Nobel Prize in Economics 2016: Contract Theory and the Hart-Holmström Prize

This note covers the Nobel Prize in Economics 2016: who won it, what contract theory is, how it explains incentive pay, insurance deductibles and incomplete contracts, how the field developed from the late 1970s to the late 1990s, why it matters for real-world institutions, and quick facts for exams.

What was the Nobel Prize in Economics 2016 awarded for?

The official citation reads: "for their contributions to contract theory". This single line covers a whole body of work on how two or more parties, who often want different things, can write an agreement that still gets the best possible outcome for everyone involved.

In plain words, a contract is any agreement that sets out what each side must do, and what happens if they do not. Employment contracts, insurance policies, bank loans and even constitutions are all contracts.

The problem the laureates tackled is that contracts are hard to get right: one side usually knows things the other does not (such as how hard an employee is really working), and no contract can list every possible future event.

The laureates built mathematical tools to design better contracts despite these limits.

The full official name of the award is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, commonly called the Nobel Prize in Economics.

It was announced on 10 October 2016 by the Royal Swedish Academy of Sciences, and the prize money of 8,000,000 Swedish kronor was split equally between the two laureates.

Who are the laureates?

Oliver Hart

Oliver Hart was born on 9 October 1948 in London, United Kingdom. At the time of the award he was affiliated to Harvard University, Cambridge, MA, USA, where the press release named him the Andrew E. Furer Professor of Economics. He received one half of the prize.

According to the nobelprize.org facts page, Hart studied mathematics at Cambridge University and economics at the University of Warwick, and earned his PhD from Princeton University in 1974.

He worked at several universities, including the London School of Economics and MIT, before joining Harvard in 1993.

In the mid-1980s he built key parts of the theory of incomplete contracts, working out how the right to make decisions should be assigned when a contract cannot cover every future situation.

Bengt Holmström

Bengt Holmström was born on 18 April 1949 in Helsinki, Finland. At the time of the award he was affiliated to the Massachusetts Institute of Technology (MIT), Cambridge, MA, USA, named in the press release as the Paul A. Samuelson Professor of Economics.

He also received one half of the prize.

The facts page states that Holmström studied mathematics and physics at the University of Helsinki, belongs to Finland's Swedish-speaking minority, and earned his PhD from Stanford University in 1978.

He later worked at the Stockholm School of Economics, Northwestern University and Yale University before joining MIT in 1994.

In the late 1970s he worked out how a "principal" (such as a firm's owners) should design an optimal contract for an "agent" (such as a CEO) whose actions the principal cannot fully observe.

What problem does contract theory answer?

Modern economies run on an enormous number of contracts: between a company and its CEO, an insurer and a car owner, or a government and the firms that supply it.

The popular science background notes that contracts help people be cooperative and trusting when they might otherwise be "disobliging and distrusting", because employment contracts, credit contracts and insurance contracts all set out what each side owes the other.

The underlying difficulty is that the two sides to a contract often have conflicting interests, and one side usually cannot fully observe what the other side is doing.

An employer cannot watch every minute of an employee's work; an insurer cannot see whether a driver was being careless. Economists call this an information problem: an agent has information the principal does not.

A second difficulty is that the future is too complicated to write down in full.

The presentation speech by Professor Per Strömberg illustrated this with an ancient example: a 2,200-year-old marble lease agreement from the Greek city of Teos listed extra fees and penalties across more than half of its fifty lines, trying to anticipate every possible breach by the tenant. The same speech noted that the agreement even let the owners hold religious rites there for three days a year, which conveniently kept their rental income tax-exempt, showing how far a careful drafter will go to cover every angle.

Even such a detailed contract could not cover every future circumstance, which is exactly the gap that incomplete-contract theory addresses.

Contract theory therefore developed in two connected directions: Holmström's work on how to reward effort when it cannot be fully observed, and Hart's work on who should hold decision rights when a contract cannot specify everything in advance.

Together these questions matter for executive pay, insurance design, business ownership and the choice between public and private provision of services such as schools and prisons. As the presentation speech put it, contracts regulate not only economic relationships but also non-economic ones, from marriage to constitutional law to international treaties, which is why the tools built by these two laureates reach so far beyond a single industry.

The speech also stressed that contracts are, at heart, an exercise in cooperation rather than conflict: a well-written agreement, it said, creates "a golden compromise between parties with partly divergent interests", even though poorly designed agreements can instead lead to deception and unnecessary disputes.

How does Holmström's theory of incentive pay work?

Holmström's starting point, from the late 1970s, is the principal-agent model: a principal (for example, a firm's shareholders) wants an agent (the CEO) to work hard, but can only imperfectly observe the agent's effort through some measure of performance, such as profit or share price.

