapid antigen test will likely achieve the opposite of its intention.Richard Holden, Professor of Economics, UNSW SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/669382016-10-17T14:37:27Z2016-10-17T14:37:27ZInside the machine: how two Nobel winners taught us how companies tick<figure><img src="https://images.theconversation.com/files/141806/original/image-20161014-30272-42kxgz.jpg?ixlib=rb-1.1.0&rect=58%2C243%2C5464%2C3329&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><a class="source" href="http://www.shutterstock.com/pic-263090813/stock-photo-vintage-watch-movement-close-up-showing-cogs-wheels-and-jewels.html?src=LeMOYMx8zmq4ZMH0hcm_WA-1-28">Alex Yeung/Shutterstock</a></span></figcaption></figure><p>One of the most notable evolutions in economic theory is the change in how we look at companies. No longer do we see a black box which uses some process or technology to turn inputs into outputs. These days <a href="http://www.sciencedirect.com/science/article/pii/0304405X7690026X">we think of a business</a> as a nexus of contracts among <a href="http://www.jstor.org/stable/1815199">different stakeholders</a> – shareholders, creditors, managers, workers, customers, suppliers and so on. </p>
<p>This evolution has led us to look at corporate governance through the design of contracts between those stakeholders. Oliver Hart and Bengt Holmström have laid the foundation to enable us to do that. The 2016 <a href="https://theconversation.com/why-contract-theory-won-hart-and-holmstrom-the-nobel-economics-prize-64011">Nobel prize in Economics</a> went some way to acknowledging this contribution. </p>
<p>While contracts are commonplace, they are generally not simple. They might be designed at times when the objectives of stakeholders differ (the so-called “<a href="http://www.jstor.org/stable/1837292">agency problem</a>”). For example, shareholders may want to maximise a company’s profits, while managers may want to build an empire through mergers and acquisitions. </p>
<p>There is also something called “<a href="http://www.investopedia.com/terms/a/asymmetricinformation.asp">asymmetric information</a>”, where the actions of one set of stakeholders are not visible to other stakeholders in the company. Everyone can read the financial statements, but shareholders cannot directly see how much effort the managers put in to drive profits.</p>
<p>Shareholders can, however, enter into a contract with a company’s leaders that would give the managers an incentive to work in the interest of the shareholders. Pay can be linked to observable measures of a company’s performance. Similarly, shares and stock options may be included. <a href="http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html">In the Nobel citation</a>, Holmström, a Finnish professor working at the Massachusetts Institute of Technology, was credited with demonstrating how shareholders should design an optimal contract for a CEO whose actions they would not be able to fully monitor.</p>
<p>Contracts can also be incomplete. It is either not possible or too expensive to write contracts that take into account <a href="http://www.jstor.org/stable/1122818">all possible future outcomes</a>. It is precisely the incompleteness of contracts that provides a <a href="http://www.jstor.org/stable/2235027">rationale for corporate governance</a>. This follows from research <a href="http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html">carried out by Hart</a>, a British professor working at Harvard.</p>
<h2>Hart of the matter</h2>
<p>Consider, for example, a simple executive pay scheme in a company where shareholders own the company but control lies with the management. The relationship offers both an agency problem and asymmetric information. As mentioned earlier, one option for shareholders would be to write a contract that <a href="http://dx.doi.org/10.1016/S1573-4463(99)30024-9">links the compensation of the managers</a> to an observable outcome such as revenue or profit. </p>
<p>But profits can be affected by factors out of a manager’s control, and a contract that takes into account all combinations of managerial effort and external factors is impractical. Managers generally act in groups and so it may also prove difficult to assign an outcome to one person. You can write contracts that penalise the group if a product fails or a plant proves inefficient, of course, but Holmström argued that uncertainty about the causes of such failures would mean that monitoring would be necessary and hence the associated <a href="http://www.jstor.org/stable/3003457">costs are unavoidable</a>.</p>
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<p>You could judge the performance of managers against that of their peers to decide compensation (a supermarket CEO might cheer that sales are up 10%; shareholders less so if other stores are up 12%). But this approach would still only work if you can successfully remove the influence of common external factors affecting how managers perform. </p>
<p>In this case, where simple contracts may not be easy to design or enforce, we need a mechanism – corporate governance – that ensures that the interests of non-managerial stakeholders are not undermined. Hart views <a href="http://www.jstor.org/stable/1122818">corporate governance</a> as a mechanism to allocate rights to control a company’s non-human assets among the stakeholders.</p>
<h2>Credit due</h2>
<p>An interesting implication of this perspective on corporate governance is <a href="http://www.jstor.org/stable/2297860">a rationale for debt</a>. Suppose the shareholders of a firm are mainly interested in short-term profits, while managers prefer grandiose empire building that brings private perks and benefits. Any contract that attempts to address this conflict is likely to be incomplete, unable to account for every influence over the company’s future profits. </p>
<p>This opens up the possibility of a significant dispute between the shareholders and the managers about the latter’s compensation. Managers might claim low profits came despite their best efforts, rather than because of their poor efforts or judgement.</p>
<p>How can debt help in this case? A debt contract can enable the creditor to enforce liquidation of a firm if it cannot meet its repayment obligations. If the firm performs well and can meet these obligations, control over the assets of the company remains with the managers. If, on the other hand, the company performs poorly and cannot repay the creditors then it can be liquidated. At the time of liquidation, after the creditors have been repaid, the residual (or remaining) rights over the company’s assets are with the shareholders – the managers have no rights over these assets any more. </p>
<p>In other words, where contracts between shareholders and managers are incomplete, debt taken on for whatever reason can force an alignment of objectives. In the words of <a href="http://www.nber.org/chapters/c4434.pdf">Hart and Sanford J Grossman</a>: “managers can avoid losing their positions only by being more productive.” Productive managers are precisely what shareholders want. A company’s capital structure can, therefore, be used to both discipline managers and give <a href="http://www.jstor.org/stable/2118355">outsiders (creditors) an incentive</a> to enforce the discipline. Hart and Grossman also examined how control is exerted in <a href="http://www.nber.org/papers/w2347">work on voting rights</a>. </p>
<p>Holmström and Hart do not provide all the answers to resolve the problems associated with weak corporate governance. They do, however, induce us to think about a firm as a microcosm of the society in which we live, where stakeholders with different objectives compete for power and control. Their work has helped us to move away from one-size-fit-all rules about things such as financial structure and pay and has led us to focus on making contracts and mechanisms that work. That is a transforming contribution to corporate governance research.</p><img src="https://counter.theconversation.com/content/66938/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>I am a (joint) recipient of a UKIERI grant to undertake research on financial sector development and corporate governance in India.
I am a member of the University and College Union.</span></em></p>Hart and Holmström changed the way we think about corporate governance.Sumon Bhaumik, Chair in Finance, University of SheffieldLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/668262016-10-11T15:20:34Z2016-10-11T15:20:34ZExplainer: what is contract theory and why it deserved a Nobel Prize<figure><img src="https://images.theconversation.com/files/141204/original/image-20161011-12031-17pl99e.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Contract theory goes beyond analyzing deals on paper to other sorts of agreements.</span> <span class="attribution"><span class="source">www.shutterstock.com</span></span></figcaption></figure><p>The Nobel Memorial Prize in Economic Science has just been awarded to Oliver Hart and Bengt Holmström <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html">for building the foundations of contract theory</a>. </p>
<p>Contract theory is not merely the study of legally binding contracts. Broadly defined, it studies the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions. Contract theory guides us in structuring arrangements between employers and employees, shareholders and chief executives, and companies and their suppliers. </p>
<p>In essence, contract theory is about giving each party the right incentives or motivations to work effectively together. </p>
<p>Hart and Holmström have developed elegant and powerful methods that are taught to all students in economics. Their work forms the fundamental building blocks of many areas beyond economics, such as finance, law, public policy and management.</p>
