A cutting-edge Nobel

Contract theory helps fill out traditional economics

The basic building block of the modern market economy is the contract. An enforceable agreement between a buyer and a seller is the prerequisite for any market to exist. Countries with successful market economies have contracts that can be clearly defined and clearly enforced; those that are less successful, like India, are the ones where contracts are more difficult to agree on, and where they can be broken with greater impunity. The discipline of academic economics, however, has not always taken the contract as seriously as it should. Two of the economists most responsible for forcing the field to begin the formal study of contracts are Oliver Hart of Harvard and Bengt Holmstrom of the Massachusetts Institute of Technology - and they are deserving recipients of the Alfred Nobel Memorial Prize in Economic Sciences for 2016. That it has taken so long to reward contract theory is a sign that its attempt to transform economics by focusing on theories of agreement is still an ongoing process.

Contract theory is exactly the kind of field that tends to disarm many of the objections to neo-classical economics. Those who tend to criticise academic economics say that it features unrealistic assumptions and that it does not focus on real-world places where markets work - or on the sort of real-world problems that led to the 2008 financial crisis. But this is not the case, as the careers of Mr Hart and Mr Holmstrom show. While very much within the mainstream of economics - and in fact, using mathematical tools that are the cutting-edge of the discipline - they and their peers such as Sanford Grossman, Steven Milgrom and Jean Tirole - have investigated one of the central barriers to the creation of market economies. The English-born Mr Hart's work, for example, looks carefully at the notion of the "incomplete contract" - where a contract is signed, but it does not specify who wins and who loses in every possible circumstance. How is it renegotiated? What power do the two parties have over each other? How can incomplete contracts be as efficient as complete contracts? These are questions that fill in the gaps in traditional economics. They are also crucially important for countries such as India. For example, Mr Hart's work helps explain why the private-public partnership (PPP) model failed, and how such contracts can be rewritten to improve outcomes. He has also helped demonstrate why the privatisation of basic services may be a mistake when the quality of those services is as important as their cost.

The Finnish-born Mr Holmstrom's work, meanwhile, introduces to American economics a touch of the Nordic concern about wage inequality. In general, he has examined the "principal-agent" problem - in which a "principal" wants a task done, and has to sign a contract with an "agent" to conduct it. What sort of contract can the principal sign, and how does it depend on the quality of the work, and whether the agent's effort can be observed or not? One of his more specific and particular interests has been the money paid to corporate executives, and what their incentives are - a major question following the errors of high finance that came to light in 2008. These are basic questions of the moment - and the Nobel to Mr Hart and Mr Holmstrom recognises that economics is working to answer them.