Bonuses, risk and moral hazard -- an 8-point explainer of contract theory

Oliver Hart from Harvard and MIT professor Bengt Holmström won this year’s Nobel Memorial Prize in Economics for their study of contracts and human behaviour in business.

The field is known as contract theory.

It is, partly at least, an attempt to find out how contracts between firms and employees can lead to short-termism and how those contracts could be better constructed.

The two economists provided 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.”

It has become especially relevant in the years after the 2008 financial crisis, which was blamed on the short-term risk encouraged by huge cash bonuses paid to investment bankers. It also touches on themes of moral hazard, which arises where those that take the risks don’t share in the costs of failure.

The Royal Swedish Academy of Sciences published a paper on contract theory and the work that won Hart and Holmstrom their prize this year.

Here is a quick breakdown of the key ideas:

  1. Contract theory has its roots in the 1700s, when Adam Smith argued that share-cropping contracts did not incentivise tenants to improve the land. The theory was revisited in the 1930s when American business executive Chester Barnard considered how to get employees to put more effort into their work in big companies. Barnard is considered the pioneering author related to management theory and organisational studies.
  2. The theory looks at the difficulty of tying pay to performance. A company might pay a CEO based on an increase in stock-market value, but this could end up being just luck. In the late 1970s and early 80s work by Holmström on the “Informativeness Principle” helped develop models of performance that counter-balanced external factors beyond the control of managers.
  3. Contract theory also looks at short-term incentives and the problem that managers might prioritise quick gains over future stability. In the 1990s Holmström developed the “Multitasking Model,” which provided a way of measuring this effect.
  4. The model has been expanded to capture the moral hazard of teamwork, whereby some members of a team can piggy-back on the hard work of others, as well as future “career concerns,” which might motivate someone to take more or less risk than their contract with their current employer suggests.
  5. Oliver Hart’s work focuses on the idea of “incomplete contracts” and their relationship to property rights.
  6. The theory goes that almost all contracts are incomplete because performance is to hard to measure accurately. Even if you could measure it accurately, it would be too complex to reflect in a contract.
  7. His work has been applied to studies of the competing interests of company shareholders and managers, and the rights of investors in bankruptcy.
  8. The work is important and has far-reaching applications. Here is what the Academy said: “It generates precise hypotheses that can be confronted with empirical data and lays an intellectual foundation for the design of various policies and institutions, from bankruptcy legislation to political constitutions.”

Oliver Hart is currently the Andrew E. Furer Professor of Economics at Harvard University, where he has taught since 1993.
Bengt Holmström is the Paul A. Samuelson Professor of Economics at Massachusetts Institute of Technology, where he also was head of the Economics Department from 2003-2006.

Unlike Nobel honours in other sciences and areas, the economics award is a collaboration between Sweden’s central bank, called the Sveriges Riksbank, and the Nobel Foundation.

The prize has previously gone to such major names as Milton Friedman, Paul Krugman, and Friedrich von Hayek. Political scientists whose work has influenced economics as a discipline have also been honoured in the past.

Last year it went to Deaton was given the prize for his work on “consumption, poverty, and welfare.”

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