Nobel Prize in Economics 2016: Contract Theory (Hart and Holmström) in Economic Theory

In 2016, the Nobel Prize in economics was awarded to two scholars, Oliver Hart and Bengt Holmström, who had developed the contract theory and applied it in industrial economics, organizational economics and managerial economics. A great part of research of industrial psychology in modern economics is tightly related to the contractual relationships between stakeholders, managers and employees. By developing the contract theory, Hart and Holmström have created a tool for studying the contractual landscape of modern economies of scale. 

Contract Theory by Hart and Holmström (Nobel Prize in Economics 2016) | Industrial psychology in economies of scale | Organizational Economics, Industrial Economics and Managerial Economics

Economic Theory: Industrial Economics, Organizational Economics, Managerial Economics | Nobel Prize in Economics 2016 for Hart and Holmström | Contract Theory and Industrial Psychology

What is Contract Theory?

Contract Theory Definition

Contracts are an integral part of our life. Whatever we agree to do or whatever we arrange to be done for us, we are entering contracts with others. The notion of contract has grown out of its legal usus and has successfully penetrated other areas of life, retaining a grain of its legal meaning, namely the aspect of obligation resulting from the background of industrial psychology. 

Economics is one of the areas that has readily adopted the notion of contract. Specifically, such domains of economic theory as industrial economics, organizational economics and managerial economics studying economics of scale, have embraced the concept of contract between different economic actors withing the basic economic entity - the firm. In many ways, thanks to Hart and Holmström, the winners of the Nobel Prize in Economics in 2016 who have developed a complete framework for analysis of modern economies of scale.

Models of Contract Theory

In our daily life we enter contracts without even thinking about it. Indeed, every economic transaction may, with a considerable level of abstraction, be considered as a contract. In economic theory (industrial economics, organizational economics and managerial economics) when we want to have an insight into industrial psychology and start to analyse how efficient the work of different economic actors is, we need to apply different contract theory applications. Besides, the economic entity can consist of just one or many persons

When people negotiate their interests and decide to work together, they start a contract relationship, i.e. they discuss different ways of cooperation. Having different interests, there are most often three groups within a firm: stakeholders, management and employees. The least complex entity is the sole proprietorship which normally includes only one person who is the employee, manager and shareholder at the same time. Other entities have a more complicated structure. The least complicated example would be a situation when the principal (CEO, or the head 'stakeholder') has to design a contract with his employee so as to maximise the benefit of the work of the latter. 

   

Contract Types and Principles of Contract Design

In order that the company functions in the most efficient way, it should fine-tune its contractual landscape in the most efficient way. That means in such a way that all the actors are motivated to produce the best possible result. In that so-called principal-agent model, the effort of the employee is maximised with respect to his utility function so as to find the most interesting way of exploiting his services.

Can contracts be complete and predict every sort of risk? Hart and Holmström has been working on that question since the 1980s. Their research has shed a vast light on those questions as well as others concerning financial markets, mergers and acquisitions etc. For more info about contract theory and the Nobel Prize in economics 2016, please follow the link.