Here are some surprisingly real-world applications of contract theory.
By Dwyer Gunn
Oliver Hart. (Photo: Scott Eisen/Getty Images)
Earlier this week, the Royal Swedish Academy of Sciences announced this year’s winners of the Nobel Prize in Economics. This year’s prize was shared between Oliver Hart, a professor at Harvard University, and the Massachusetts Institute of Technology’s Bengt Holmström, for their work in a field of economics called contract theory. Here’s how the Nobel committee described their contributions:
Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, 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.
Contract theory may not sound like the most exciting branch of economics, but it’s got lots of fascinating, real-world applications. Here, as an example, are three puzzles that this Hart and Holmström have studied:
How Do We Get Executive Pay Right?
In recent years, quite a bit of attention has been paid to the outsized pay of top business executives, which often seems to bear little relation to actual CEO performance. But determining appropriate levels of executive pay isn’t always simple. Many people would agree, for example, that the CEO of a company should be compensated based on some joint measure of their own effort and the firm’s performance. But effort is hard to measure, and even firm performance can be misleading. If an entire industry’s performance improves because of larger economic factors, should an individual firm’s CEO be rewarded for that performance? And it’s not always wise to judge a CEO based solely on the firm’s performance in one year.
In his 1979 paper on the topic, “Moral Hazard and Observability,” Holmström proposed the “informativeness principle,” which stated that compensation contracts should consider all the information available. In the case of CEO compensation, for example, pay packages should be pegged to both firm performance and to the performance of other firms in the industry. Holmström’s research is also often cited as an inspiration for deferred compensation models, in which a portion of an employee or executive’s pay is held back year-to-year so that long-term performance can be assessed.
Should Teacher Pay Be Tied to Student Performance?
One of the most contentious debates in education today centers on whether teacher compensation, which has historically been based on tenure, should be tied to the performance of students. A 1991 paper by Holmström and Paul Milgron pointed out one major flaw of performance-based pay schemes: If they’re structured in a manner that primarily rewards one outcome (say, test scores), the employee will be incentivized to focus exclusively on that outcome, at the expense of others.
“For instance, if teachers’ salaries depend on (easy to measure) student test scores, then teachers might spend too little time teaching equally important (but harder to measure) skills such as creativity and independent thinking,” writes the Academy in an explainer on Holmström and Hart’s research. “A fixed salary, independent of any performance measures, would lead to a more balanced allocation of effort across tasks.”
Should Prisons Be Privatized?
In 1997, Hart, who is best known for pioneering the study of incomplete contracts, and several co-authors turned their attention to the question of privatization. Should the government turn over the management of public services — that includes schools, hospitals, prisons, even ambulance and firefighting services — to the private sector? Hart and his co-authors concluded that privatization might be advantageous in some situations (garbage collection, for one), but that the contracts governing these relationships generally provided strong incentives to reduce costs. A private contractor hired by the government to run an ambulance service might choose to skimp on necessary supplies or personnel and keep the cost savings for themselves.
In a particularly prescient conclusion, Hart and his co-authors wrote that, when it comes to prisons, privatization should be viewed with “significant skepticism”: “[P]rivate contractors may seriously reduce quality in the process of reducing costs, and, moreover, the benefits from the potential quality innovation by the private contractors are limited,” they conclude.
The influence of Holmströmand Hart’s research also stretches far beyond the papers they themselves have written. In recent years, economists have used the fundamentals of contract theory to study the gig economy, health insurance contracts and moral hazard, and the behaviors of competing firms.
