Two U.S.

-based economists won the Nobel Prize in economics Monday for their analysis of
contracts, work aimed at helping individuals, businesses and public bodies better assess whether
the deals they strike are in their best interests.
The Royal Swedish Academy of Sciences recognized U.K.-born Oliver Hart and Finlandborn Bengt Holmstrm for their theories that have been used to look at a diverse range of issues,
from the use of performance-based pay for top executives to whether a public entity should be
privatized.
Modern economies are held together by innumerable contracts, the academy said. The new
theoretical tools created by Hart and Holmstrm are valuable to the understanding of real-life
contracts and institutions, as well as potential pitfalls in contract design, it said.
The winners will split an 8 million Swedish kronor ($924,000) award funded by the Swedish
central bank.
Mr. Holmstrm, a longtime director on the board of Finnish telecom-equipment
giant Nokia Corp. who is now based at the Massachusetts Institute of Technology, began work in
the late 1970s on a model that looked at how pay should be linked to performance and how an
optimal contract carefully weighs risks against incentives.
In further influential work, Mr. Holmstrm, 67 years old, later added incentives other than pay to
the model, such as promotion.
Mr. Hart, now based at Harvard University, made a breakthrough in the mid-1980s with his work
on incomplete contracts. The now 68-year-old economist dealt with the reality that not
everything is known when a contract is constructed by looking at how decisions should be made
following an agreement, and who should have what level of control.
Messrs. Hart and Holmstrm launched contract theory as a fertile field of basic research, the
Nobel committee said.

They have both written extensively on banking, financial markets and liquidity.
Mr. Hart has been critical of the government responses to the global financial crisis, writing with
University of Chicago finance professor Luigi Zingales in The Wall Street Journal in December
2008 that economists had abandoned their principles by favoring bank bailouts.
In a 2015 paper, the two said that in the case of a large shock to the banking system, a better
response would be to help people, not banks. They suggest that governments could offer help
to individuals who suddenly find themselves illiquid, rather than financial institutions
themselves.
Mr. Holmstrm has recently written on the subject of shadow bankingthe creation of credit
outside of traditional regulatory channels, which came to prominence during the financial crisis.
Some of his recent work focuses on opaque markets, how a lack of transparency can actually
make them more liquid.

SUPPOSE that you and I are interested in opening a lemonade stand together. We
agree that I will bring the materials we need (cups, stand and so forth) while you will
make the lemonade. Ill do the pouring while you mind the cashbox and at the end we
will split the proceeds fairly. A doubt niggles, though. I am worried you might, at the end,
try to hog the contents of the cashbox. We therefore decide to draw up a contract
(common practice in the lemonade-stand industry) dictating that the returns to our
operation must be split evenly. But then you start to worry: much of the success of our
stand will depend on the quality of the lemonade, over which I have no control. What if I
decide to slack off and piggyback on your lemonade-brewing genius, knowing that after
you pour your sweat into the lemonade (not literally), the split is still an even 50-50? We
therefore set to haggling over language in the contract setting out precisely how each of
us should do our respective jobs.
Contracts play a critical role in the operation of the modern economy. They set out who
is allowed to do what with the land they own, the people they employ and the songs
they store on their smartphones. They underpin nearly all of the banking and insurance
sectors. Individuals are self-interested, but to take advantage of economic opportunity
people must often work together and find ways to align their interests (or minimise
conflicts of interest). Thats where contracts come in. This morning, The Swedish
Riksbank awarded this years Nobel prize for economic sciences to Oliver Hart, a British
economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, for
their work improving our understanding of how and why contracts work, and when they
can be made to work better.
Their work focuses attention on the necessity of trade-offs in setting contract terms; it is
yet another in a series of recent prizes which explores the unavoidable imperfections in
many critical markets. Mr Holmstroms analyses of insurance contracts describe the
inevitable trade-off between the completeness of an insurance contract and the extent
to which that contract encourages moral hazard. From an insurance perspective, the copayments that patients must sometimes make when receiving treatment are a waste; it
would be better for people to be able to insure fully. Yet because insurers cannot know
that all patients are receiving only the treatment they need and no more, they employ
co-payments as a way to lean against the problem of moral hazard: that some people
will choose to use much more health care than they need when the pool of all those
being insured picks up the bill.
Mr Holmstrom applied a deeper analysis to the issue of performance pay, where hard
work cannot always be observed properly. His work suggested that performance-based
pay should be linked as much as possible to measures of managerial performance
(such as the price of a companys share relative to those of its peers rather than the

share price in isolation). But the more difficult it is to find good measures of
performance, the closer a pay package should get to a simple fixed salary.
Mr Harts complementary work explored cases in which contracts were necessarily
incomplete because not all outcomes could be specified. In such cases, he reckoned,
the allocation of decision rights became hugely important. In our lemonade stand
contract, for instance, we might not specify what happens when a rival stand opens
across the street, but we might agree that the chief executive is empowered to decide
what to do in such cases and then choose one of us to fill that position. Decision rights
often go hand in hand with ownership rights. Mr Harts work on the subject noted that
who owns what is not simply important in determining what happens in various
unexpected scenarios, but also matters in shaping day-to-day incentives. A scientist
working in an R&D department will spend her time in different ways if promised an
ownership share in whatever valuable intellectual property she generates than if her firm
has full ownership rights to the innovations.
This work has had important applications. Work co-authored by Mr Hart compared the
incentives to owners in public and private prisons, for example. In publicly owned
prisons, managers might underinvest in quality-improving measures, but private owners
face too strong an incentive to cut costs, leading to conditions for prisoners that are
worse than those in public prisons. This research has informed recent public debates
about private prisons in America.
A common and important thread in work by Messrs Hart and Holmstrom is the role of
power in planning co-operative ventures. Individuals or firms with the ability to hold up
arrangementsby withholding their service or the use of a resource they ownwield
economic power. That power allows them to capture more of the value generated by a
co-operative effort, and potentially to sink it entirely, even if the venture would yield big
gains for all participants and society as a whole. Contracts exist to shape power
relationships. In some cases, they are there to limit the exercise of hold-up power so
that a venture can go forward. In others, they are intended to create or protect certain
power relationships in order to encourage good behaviour: workers or firms with the
right to exit a relationship, for instance, force other parties to that relationship to take
their interests into account. The broader lessonthat power mattersis one economics
too often neglects. Hats off to the Nobel committee for awarding a prize that puts power
dynamics front and centre, and reveals the many, often unappreciated, ways in which
they affect our lives.