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“The social pact, far from destroying natural equality, substitutes, on the contrary, a moral and lawful equality for whatever physical inequality that nature may have imposed on mankind; so that however unequal in strength and intelligence, men become equal by covenant and by right.” – Jean-Jacques Rousseau, The Social Contract.

Contracts have existed since the beginning of civilization: in feudalism, peasants would pay taxes in the form of crops for their king based on a verbally agreed contract ; in the medieval ages, you would swear your life to protect a king, and he would give you a piece of his land to live ; during the industrial revolution, you would get paid to work a certain amount of hours per week. And this is only the economical aspect. Many sociologists and philosopers use the concept of contract, just like the quote of Rousseau shows above, to explain social interactions and norms.

The importance of contracts in our lives was never so clear as it was on this 10th of October, when the economists Bengt Holmström of the Massachusetts Institute of Technology (MIT) and Oliver Hart of Harvard University won the Nobel prize for their revolutionary view on the contract theory.

Be aware: like many economic concepts, contract theory may seem like a simple concept, but it is not. Business insider defines contract theory as : “ the design of formal and informal agreements that motivate people with conflicting interests to take mutually beneficial actions.”

That being said, let’s look at why their theory was so praised in the economical world.

Holmström’s research approached the lack of informativeness in principal-agent theory:

“This principle suggests that optimal contracts should structure compensation based on all outcomes that can potentially provide information about actions that have been taken. In the case of setting an executive’s compensation, for instance, that means a firm would reward the executive based on not just its own performance but also the performance of other firms in that sector — as way of evaluating not just the actions the executive took but those that he or she could have taken.” – MIT

Holmström has also approached the free-riders problem when a firm’s income is split among it’s employees: he discovered that this model makes moral hazard problems more frequent in companies, such as the ones we saw during the Financial Crisis of 2008, or in the Enron case, in 2001. He suggests that outside ownership of firms can produce more flexible compensation and boost individual incentives.

Hart, on the other hand, focused his research on privatizaton of public companies, more specifically, how ownership structures and contractual arrangements affect companies governance and boundaries. He researched the American prisons, and how private prisons lack on quality more then public ones, because of the incentives managers have to reduce costs.

The Royal Swedish Academy of Sciences offers this example to better explain his suppositions:

“Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to provide either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger.”

The improvement in contract theory has a direct affect on the better formation of all institutions in our society, and a better understanding of this, results in a better society.  Let’s just hope that “the guys up on the hill” will hear what Holmström and Hart have to say.