His key result, the informativeness principle, published independently alongside Steven Shavell in 1979, says that an optimal contract should link pay to every piece of information that helps reveal what action the agent actually took, not just to outcomes the agent can influence.

The popular information page gives the example of a manager whose pay should depend on her firm's share price relative to those of similar firms, rather than on the share price alone, because this removes the effect of industry-wide luck that the manager cannot control.

1. Identify what the principal can observe about the agent's performance, directly or indirectly.
2. Work out which of those measures genuinely reveal information about the agent's hidden effort or action.
3. Link the agent's pay to all such informative measures, not just the most obvious outcome.
4. Balance the strength of incentives against the risk this places on the agent: in riskier settings, pay should lean more towards a fixed salary; in stable settings, more towards performance-based pay.

This basic model also explains why a fixed salary is sometimes the right answer rather than a flaw in contract design. The sources note that in most employment settings, the employer is better placed than the employee to bear risk. If the employee's interests always matched the employer's, no performance pay would be needed at all, and a fixed salary, which effectively insures the employee against bad outcomes, would be optimal. The need for performance pay only arises once interests diverge and behaviour is hard to observe directly.

Holmström then extended this basic model to more realistic situations. In a 1982 article he showed that career concerns can substitute for explicit performance pay: an employee may work hard simply to protect his reputation and future salary in a competitive labour market, since a company that fails to reward good current work with higher future earnings risks losing the employee to a rival. The sources add that this career-concerns logic has also been applied beyond ordinary jobs, including to the relationship between politicians and the voters who judge them. This can make younger workers overwork and older workers without such concerns slack off.

In 1991, with Paul Milgrom, he built the multitasking model, which found that when some tasks are easy to measure and others are not, strong incentives tied only to the measurable tasks can distort behaviour, so a flatter, more balanced pay structure may work better.

He also analysed team settings, in 1982, showing that when a team's total pay cannot exceed its total output, individual members tend to free-ride, and that an outside owner can restore stronger incentives by breaking that link.

Draw two bars for a teacher's job: one labelled "easy to measure" (test scores) and one labelled "hard to measure" (creativity, independent thinking). Show an arrow from strong pay-for-performance pulling effort towards the measurable bar and away from the harder-to-measure one.

How does Hart's theory of incomplete contracts work?

Hart's contribution, developed from the mid-1980s with collaborators including Sanford Grossman and John Moore, deals with contracts that cannot specify what should happen in every future situation.

The core idea is that such a contract should instead specify who has the right to decide what to do when the parties disagree.

The party holding this decision right gains more bargaining power once outcomes become known, which in turn strengthens that party's incentive to make valuable but non-contractible investments, such as effort or innovation, while weakening the other party's incentive.

This logic produces a theory of property rights: assets should generally be owned by whichever party's investment is hardest to specify in a contract.

On privatisation, the popular information page notes that Hart, Shleifer and Vishny were particularly concerned about private prisons, and it adds that federal authorities in the United States were ending the use of private prisons, partly because a US Department of Justice report found that conditions in privately run prisons were worse than in publicly run ones.

Draw two boxes, "Party A" and "Party B", joined by an arrow labelled "unspecified future event". Show a branching path where whichever party holds the decision right gets to choose the outcome, and label that party's box "stronger incentive to invest".

How did contract theory develop?

Why does contract theory matter?

The popular information page states that contract theory does not give one definitive answer for every situation, since the best contract depends on context, but it gives people the tools to think clearly about the trade-offs involved.

This is useful for designing performance-based pay for executives, deductibles and co-pays in insurance, and decisions about privatising public services.

The press release states that the laureates' work "launched contract theory as a fertile field of basic research" and that their work on optimal contracts provides a conceptual basis for shaping policy, from bankruptcy law to political constitutions.

The theory has influenced fields well beyond economics, including corporate governance, political science and law. The press release specifically mentions that Hart's work on incomplete contracts gives economists new tools for studying which kinds of companies should merge, what the right mix of debt and equity financing looks like, and when schools or prisons should be run publicly rather than privately.

The popular information page similarly notes that, thanks to Hart and Holmström, researchers now have tools to analyse not just the financial terms written into a contract but also how it allocates control rights, property rights and decision rights between the parties involved.

Open questions remain context-specific: for instance, the sources note that the desirability of privatisation depends on weighing cost reduction against quality, and that this trade-off differs across services such as schools, hospitals and prisons. Contract theory gives a framework for making that trade-off explicit rather than a single fixed rule.

The presentation speech summed this up by telling the laureates directly that the field of contract theory stands on their contributions, and that their work helps people write better contracts to strengthen cooperation and welfare rather than simply to settle disputes after the fact.

How does this connect to what you study?

Contract theory sits inside microeconomics, specifically the study of information and incentives, which appears in economics courses under topics such as asymmetric information and moral hazard.

