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Hideshi Itoh: Two pioneers in contract theory are rewarded with a Nobel prize

About 27 years ago, when I was a junior scholar, I gave a talk at the Massachusetts Institute of Technology. Professor Oliver Hart attended the seminar and asked me many tough questions. For me, it was valuable on-the-job training. Even with his renowned achievements and contributions to society, Hart today still attends a lot of seminars as an ordinary participant.

Professor Bengt Holmstrom also inspired me with his unique insights. He invited me to a seminar when he was teaching at the Yale School of Management and helped me publish one of my academic works, which was related to his work, by giving me valuable advice.

This year's Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, better known as the Nobel Prize in Economics, was awarded to these two giants -- Hart and Holmstrom. As a researcher in the field of organizational economics, I was delighted to see the announcement in Stockholm on TV, awarding them the prize "for their contribution to contract theory." This is also my primary field of study.

The field is defined in today's standard textbooks as "the theory of incentives, information, and economic institutions, which is generally referred to in short as contract theory." It is an applied microeconomics theory, delving into how to design appropriate incentives when the relevant parties' behavior and information are difficult to observe or verify.

Real-world phenomena drove the development of this applied economic theory. Shareholders and other stakeholders find it hard to monitor how diligently and carefully corporate officers are working for their company. In general, CEOs are too busy with decision-making to communicate directly with division managers -- and the managers cannot supervise what their subordinates do all the time, either. To turn people's behavior in the right direction for their company, contracts are used as a tool to "design" appropriate incentives.

Designing incentives is also a big issue in company-to-company transactions and relationships between governments and companies, and in contractual relations between physicians and patients, insurance companies and policyholders, entrepreneurs and venture capitalists, teachers and schools, and professional athletes and their teams.

As Hart said in a phone interview, "Contracts are just an incredibly powerful way of thinking about parts of economics. ... Both sides have an incentive to construct the transaction [so that] it generates the greatest value."

PREDICTING CONTINGENCIES Contract theory is also a theory of economic institutions. While contracts can be powerful instruments for designing incentives, they usually fail to stipulate all predictable contingencies. The exact terms of trade are determined only after time passes and a particular contingency arises, so the parties have to reach some common understanding in advance about how to resolve them.

One of the most important examples is the relationship between an employer and an employee. It is often difficult for both to predict precisely what tasks the employee will work on. In a typical employment transaction, the employer offers a wage and the employee agrees to accept the employer's directions in return. That shows the employer has some formal decision-making rights concerning task assignments. Of course, the employer's decisions have to be acceptable to employees so as to generate value from the trade, and thus both sides should sit at the table.

In company-to-company transactions, the allocation of decision rights is sometimes attributed to property rights, and the owner of an asset will have formal decision rights over the use of the asset. In this case, the integration of two companies can be interpreted as an extremely skewed allocation of ownership, such as acquiring all the assets of a company that are relevant to its transactions.

Decision rights can also be contingent on certain observable outcomes. For example, while an entrepreneur can keep controlling the management of his or her business as long as performance criteria are met, the venture capitalist may obtain some voting control rights if the borrower fails to meet the criteria. This relationship between entrepreneur and venture capitalist can be applied to the relationship between Japanese companies and what were formerly known as their "main banks," as well.

Hart and Holmstrom developed fundamental, formal theoretical frameworks enabling other scholars to study various contractual relationships and economic institutions from the perspective of designing incentives. Specifically, Hart contributed to developing a framework for instances where terms of trade are difficult to specify in a formal contract from the beginning (i.e., when contracts are "incomplete").

His theory (and those following it) offer insights into questions such as whether two companies should do business as separate entities or as integrated ones, and in the latter case, which company acquires the other; under what conditions the government should privatize a state-owned company, or hold it as state-owned; and in what case a head office should delegate decision-making rights to division managers.

PAY-FOR-PERFORMANCE Holmstrom studied optimal pay-for-performance contracts in a general framework where they can be written and enforced. Some of his most important research has the following implications.

Managerial compensation should be protected from fluctuations in factors such as exchange rates or the price of raw materials (e.g., oil prices) over which the manager has no control. Such protection can be achieved via relative performance evaluations, in which the manager is compensated based on his or her performance relative to that of companies facing similar fluctuations.

Simple piece-rate or commission contracts that put constant pressure on workers are more desirable than discontinuous bonus payments based on performance targets that provide ample opportunity to manipulate the performance measures. For those who engage in multiple essential tasks, the pressure of performance-based pay can be too strong, inducing them to work hard on easy-to-measure tasks while ignoring hard-to-measure ones.

Recent developments in contract theory place the focus more on dynamic incentives under long-term relationships. This year's John Bates Clark Medal was awarded to Yuliy Sannikov in recognition of his methodological breakthrough in continuous-time contract-theoretic models.

The analysis and applications of relational contracts are applied to utilize informal performance measures in designing incentives for ongoing or repeated relationships. It is well known that Toyota Motor and its first-tier suppliers, such as Denso, formulate only a general transaction framework in a formal contract, and details are determined as their relationships develop.

"[Contract theory is] not just about money," Holmstrom said in a phone interview. "The issue of motivation is hugely broader than just asking, you know, how should people get the CEO to behave in a particular way. And financial, monetary incentives are in some sense too effective, often."

Hideshi Itoh is a professor of economics and management at the Graduate School of Commerce and Management at Hitotsubashi University in Tokyo. He earned a doctorate from Stanford University in 1988.

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