Oliver Hart and Bengt Holmström were awarded the 2016 Nobel Prize in Economics on Monday. The award was given in recognition of their contribution in contract theory- their work in conceptualizing a structure to better understand agreements like insurance contracts, property rights and employer-employee relationships.
Hart and Holmström were inspired to work on the pressing issues often familiar to most individuals who are employed or who are paying insurances.
Specifically, Holmström's focus was on providing balance between risks and incentives.
The Nobel committee further highlights a valuable insight on high-risk industries. According to Holmström, high-risk industries should aim to provide more stable salaries. Stable industries, on the other hand, should also provide performance bonuses.
On the other hand, Hart worked in emphasizing the fundamental shortcomings of most contracts- specifically on issues of unpredictability of future circumstances finding a way to codify them in a single contract.
In short, Hart provided solutions on how to deal with unforeseen circumstances. This certain aspect represents the field of "incomplete contracts".
Hart established a way to identify who among the parties should make future decisions about the contract-- specifically identifying a significant kind of power.
Specifically, provided below is a short summary as provided by the Nobel committee:
"Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to provide either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger."
50 years ago, The Economics Prize was first established as Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. The prize has come a long way as it is now considered as among the original Nobel Prizes.