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Insight into the Contract Theory Wins Nobel Prize Economics

Oliver Hart of the Harvard University and Bengt Holmstrom of the Massachusetts Institute of Technology have won the 2016 Nobel Prize in Economics on their making pioneering contributions to the Contract Theory, shedding light on how contracts help people deal with conflicting interests.  Their work revolves around relatively esoteric subjects like contract theory, modelling corporate structure, principal-agent relationships, information asymmetries and the like, all garnished with heavy dollops of game-theoretic mathematics. They have given insights into how best to write contracts, the deals that bind together employers and their workers, or companies and their customers. As per the Royal Swedish Academy of Sciences, their theories are valuable to the understanding of real—life contracts and institutions, as well as potential pitfalls in contract design. In real-life applications, Hart’s work has influenced lawsuits between the US government and companies.

Their contributions highlight understanding of contracts and organisations as well as the potential pitfalls of privatisation of provisions of public goods and services. At work, employees perform multiple tasks. A lender uses debt contract to guard against default by the borrower. An insurance company uses contract to regulate future behaviour of the insured. Private firms are regulated by the government through regulatory contracts. Contracts are crucial for the functioning of public and private organisations. Employment contracts are used by the government agencies to regulate future activities of their employees.

The awardees have sought to determine how contracts can encourage mutually beneficial behaviour. Among the contracts they have studied is Holmstrom’s research on employment contracts, including between CEOs and shareholders. They were particularly concerned about private prisons. Federal authorities in the United States are in fact ending the use of private prisons, partly because, according to a recently released US Department of Justice report, conditions in privately-run prisons are worse than those in publicly-run prisons.

Their work lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions. Hart’s research has looked at whether providers of public services, such as schools, hospitals, or prisons, should be publicly or privately owned. The research showed that “incentives for cost reduction are typically too strong”. Privatizing those types of services can lead to a reduction in quality greater than the advantages of cost savings.

Alfred Nobel’s will of 1895, established the eponymous prizes in Physics, Chemistry, Physiology or Medicine, Peace and Literature. The Sveriges Riksbank or the Sweden’s Central Bank established, in 1968, the Prize in Economic Sciences in Memory of Alfred Nobel. Each award is worth 8 million kronor, or about $930,000. By the terms of Alfred Nobel’s will the Nobel Peace Prize is awarded by the Norwegian Nobel Committee since 1901, while the other four prizes are handled by Swedish committees.

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