The idea that insurance with full reimbursement can make people more careless, discussed on the popular information page, is a direct example of moral hazard, a term used in economics textbooks when discussing insurance markets.

The sources explain that this tension between insurance and incentives rests on two separate factors: a genuine conflict of interest, since not everyone behaves equally carefully once protected from consequences, and a measurement problem, since an insurer cannot observe every careless action a policyholder takes.

The same logic of principals and agents is useful for understanding everyday institutions studied in civics and economics, such as why employment contracts, bank loans and government tenders are structured the way they are.

Students preparing for economics or general-studies exams can use Hart's and Holmström's work as a concrete, real example of how theoretical tools from economics are applied to design practical institutions, from a simple weekly household allowance offered for chores, an example the presentation speech itself used to show how ordinary and widespread implicit contracts really are, up to national bankruptcy law.

The financial-contracts application also connects directly to any study of how banks lend money: the sources explain that most bank loans work exactly like the theory predicts, giving a borrower most decision rights while performance is good but shifting control, through collateral, to the lender once performance worsens.

Quick facts for exams

The Nobel Prize in Economics 2016, formally the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, was awarded jointly to Oliver Hart and Bengt Holmström "for their contributions to contract theory".

It was announced on 10 October 2016 by the Royal Swedish Academy of Sciences. Hart, born in London and affiliated to Harvard University, developed the theory of incomplete contracts and property rights.

Holmström, born in Helsinki and affiliated to MIT, developed the informativeness principle and models of career concerns, multitasking and team incentives. Each laureate received one half of the 8,000,000 Swedish kronor prize.

Note: Source. The prize facts in this note are from the Nobel Prize's official site, nobelprize.org.

Glossary

• Contract theory — the branch of economics that studies how agreements between parties with different interests and information should be designed.
• Principal — the party in a contract who delegates a task, such as a firm's shareholders or an employer.
• Agent — the party in a contract who carries out the task, such as a CEO or employee, whose actions the principal cannot fully observe.
• Informativeness principle — Holmström's rule that pay should depend on every measure that reveals information about the agent's hidden effort, not only on outcomes the agent can influence.
• Incomplete contract — a contract that cannot specify what should happen in every possible future situation.
• Decision right — the authority, assigned by a contract, to decide what to do in situations the contract did not foresee.
• Property rights — rights over the ownership and control of an asset, which determine who can make decisions about its use.
• Moral hazard — the tendency to behave less carefully once protected from the consequences, such as by full insurance.
• Career-concerns model — Holmström's model in which an employee works hard to protect future earnings and reputation, rather than for explicit current pay-for-performance.
• Multitasking model — the Holmström-Milgrom model showing that strong incentives on easily measured tasks can crowd out effort on harder-to-measure but equally important tasks.
• Free-riding — a team member benefiting from the group's shared output while contributing less effort than others.
• Privatisation — transferring the ownership or operation of a service, such as a school or prison, from the public sector to a private party.

Common errors and misconceptions

• Misconception: Contract theory gives one correct answer for every contract. Correct: the sources state that the best contract depends on the specific situation and context; the theory provides a framework for thinking, not a single fixed answer.
• Misconception: Holmström's and Hart's work are the same idea. Correct: Holmström's work mainly concerns performance pay under imperfect observation, while Hart's work mainly concerns who holds decision rights when contracts are incomplete.
• Misconception: Full insurance is always the best insurance design. Correct: the popular information page explains that full insurance can create moral hazard, so deductibles and co-pays are used to preserve some incentive for care.
• Misconception: Performance pay should always be tied as tightly as possible to measurable outcomes. Correct: the multitasking model shows that very strong incentives on easily measured tasks can crowd out effort on equally important but harder-to-measure tasks.
• Misconception: Hart and Holmström shared the prize for separate, unrelated discoveries. Correct: the citation covers their joint field, "contributions to contract theory", recognising their complementary work in the same area.
• Misconception: Privatisation is always better, or always worse, than public ownership for a service. Correct: the theory shows private ownership strengthens incentives for cost reduction, sometimes excessively, so the right choice depends on balancing cost against quality.

Exam-style questions with model answers

Q1. For which contribution was the Nobel Prize in Economics 2016 awarded? [1 mark]

1. It was awarded for their contributions to contract theory, as stated in the official citation.

Q2. Name the two laureates of the Nobel Prize in Economics 2016 and their affiliations at the time of the award. [2 marks]

1. Oliver Hart, affiliated to Harvard University, and Bengt Holmström, affiliated to the Massachusetts Institute of Technology, shared the prize equally.