<p>Previously, general equilibrium theory had already shown how efficient outcomes can be achieved under ideal circumstances, through detailed contractual agreements. In fact, research in this area has already led to a number of other economic science prizes (<a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1972/">John Hicks and Kenneth Arrow, 1972</a>; <a href="http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1983/debreu-bio.html">Gérard Debreu, 1983</a>; <a href="http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1991/coase-facts.html">Ronald Coase, 1991</a>). </p>
<p>However, this research ignored two potential issues: informational problems and incomplete contracts. By studying these two issues, Hart and Holmström developed what has become modern contract theory. Here we examine a few of the papers that explore those problems and made substantial contributions to the field.</p>
<h2>Holmström’s contributions</h2>
<p>Holmström’s work focuses on informational problems in which some parties do not observe what others are doing. </p>
<p>Consider the problem of motivating an employee to work hard. If the employer can perfectly monitor the employee, then she can simply reward the employee if he works, and punish him if he shirks. However, such monitoring is often unrealistic. Often, employers can base employee rewards only on the outcome of the employee’s work. </p>
<p>Holmström’s 1979 paper, “<a href="http://www.econ.yale.edu/%7Edirkb/teach/pdf/holmstrom/1979%20moral%20hazard.pdf">Moral Hazard and Observability</a>”, shows how employers should optimally link employee rewards to performance outcomes. One key insight is that a CEO’s pay should not depend only on his or her company’s share price. Such a scheme would unnecessarily penalize the CEO for factors beyond his or her control, such as commodity prices. </p>
<p>A better reward scheme would seek to eliminate such factors by, for example, linking the CEO’s pay to the company’s share price relative to competitors in the same industry.</p>
<p>Another paper, published in 1982 and titled “<a href="https://www.kellogg.northwestern.edu/research/math/papers/471.pdf">Moral Hazard in Teams</a>”, extends his 1979 analysis to settings in which a team of employees contributes individual efforts towards a collective output, such as a team of inventors working together to develop a new product. </p>
<p>A partnership scheme that simply shares profits amongst team members creates a free-rider problem: Each team member is insufficiently motivated by his or her share of profits and thus exerts too little effort. Holmström shows that the free-rider problem can be resolved by introducing a “budget-breaker”, a third party such as a venture capitalist who assigns rewards and penalties to the team members and keeps what is left for herself. </p>
<p>Holmström’s 1991 paper with Paul Milgrom, “<a href="http://web.stanford.edu/%7Emilgrom/publishedarticles/Multitask%20Principal%20Agent.pdf">Multitask Principal Agent Analyses - Incentive Contracts, Asset Ownership and Job Design</a>”, considers situations in which the employee allocates effort amongst multiple tasks. The employer only observes the outcome of some tasks. For example, a teacher may devote effort towards improving test scores or towards inculcating student creativity. </p>
<p>One insight is that the school should not make teacher pay too sensitive to observable outcomes. Rewarding teachers for high test scores may distort teacher effort away from hard-to-measure tasks such as developing student creativity.</p>
<h2>Hart’s contributions</h2>
<p>Hart, for his part, developed foundations for the theory of incomplete contracts. </p>
<p>The basic idea is that it is impossible to write a contract that anticipates every potentially relevant future contingency. Consequently, the allocation of control rights becomes a powerful tool for creating incentives. This perspective enables the analysis of fundamental questions such as whether companies should outsource or integrate production, which assets they should own and how they should choose between equity and debt financing. </p>
<p>Hart’s 1986 paper with Sanford Grossman, “<a href="https://dash.harvard.edu/bitstream/handle/1/3450060/Hart_CostsBenefits.pdf">The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration</a>”, studies incomplete contracting in which various parties invest to increase the productivity of an asset. When unforeseen contingencies arise, the parties have to bargain over what to do. </p>
<p>Crucially, asset owners have stronger bargaining power, which motivates them to invest. Therefore, the asset should be owned by the party whose investment is most important.</p>
<p>A paper Hart published in 1990 with John Moore, “<a href="https://dash.harvard.edu/bitstream/handle/1/3448675/Hart_PropertyRights.pdf">Property Rights and the Nature of the Firm</a>”, extends his 1986 analysis to study optimal ownership of multiple assets. It shows that highly synergistic assets – whose values are enhanced when used together – should be owned by a single party, rather than separately by multiple parties. </p>
