From The Economist, October 10th 2016
The pair helped the field understand how contracts work
SUPPOSE that you and I are interested in opening a lemonade stand together. We agree that I will bring the materials we need (cups, stand and so forth) while you will make the lemonade. I’ll do the pouring while you mind the cashbox and at the end we will split the proceeds fairly. A doubt niggles, though. I am worried you might, at the end, try to hog the contents of the cashbox. We therefore decide to draw up a contract (common practice in the lemonade-stand industry) dictating that the returns to our operation must be split evenly. But then you start to worry: much of the success of our stand will depend on the quality of the lemonade, over which I have no control. What if I decide to slack off and piggyback on your lemonade-brewing genius, knowing that after you pour your sweat into the lemonade (not literally), the split is still an even 50-50? We therefore set to haggling over language in the contract setting out precisely how each of us should do our respective jobs.
Contracts play a critical role in the operation of the modern economy. They set out who is allowed to do what with the land they own, the people they employ and the songs they store on their smartphones. They underpin nearly all of the banking and insurance sectors. Individuals are self-interested, but to take advantage of economic opportunity people must often work together and find ways to align their interests (or minimise conflicts of interest). That’s where contracts come in. This morning, The Swedish Riksbank awarded this year’s Nobel prize for economic sciences to Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, for their work improving our understanding of how and why contracts work, and when they can be made to work better.