Contributions of Oliver Hart and Bengt Holmström to Contract Theory

• DOI: http://doi.org/10.1111/sjoe.12245
• Published date: 01 July 2017
• Date: 01 July 2017

Scand. J. of Economics 119(3), 489–511, 2017

DOI: 10.1111/sjoe.12245

Contributions of Oliver Hart and Bengt

Holmstr¨

om to Contract Theory∗

Klaus M. Schmidt

University of Munich, DE-80539 Munich, Germany

klaus.schmidt@lrz.uni-muenchen.de

Abstract

Oliver Hart and Bengt Holmstr¨

om were awarded the 2016 Sveriges Riksbank Prize in Eco-

nomic Sciences in Memory of Alfred Nobel for their fundamental contributions to contract

theory. This article offers a short summary and discussion of their path-breaking work.

Keywords: Contract theory; incomplete contracts; Nobel prize; optimal incentive schemes

JEL classification:B21; D23; D82; L20

I. Introduction

The 2016 Sveriges Riksbank Prize in Economic Sciences in Memory of

Alfred Nobel was awarded to Oliver Hart and Bengt Holmstr¨

om for their

fundamental contributions to contract theory. Oliver Hart was born in

1948 in London. He studied mathematics at King’s College in Cambridge

and economics at Warwick University, and he did his PhD at Princeton

University in 1974. He worked at the University of Essex, Cambridge

University, the London School of Economics (LSE) and the Massachusetts

Institute of Technology (MIT) before going to Harvard University in 1993.

Bengt Holmstr¨

om was born in Finland in 1949. He studied mathematics

at Helsinki University and Operations Research at Stanford University,

where he also did his PhD at the Graduate School of Business. He worked

at Northwestern University and Yale University before moving to MIT in

1994.

Contract theory analyzes the optimal design of incentive schemes (“con-

tracts”) that induce the involved parties to behave more efficiently. It

is closely related to mechanism design theory, for which Leonid Hur-

wicz, Eric Maskin, and Roger Myerson received the 2007 Sveriges Riks-

bank Prize in Economic Sciences in Memory of Alfred Nobel. While

mechanism design theory is mostly interested in allocation mechanisms

that involve many agents (such as markets, auctions, tax systems, etc.),

∗Financial support by Deutsche Forschungsgemeinschaft through CRC TRR 190 is gratefully

acknowledged.

CThe editors of The Scandinavian Journal of Economics 2017.

490 Contributions of O. Hart and B. Holmstr¨

om to contract theory

contract theory focuses on situations in which only a few parties interact

with each other (often just two).

Contract theory deals with a fundamental problem of economic co-

operation. Two (or more) parties can jointly generate a surplus in addition to

what each of them can generate on their own. The amount of the surplus de-

pends on the actions that each of the parties take. The problem is that each

party has an incentive to behave opportunistically (i.e., to maximize its own

pay-off rather than the joint surplus). If the parties could write a complete

contingent contract that specifies the actions that each of them has to take

in every possible state of the world and if this contract could be enforced

by the courts, then the solution to this problem would be trivial. The parties

would write a contract that obligates them to take exactly those actions that

maximize the joint surplus in each possible state of the world, and then they

would share this surplus in some way between them. If a party deviates

from the prescribed behavior, then it has to pay a penalty that is sufficiently

high to guarantee that everybody honors the terms of the contract.

Unfortunately, in the real world, it is often impossible to write complete

contingent contracts, for example, because the actions of some parties are

not observable (moral hazard) or because the actions or the different states

of the world cannot be described and verified to a third party, such as the

courts (incomplete contracts). In these situations, it is still possible to write

contracts, but these contracts cannot enforce the desired behavior directly;

rather, they have to offer incentives that induce the parties indirectly to

behave more efficiently. This could be financial incentives, career concerns,

or incentives that are provided by the allocation of control and property

rights.

Hart and Holmstr¨

om developed canonical models for the analysis of the

optimal design of incentive mechanisms. Because of their contributions, we

now have a much better understanding of the incentive effects of contracts

and of how optimal incentive mechanisms should be designed. There is

a broad range of possible applications of these models. They include the

optimal design of incentive schemes for managers and workers, the optimal

financial structure of a f irm, the optimal design of hierarchies and decision

structures in organizations, and the optimal allocation of property rights. A

large body of literature on contract theory grew out of their work, which

cannot possibly be summarized in this short review. A good overview of

this literature is provided by the textbook of Bolton and Dewatripont (2005)

and the anthology edited by Aghion et al. (2016).

In this short paper, I first discuss Bengt Holmstr ¨

om’s work on optimal

incentive schemes with moral hazard. I then move on to Oliver Hart’s work

on incomplete contracts and the optimal allocation of property rights. They

were awarded the 2016 Sveriges Riksbank Prize in Economic Sciences in

Memory of Alfred Nobel for these contributions. Both authors have made

CThe editors of The Scandinavian Journal of Economics 2017.