Earlier this week the 2016 Nobel Prize in economics was jointly awarded to Oliver Hart and Bengt Holmström on Monday for their shared contributions to our understanding of contract theory. “Taken together the work of Hart and Holmström has allowed all of us to understand more clearly what a “good” contract might look like,” says Victor V. Claar in this week’s Acton Commentary, “even when both parties face an uncertain future.”
Most of Professor Hart’s work has dealt with “principal-agent problems.” These arise out of information asymmetries: instances in which one party, the “agent,” is charged with carrying out the wishes of its overseer, the “principal,” though the agent knows more about its own behavior than the principal. Stated another way, principal-agent problems are characterized by an overseer who is not, in fact, all-seeing. In such cases the principal and agent do not share complete information about the behavior and effort of the agent: Thus, information is asymmetrical between the parties, with the agent holding the informational upper hand.
In such cases it makes sense for the principal to structure its contracts with an agent in a way that renders the incentives of all parties compatible. Otherwise the agent will serve two masters, serving his own interests first while merely appeasing the principal.