<p>Concentrating bargaining power in the hands of one party is more effective than diffusing bargaining power across multiple parties. This paper paints a compelling picture of large integrated firms where all physical and intellectual assets are owned by a single corporate entity.</p>
<h2>From theory to real-world application</h2>
<p>We have merely highlighted a few of Holmström’s and Hart’s fundamental contributions to contract theory. </p>
<p>These economists as well as others have applied this work to study key features of real-world contractual agreements: liquidity provision by governments and banks, long-term compensation and promotion schemes for senior managers and executives, and public versus private ownership of institutions such as prisons and utilities. </p>
<p>Contracts have governed the workings of the economy since ancient times. As technology improves and organizations become more complex, the theory and practice of contract design will only increase in importance. </p>
<p>As such, we owe a great debt to Holmström and Hart for giving us powerful tools to structure effective contracts.</p><img src="https://counter.theconversation.com/content/66826/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Anton Kolotilin receives funding from Australian Research Council. </span></em></p><p class="fine-print"><em><span>Hongyi Li does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Contracts have governed the workings of the economy since ancient times. Contract theory is about ensuring they have the right incentives.Hongyi Li, Lecturer in Economics, UNSW SydneyAnton Kolotilin, Senior Lecturer, UNSW SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/640112016-10-10T15:12:29Z2016-10-10T15:12:29ZWhy contract theory won Hart and Holmström the Nobel economics prize<figure><img src="https://images.theconversation.com/files/141112/original/image-20161010-3909-9unmfh.jpg?ixlib=rb-1.1.0&rect=143%2C133%2C1000%2C677&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><a class="source" href="https://www.flickr.com/photos/tereneta/88098709/in/photolist-8MwFg-7Ui3rF-FasNN">Tim Ereneta/Flickr</a>, <a class="license" href="http://creativecommons.org/licenses/by-nc/4.0/">CC BY-NC</a></span></figcaption></figure><p><a href="http://scholar.harvard.edu/hart/home">Harvard’s Oliver Hart</a> and <a href="http://economics.mit.edu/faculty/bengt">Bengt Holmström</a> from the Massachusetts Institute of Technology have won the <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html">Nobel Prize for economics</a> for their research into contract theory. Their contributions have helped our understanding of the often conflicting incentives that operate in the contracts that enable cooperation between individuals, between employers and their workers, between governments, and which affect all of our lives.</p>
<p>The Royal Swedish Academy of Sciences, which decides the winners of the economics prize, said the <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular-economicsciences2016.pdf">pair had developed</a>:</p>
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<p>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.</p>
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<h2>Risk sharing</h2>
<p>Holmström, from Finland, developed research on optimal design of contracts from the perspective of an employer and their arrangements with a worker. This is work in the area of the “principal-agent problem”, where the employer is the principal. Here, there is potentially an issue in designing the best contract since there are competing incentives for the principal and agent, although they would still like to cooperate.</p>
<p>Risk sharing is an important part of this relationship, since workers would rather not have to bear all the uncertainties a firm experiences with variable revenue and profits. Firms would rather pass on some of these risks to workers, such that their costs are aligned with revenue. Holmström developed the <a href="http://www.investopedia.com/terms/p/principal-agent-problem.asp">informativeness principle</a>, setting out how optimal pay should be linked to performance. </p>
<p>In our post-financial crisis world, we would all probably now agree that we should probably not reward the chief executive of a company with a large bonus for outcomes that are random. Further, career path matters for optimal contracts, for example we should pay different bonuses to younger or older workers, because younger workers can be rewarded with potential promotion in the future.</p>
<p>In the context of insurance contracts, problems can arise because individuals can become more careless after the contract has been agreed. Specifically there may be a conflict of interest between the less-than-moral contract holder or issuer. Indeed, the fact that it is difficult to measure compliance with a contract, and who was responsible for violations, can also present a challenge. Some key contributions in Holmström’s work in these areas were developed in collaboration with Stanford’s <a href="http://www.milgrom.net/">Paul Milgrom</a> and Nobel Laureate <a href="https://theconversation.com/nobel-economics-prize-winner-an-economist-and-a-gentleman-33017">Jean Tirole</a>.</p>
