Barry McNamara  |   Published October 11, 2016

The importance of contracts

This year’s Nobel Prize in Economics resonates with Monmouth professors
  • Since 1969, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to 78 Laureates.
The two recipients of this year’s Nobel Memorial Prize in Economic Science may not be household names, but their work affects something all consumers use – contracts.

Earlier this week, professors Oliver Hart of Harvard University and Bengt Holmström of the Massachusetts Institute of Technology were awarded the Nobel Memorial Prize in Economic Science for work to improve the design of contracts – the deals that bind together employers and their workers, or companies and their customers.

Hart has contributed to the debate about the outsourcing of public services such as prisons and garbage collection, and Holmström has had an influence on executive pay practices.

Monmouth College assistant professor Ramses Armendariz, who teaches in the political economy and commerce department, said the announcement came as a surprise.

“Pretty much, no one in the profession was expecting to see these award-winners this year, because the academy gave the prize to (Jean) Tirole two years ago, and he worked on a very similar field of study,” Armendariz said. “However, that does not imply these winners do not deserve it. Definitely, their studies have been picked up by all the top economic departments and, therefore, their papers have become standard knowledge in graduate programs.”

Armendariz’s colleague, Mike Connell, said the award ties into the philosophy of Monmouth’s department.

“Because we are a department of political economy, our curriculum includes more on the economics of contracts than most business programs,” he said. “So in a way, this prize is a validation of the political economy approach to economics as opposed to more mainstream theoretical economics – especially macroeconomics.”

Armendariz said that this year’s Nobel economists’ work focused on what he calls “solving the problem of incomplete information,” which is a fundamental problem that people face when they write contracts.

“For example, consider a person who buys a car,” he said. “The buyer has some expectations about the car’s performance. However, she has no certainty that the car will meet her expectations completely. Therefore, at the moment of purchase, sellers provide a warranty, which is a very particular kind of contract that aims to solve the natural uncertainty that exists at the moment of buying a car. And since there are many different ways that anyone can write a warranty, sellers and buyers want to know which is the best way to write a warranty, or a contract in general.”

Armendariz said Hart and Holmström study the relationship between incomplete information and contract design.

“Their contribution has brought a new set of questions to the field of economics,” he said. “For instance, what kind of incentives should be offered in a contract in order to maximize the firm’s profits? Since contract theory is based on incomplete information, it is a very complex area of study.”

Armendariz said that insurance companies are one of the most likely groups to benefit from Hart and Holmström’s work. An auto policy is as an example of two types of incomplete information.

“In order to maximize profits, insurance companies must write the correct incentives on the insurance contract to make customers reveal what kind of driver they are and, consequently, revealing the probabilities of each possible event,” such as denting the vehicle, totaling it, or not damaging it at all.

“On the other end, unknown information means that there are events that we are not even aware that they can happen,” Armendariz said. “In those cases, economists are interested in knowing how contracts should respond to events that are not explicitly stipulated in them.”

This type of problem is known as writing incomplete contracts, and some solutions involve the government taking an active role in designing and enforcing law – which, by itself, is also another kind of contract.
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