Nobel Prize in Economic Sciences and ethical insights from contracting theory

kva_logo_09The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016, awarded by the Royal Swedish Academy, was given to Oliver Hart, a professor at Harvard University, and Bengt Holmström, who is at the Massachusetts Institute of Technology. They were awarded the prize “for their contributions to contract theory.” While both made significant and award-worthy contributions that changed the way we think about contracting and the organization of firms, their insights also have ethical implications.

Hart’s work is based on the idea that contracts are inherently incomplete. That is, it is not possible to design a contract that specifies outcomes for all possible contingencies and states of the world, since there will be some (or perhaps many) situations that are unforeseeable or so complicated that they cannot be reasonably accounted for in contracts. In other words, all contracts contain gaps or missing provisions. Because contracts are incomplete, someone has to be charged with making decisions and reaping the consequences of those decisions (whether good or bad) in those cases not dictated by contract. This is another way of saying that someone has to have authority. Hart’s theories help us understand what authority means, particularly in terms of ownership and decision-making rights.

Holmström’s work focuses on the idea that information is often hidden or not available to everyone. This is, it is not possible for everyone to have all relevant information when they are making important decisions or for bosses to know perfectly what each of their employees is doing in the firm. The implication is that people will have to rely on others for information or, more generally, to do things on their behalf. One person relying on another can create what is known as the Principal-Agent Problem. An example is when employers have to rely on employees for reports on how the business is operating or to take actions on behalf of the firm, such as negotiate with customers. Holmström’s theories provide insights into how contracts should be structured so as to provide the necessary incentives for people to provide accurate information or to act in the interest of their employer or the organization to which they belong.

Ethical problems arise when there is a conflict of interests, values or rights. Interests are things we care about; values are ends in themselves or ideals to which we aspire; and rights are entitlements to things we obtain or do. Hart and Holmström’s ideas provide clarity about where and why these conflicts can arise in the business world. For example, the rights of firm owners are in conflict with the interests of workers; firm owners want workers to work hard and generate increased profits for the owners, but doing so is costly for workers, who have an interest in relaxing and taking long lunch breaks. Employees have an interest in receiving higher wages and better benefits, but these conflict with the interests of employers who pay for them. Interestingly, Holmström also demonstrated that there is a conflict between the interests of firm owners to maximize profits and their interest in running the firm efficiently. In other words, it is not possible for a firm owner to provide an efficient incentive system for workers and at the same time generate the highest profits possible. To have one the owner must give up on the other.

Contracting theory that builds on Hart and Holmström’s work is based on the assumption that people will try to take advantage of their situation. In other words, people will try to lie, cheat and steal unless they have an incentives not to, which incentives are governed by contracts. This raises the question of whether contracts would be necessary if everyone were perfectly ethical, honest and forthright. It’s an interesting academic question only, because we don’t live in a world where everyone is perfectly ethical, honest and forthright. Yet. Until then, we have to use the best theories for organizing ourselves. Fortunately, Hart and Holmström have given us a solid foundation on which to do this.