<h2>Complete the following…</h2>
<p>Hart’s work made substantial progress on so-called incomplete contracts. Not all elements of a contract can be specified. Therefore there is a question about what should happen if an unexpected event occurs which has not been specified in the agreement. This means that decision rights are important. Whoever has the right to make a decision on the unspecified elements of the contract consequently has more bargaining power. </p>
<p>The right to decide allows you to take a bigger reward under certain circumstances and can impact upon incentives. Decision rights can also be seen as an alternative to performance related pay.</p>
<p>Hart’s ideas can be applied to several areas including the relationships between a firm and its suppliers, as well as welfare enhancing approaches to public ownership of schools and hospitals. The lack of specified elements in contracts could encourage greater integration within a production chain and one individual owning the other elements of the chain. For instance, the researcher in a company could have the most unspecified contract. That is to say you won’t know the R&D innovation before you see it, hence it’s inherently unspecified. One solution to this contract problem is to give the researcher decision rights and ownership of the complete production chain. </p>
<p>This was developed in work with <a href="http://www.newyorker.com/news/john-cassidy/the-nobel-that-should-have-been">Sanford Grossman</a> and <a href="http://www.lse.ac.uk/researchAndExpertise/Experts/profile.aspx?KeyValue=j.h.moore@lse.ac.uk">John Moore</a>, who were key collaborators of Hart. </p>
<p>Another example of Hart’s ideas is in public sector services and whether the state should own the providers of basic services. The main issue is how to reconcile quality and costs, and the incentives of government and private ownership of these services, since these can represent a trade-off. </p>
<p>Simply put, if cost cuts hurt the quality of service then governments should provide the services. Hart’s work with Andrei Schleifer and Robert Vishny indicates that private contractors’ incentives for cost reduction are typically too strong. Moreover, if competition is ineffective the government should also provide basic services. Hart’s work can be generalised to other fields in the social sciences in which contracts matter.</p>
<h2>Relevance</h2>
<p>The Nobel Prize in Economic Sciences was not in the original list of awards included in Alfred Nobel’s 1895 will. It was established in 1968, thanks to a bequest from Sveriges Riksbank as a way to mark the bank’s 300th birthday. Prominent winners have included <a href="Friedrich%20von%20Hayek">Friedrich von Hayek</a>, <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1976/friedman-facts.html">Milton Friedman</a> and <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1994/nash-facts.html">John Nash</a>.</p>
<p>The award award tends to reflect the world’s economic preoccupations, rewarding work which sheds light on areas which have demanded, and perhaps confounded, financial and political attention. Last year’s <a href="https://theconversation.com/correct-and-brilliant-angus-deatons-work-is-a-model-of-applied-economics-49033">award to Angus Deaton</a> was a nod to his work on consumption, poverty and welfare. <a href="https://theconversation.com/nobel-rewards-economist-who-told-us-how-to-tame-the-big-firms-which-run-our-lives-32908">Jean Tirole’s 2014 win</a> came on the back of studies into market power and the role of regulation. </p>
<p>Hart and Holmström’s work has made a significant contribution to age old questions and new issues in economics. They can resolve some of the competing incentives in contract design while allowing cooperation. In many ways, their contributions are fundamental to modern ways of thinking in economics, but also have substantial cross-overs with many other areas of society and policy where contracts are very important. </p>
<p>In deciding to award the prize, the Royal Swedish Academy of Sciences have perhaps emphasised the point that the applications of these methods and theories are pervasive, and anyone interested in contracts may benefit from an understanding of the key principles behind their contributions. In some ways, that probably includes almost all members of society and the economy – individual households, workers and firms, the government and multilateral agencies.</p><img src="https://counter.theconversation.com/content/64011/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Two US-based professors who improved our understanding of how contract theory works have won the 2016 award.Arnab Bhattacharjee, Professor of Economics, Heriot-Watt UniversityJoseph Byrne, Professor of Economics, Heriot-Watt UniversityLicensed as Creative Commons – attribution, no derivatives.