You and I MUST open a lemonade stand together. We agree that I will bring the materials we need (cups, stands and so on) while you make the lemonade. I will do the pouring while you remember the money box and at the end we will divide the money equally. There is doubt, however. I am concerned that you may, in the end, try to lift the contents of the cash box. So we decide to draw up a contract (common practice in the lemonade stand industry) stipulating that the returns to our work must be shared equally. But then you start to worry: a lot of the success of our stand will depend on the quality of the lemonade, which I have no control over. What if I decide to go back and go back on your lemonade masterpiece, knowing that after you pour your sweat into the lemonade (not literally), the split is still even 50-50? So we started drawing over language in the contract explaining in detail how we should do our individual jobs.
Contracts play a vital role in the functioning of today’s economy. They define who is allowed to do what with the land they own, the people they employ and the songs they store on their smartphones. They form the basis of almost all banking and insurance sectors. People are self-interested, but to take advantage of economic opportunity people must often work together and find ways to align their interests (or reduce conflicts of interest). That’s where contracts come in. This morning, Sweden’s Riksbank awarded this year’s Nobel Prize in economic sciences to Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, for their work in improving our understanding of how and why contracts work, and when they can be made to work better.
Their work focuses attention on the importance of trade in setting contracts; Another is a series of recent awards that explore the inevitable imperfections in many critical markets. Mr. Holmstrom’s analysis of insurance contracts describes the inevitable trade-off between the integrity of an insurance contract and the degree to which that contract encourages moral hazard. From an insurance perspective, the co-payments that patients sometimes have to make when receiving treatment are a waste; it would be better for people to be able to have comprehensive insurance. But because insurers can’t know that all patients are getting only the treatment they need and no more, they use co-payments as a way to stand up face the problem of moral hazard: that some people will choose to use much more health care than they need. when the insured’s group picks up the bill.
Mr. Holmstrom applied a deeper analysis to the issue of pay for performance, where hard work is not always seen as fair. His work suggested that performance-based pay should be linked as much as possible to managerial performance measures (such as a company’s share price relative to its peers rather than the individual share price). But the harder it is to find good performance measures, the closer a pay package should get to a simple fixed salary.
Mr. Hart’s ancillary work examined cases where essential contracts were incomplete because not all outcomes could be specified. In such cases, he believed, the allocation of decision-making rights was extremely important. In our lemonade stand contract, for example, we might not specify what happens when a competitor opens across the street, but we might agree that the chief executive has the power to decide what which we do in such cases and then choose one of us to fill it. that situation. Decision-making rights often go hand in hand with property rights. Mr. Hart’s work on the subject noted that who owns what is not only important in determining what happens in various unexpected situations, but is also important in shaping daily motivations. A scientist working in the R&D department spends her time in different ways if she is guaranteed an ownership share of any kind of valuable intellectual property she generates than if her company has full ownership rights on the inventions.
This work has had important applications. Work co-authored by Mr. Hart compared the incentives for owners in public and private prisons, for example. In publicly owned prisons, managers may underinvest in quality improvement measures, but private owners face too strong an incentive to cut costs, leading to conditions for prisoners that are worse than the those in public prisons. This research has informed recent public debates about private prisons in America.
A common and important thread in the work of Messrs. Hart and Holmstrom is the role of power in designing collaborative ventures. Individuals or companies with the ability to maintain arrangements – by withholding their service or using a resource they own – gain economic power. That power allows them to capture more of the value that comes from a collaborative effort, and perhaps suppress it altogether, even if the venture would bring great benefits to all the partners and to society as a whole. . Contracts exist to shape power relationships. In some cases, they are there to limit the use of maintenance power so that your campaign can continue. In others, it is intended to create or protect certain power relations to encourage good behavior: employees or companies with the right to leave a relationship, for example, make other parties to that relationship their interests to be noted. The broader lesson – that power matters – is one economics too often overlooks. Hats off to the Nobel committee for awarding a prize that puts power dynamics front and center, and that shows the many ways in which they affect our lives, often not appreciated.
