Bengt Homstrom and Oliver Hart
Bengt Homstrom (left) and Oliver Hart.MIT and Harvard official websites

The 48th Sveriges Riksbank Prize in Economic Sciences in the memory of Alfred Nobel, awarded by the Royal Swedish Academy of Sciences, has this year been given to Oliver Hart of Harvard University and Bengt Holmstrom of Massachusetts Institute of Technology for their work on Contract Theory. 

According to an official statement released by the Nobel Prize committee: "Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmstrom are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design."

The statement adds: "This year's laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities."

It is for this contribution of theirs that they have received the Sveriges Riksbank Prize in Economic Sciences in the memory of Alfred Nobel, which is also known as the Nobel Prize in Economics. The prize was established by the Swedish central bank, Sveriges Riksbank, on its 300th anniversary, and has been awarded every year since 1969.

Finland-born Holmstrom, in the 1970s, "demonstrated how a principal (like a company's shareholders) should design an optimal contract for an agent (the company's CEO), whose action is partly unobserved by the principal," said the official statement, adding: "Holmstrom's informativeness principle stated precisely how this contract should link the agent's pay to performance-relevant information."

UK-born Hart, in the 1980s, "made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: Which party to the contract should be entitled to make decisions in which circumstances?"

The official statement explained the rationale behind the awarding of the prize thus: "Through their initial contributions, Hart and Holmstrom launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions."