Must-Read: Mark Thoma: This Nobel Prize for Economics Is Well Deserved

Must-Read: Mark Thoma: This Nobel Prize for Economics Is Well Deserved: “Most people have probably never even heard of “contract theory”… Oliver Hart and Bengt Holmström…

…When should workers be paid a bonus based on performance? What’s the best way to structure the contract specifying the terms for paying a bonus? Should managers have stock options as part of their contracts, or is some other arrangement preferable? When should insurance companies require co-payments, and what’s the best co-pay schedule?… People often find themselves in situations in which they must trust that someone else will act in their best interest, so contracts are a way of creating incentives that avoid conflicts of interest and specify how to share any risks…. The optimal construction of these “pay for performance” contracts is a harder problem than it might appear at first glance…. Holmström’s work has wide application… whenever contracting arrangements between people or firms are needed. 

Hart’s… main contribution is more difficult to describe…. It’s not possible to specify all possible contingencies… “incomplete contracting” theory….

The main idea is that a contract that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree…. In complex contracting situations, allocating decision rights therefore becomes an alternative to paying for performance.

Since decision rights and ownership rights go hand in hand, Hart’s contributions also deliver a theory of property rights that has wide applications…