Q3. Explain Holmström's informativeness principle with an example. [4 marks]

1. The informativeness principle states that an optimal contract should link an agent's pay to every measure of performance that carries information about the agent's hidden actions, not only to the most obvious outcome.
2. For example, a manager's pay should not depend only on her own firm's share price, because that price also reflects industry-wide factors outside her control.
3. Instead, pay should be linked to her firm's share price relative to similar firms, which removes the effect of general economic luck.
4. This way, the manager is rewarded for her own effort rather than for conditions she cannot influence.

Q4. What is an incomplete contract, and why does it matter for allocating decision rights? [4 marks]

1. An incomplete contract is one that cannot specify in advance what the parties should do in every possible future situation.
2. Because it is impossible to foresee and write down every eventuality, the contract instead needs to specify who has the right to decide what happens when an unforeseen situation arises.
3. Oliver Hart's research showed that the party holding this decision right gains more bargaining power once outcomes are known.
4. This strengthens that party's incentive to make important, non-contractible investments, while weakening the other party's incentive, which guides how ownership of assets should be allocated.

Q5. Discuss the tension between insurance and incentives, using the example given in the sources. [5 marks]

1. If accidents happened purely by chance, full insurance that covers every loss would seem ideal, since it would protect people from unpredictable harm without any downside.
2. However, full insurance creates moral hazard: once a person knows they are fully reimbursed, they may become less careful, because they no longer bear the consequences of carelessness.
3. This tension exists because of two factors: not everyone behaves equally carefully regardless of consequences, and an insurer cannot perfectly observe every careless action taken by the insured.
4. If careless behaviour could be perfectly observed, the insurer could cover only true accidents and exclude reckless ones, removing the problem entirely.
5. Since this is not possible, insurers use deductibles and co-pays, which require the insured to bear part of any loss themselves, to preserve some incentive for care while still providing meaningful protection against genuine accidents.

Q6. Describe Hart's theory of incomplete contracts and its application to privatisation of public services. [6 marks]

1. Hart's theory of incomplete contracts, developed from the mid-1980s, addresses situations where a contract cannot specify what should happen in every future circumstance.
2. In such cases, the contract should instead assign decision rights, determining which party gets to decide what happens when an unforeseen situation arises, and the party with stronger decision rights gains more bargaining power and stronger investment incentives.
3. Applied to privatisation, the theory considers a manager of a welfare-service facility who could invest either in improving quality or in reducing cost, where both types of investment are hard to specify in a contract.
4. If a government owns the facility, the manager has weak incentives for either type of investment, because the government cannot credibly promise rewards for non-contractible effort.
5. If a private contractor runs the facility, incentives for both quality improvement and cost reduction become stronger, but a 1997 article by Hart, Andrei Shleifer and Robert Vishny found that incentives for cost reduction are typically too strong under private provision.
6. The sources note this trade-off was of particular concern for private prisons, where a US Department of Justice report found conditions were worse than in publicly run prisons, so the desirability of privatising any given service depends on weighing quality against cost reduction.

Key takeaways

• The Nobel Prize in Economics 2016 went jointly to Oliver Hart and Bengt Holmström for their contributions to contract theory.
• Holmström's informativeness principle says pay should depend on every measure that reveals information about an agent's hidden effort.
• Holmström also developed models of career concerns, multitasking and team incentives to extend his basic framework.
• Hart's theory of incomplete contracts explains how decision rights should be assigned when contracts cannot cover every future event.
• Hart's work underpins theories of property rights, financial contracts and the trade-offs in privatising public services.
• Insurance deductibles and co-pays exist to balance protection against risk with the need to preserve incentives for care.
• Contract theory does not give one fixed answer but gives tools for thinking clearly about contract design across many real-world settings.

Test yourself

What was the official citation for the 2016 Nobel Prize in Economics?

The citation was "for their contributions to contract theory", awarded jointly to Oliver Hart and Bengt Holmström.

Where was Oliver Hart affiliated at the time of the award?

Oliver Hart was affiliated to Harvard University in Cambridge, Massachusetts, USA, at the time of the award.

Where was Bengt Holmström affiliated at the time of the award?

Bengt Holmström was affiliated to the Massachusetts Institute of Technology in Cambridge, Massachusetts, USA.

What does Holmström's informativeness principle say?

It says that an optimal contract should link pay to every outcome that gives information about the agent's hidden action, not just the obvious performance measure.

What question does Hart's incomplete-contracts theory answer?

It answers who should hold the right to decide what happens when a contract cannot specify every future situation in advance.

Why can full insurance create a problem?

Full insurance can create moral hazard, making people less careful since they no longer bear the consequences of their own carelessness.

What did the 1997 article by Hart, Shleifer and Vishny find about privatisation?

It found that incentives for cost reduction under private provision are typically too strong, which can hurt quality in services such as prisons.

What is the multitasking model about?

It shows that strong pay-for-performance tied to easily measured tasks can cause employees to neglect equally important, harder-to-measure tasks.