The Nobel prize in Economics for theory of contracts

The Nobel prize in Economics for theory of contracts

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Statue of Alfred Nobel at the Karolinska Institute in Stockholm

Photo: Jonathan Nackstrand/AFP

Prize in memory of Alfred Nobel in Economics was awarded to Oliver HART of Harvard University, and Bengt Holmstrom from the Massachusetts Institute of technology “for their contributions to the theory of contracts”

The return to reality

The Nobel Committee awarded the prize in Economics, established by the Bank of Sweden in 1968, Oliver HART of Harvard University, and Bengt Holmstrom from mit with the wording “for their contributions to the theory of contracts”. HART was born in England, and Khol’mstrem in Finland, but both received economic education and work in the United States. They are almost the same age HART was born in 1948 Khol’mstrem — 1949-M.

Prize in Economics this year continues the tradition of recent years to reward research close to the “real world” — for what people face regularly in practice. “The Nobel prize HART and Holmstrom — fully about how economic theorists reunited with the real world and all its imperfections,” — wrote in his Twitter Professor of Economics, University of Michigan Justin Wolfers. HART and Khol’mstrem have developed new theoretical tools for understanding the contracts that occur in real life. Their analysis of the optimal contractual arrangements have laid the intellectual foundations for the development of policies and institutions in many areas, including bankruptcy law and the political Constitution, it is noted in the statement of the Committee. The model of HART and Holmstrom applicable to the study of many relations in the real economy: teacher — student, employer — employee, regulator — banker, etc.

The classical model of contract are described as follows: between the principal and the agent have an agreement in which the agent performs certain actions in the interests of the principal. The problem is that the principal cannot directly observe the actions of the agent and this creates a “moral hazard” (moral hazard): the agent has the incentive to unscrupulous (opportunistic) behavior in their own interests. A typical example: a business owner delegates to the Manager authority to manage the business. Management often takes decisions that are profitable from the point of view of profit and personal reward, but risky from the point of view of long-term stability of the business. It was called one of the causes of the global financial crisis of 2008-2009. “The reward system of top managers developed in the conditions of cheap money, intense competition and soft regulation, too often encouraged reckless trades, short-term profit without adequate consideration of long — term consequences,” – noted in its final report, the U.S. Commission investigating the financial crisis of 2008.

Ideally, the compensation that the principal pays the agent should be based on observable and verifiable variables, but in practice none of these criteria like market capitalization of the company or its net profit is not providing optimum results for both parties. “If the agent is paid a flat salary that does not depend on anything, then of course he will just do what he likes. To create the incentives needed to make his payment (payment, promotion, risk of job loss) is sensitive to the results of his work. However, for him there is a risk — he’s not fully in control of the result, play the role of randomness, work colleagues, etc.,” explains associate Professor of Department of theoretical Economics Higher school of Economics (HSE) Anton Suvorov.

To separate “noise”

In 1979, Bengt Khol’mstrem brought and formalized the “principle of informativeness”, which implies that the wage of an agent should depend on variables (signals) that provide information about its actions, separating random factors (“noise”) that are not associated with the actions of the agent. If you put the agent in dependence on the absolute parameter (e.g., volume of production, sales or capitalization of the company), the “bad” agent can win just from the good state of the economy or market, and “good” to lose from a bad situation in the economy. Of course, this scheme is not effective. In the example of remuneration of the Manager the principle Holmstrem means that it is not enough to tie wages to the cost of the stock of his company: quotes largely depend on factors outside the control of management. More correct decision — to consider the value of shares and other companies, for example from the same industry. Share price relative to the cost of comparable firms is more informative variable. Suvorov from the HSE gives the example of an excessive and binding salaries of teachers to the results of the exam as a possible inefficiency.

In addition, the scientist developed the theory of dynamic incentives. Unlike classical contract theory, it provides a situation when you cannot be incentives, but he still works a lot to create a good reputation, to impress the market and to change jobs in the exhaustion of possibilities at its present location, says Suvorov. But it could be the reverse situation: many workers deliberately do not disclose fully their abilities and competence, not to give managers a reason to exploit these skills more and more.

All contracts are imperfect

Study other winners, Oliver HART, in the 1980’s helped to make a breakthrough in understanding so-called incomplete contracts. In the real world it is impossible to produce an exhaustive, perfect contract. Therefore, in conditions when not all variables or potential States of the world can be stipulated in the contract, you need to identify the third party, which will be given to decide what to do when the parties to a contract are unable to agree. Theoretical studies of HART and his colleagues can be applied in the analysis of complex financial contracts and the privatization of assets. The role in this situation plays the one who can make decisions — has formal rights and real possibilities (the information needed to make rational decisions), indicates Suvorov.

So, the answer to the question whether providers of public services (schools, hospitals, prisons, etc.) to be private or public, is not clear: privatization reduces costs of the business, but at the same time can lead to deterioration. Interestingly, conditions in the us private prisons are often worse than the public — which is why the US Federal government has recently decided to stop using private prisons.

In 2015, the prize in Economics went to a British and American economist Angus Deaton “the analysis of consumption, poverty and welfare”. The winner receives a cash award of 8 million Swedish kronor ($925 thousand at current exchange rates), in the case Holmstrom and HART they will divide it in half.

The Swedish national Bank prize in economic Sciences in memory of Alfred Nobel was established in 1969. Until 2016 it received 47 scholars, 46 of them men. Almost all of the prizes were awarded to scientists working in the United States, and they were all over 50 years old.

Elinor Ostrom became the first and only woman awarded the Nobel prize in Economics. In 2009, she was awarded the prize for “his analysis of economic governance”.

Most often (28 winners) prize is given to those laureates who studied or worked at the University of Chicago.

The only Soviet scientist, who received the award, was a mathematician and economist Leonid Kantorovich in 1975 he received the award “for contribution to the theory of optimum allocation of resources”.