Nobel Prize in Economics: Contract Theory Meets Contract Reality:

The academic field of economics can feel esoteric and far removed from our everyday lives. The work of the two winners of the 2016 Nobel Memorial Prize for Economic Science proves otherwise.

In announcing the prize, the Royal Academy of Sciences reminded us that “contracts are essential to the functioning of modern societies.” The two awardees, Oliver Hart and Bengt Holmström have spent decades researching how contracts help parties deal with conflicting interests. Particularly notable is Holmström’s research on employment contracts, which presents evidence that businesses should link compensation to the broadest possible evaluation of an employee’s performance.

Contract Theory Meets Contract Reality

Holmström’s work implies that companies should withhold compensation, to evaluate the impact of an employee’s work. This type of deferred compensation has become increasingly popular, especially with senior executives. But Holmström has also argued, in conjunction with Hart, that there are profound limitations to this pure performance-based compensation.

This is why real-life contracts tend to be simpler than theory would predict. Companies recognize that providing too specific contractual instructions can be counterproductive by overemphasizing whatever happens to be measurable.