This year’s Nobel Prize in Economics has gone to two economists, Oliver Hart from Harvard University, and Bengt Holmström from the Massachusetts Institute of Technology, for their work on contract theory. Although contract theory sounds like it might be more relevant to the practice of law, it turns out that understanding the way contracts are modelled is fundamental to many economic behaviours and phenomena.

What is the Nobel Prize in Economics?

The Nobel Prize in Economics (or more volubly the Swedish National Bank's Prize in Economic Sciences in Memory of Alfred Nobel), was first awarded in 1968 based on a donation from Sweden's central bank, on its 300th anniversary. It is thus the youngest addition to the Nobel prize family and each year recognizes an outstanding contribution to the economics field.

This is the 48th year in which the prize has been given and the two winners will share a prize of 8m Swedish krona ($920,000).

What is contract theory?

Contract theory aims to further our understanding about how actors in the economy build contractual arrangements between themselves. In particular, given that contracts are often developed under incomplete information, or asymmetric information (when one party has more information than the other in the transaction), it explores ways to overcome suboptimal outcomes brought about by fears of “moral hazard” or free riding. How can optimal contracts for all parties be built under such constraints?

Optimal contracts can be developed by modelling behaviours of decision makers under different assumptions, and then applying specific rules to encourage optimal decisions (where both parties in a transaction are better off). The idea is to find ways to get actors to take appropriate actions, for example in the cases of selling used cars, taking out insurance or devising employment contracts.

What is so special about this contribution?

According to the Nobel Committee, the initial contributions of the two winners “launched contract theory as a fertile field of basic research… we now have the tools to analyse not only contracts’ financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties. The contributions by the laureates have helped us understand many of the contracts we observe in real life.”

In other words they have contributed a very valuable tool for the functioning of everyday transactions. In an economic climate characterized by so much uncertainty and distrust, this is an important contribution, and one that will remain useful for years to come.