It's a great pleasure for me to be able
to present today's little discussion of
the award for economics, to Oliver
Hart and uh, Bengt Holmstrom for their
contributions to Contract Theory, because
as a researcher, myself, I've studied
their contributions in great detail and
one thing that's important to note about
the Economics Nobel, that's it
aside from the difficult to pronounce
name that comes before, but it's not
given for one single discovery but
rather for a body of research, right. So,
so really what I'm going to talk about
today is I'm gonna try my best to summarize
the contributions of two great
researchers to the field of Contract
Theory where they've made contributions for
over the past 40 years. You kind of get a
sense of this, we're all familiar with
contracts. Contracts surround us everywhere.
Where, many of us are uh, are currently under
some obligations for contracts either a
marriage contract you're obliged to do
something that with your spouse, or
you're in an employment contract, your employer
requires you to take certain actions.
You may be in a mortgage contractors,
contracts all around, and the contract we
can think of them simply, as simply having
a couple of elements in common.
First one here, is that there's a, a
preliminary stage in which we call the
contracting stage.
Ok, or contracting phase where the
parties get together and write out the
contract and agree to the terms. And then
we have what we call the interim, that's
the time between the contracting stage
and the time at the end when payoffs are
realized, where actions can be taken and
typically in this, in this interim period
there's still some uncertainty, right. So
in that when you, when you write a
contract you imagine you, we don't sit
down right marriage contracts, it's an
off-the-shelf contract that we all just
tend to use, right. But you know, you can
imagine that if you are going to write a
contract with your spouse, you know,
before entering into the marriage vows
um, you know there's some uncertainty
perhaps over how things will be once you
say I do, right. And you may want to
specify some particular, um, actions that you
would like to see taking take place so
many times that your spouse will do the
dishes, or mow the lawn, right. Um, but there's
uncertainty as to how people will b-
have,
and there's uncertainty as to what
kind of people these, these, these parties of the
contract really are. So, the problems that
we're trying to solve with their
contracts are typically moral hazard,
which is the hidden action, right. Um, so an
example of moral hazard, uh, would be in this
marriage contract, for example. You
know, you don't know if your spouse is
actually doing what they say that they
claim they want to do, right. They say
they're going to do the dishes all the
time, but if you're not around watching them
maybe they aren't going to be doing the
dishes, right. So moral hazard is simply
the, the fact that there are actions
that cannot be contracted on that, are
there observed they could be
observable, but they're not, they're non-
contractible, ok, and so we did you think
about the dishes you could write, I mean,
my wife could write a contract with me
about doing the dishes you can say, I
want you to do dishes and you mean she comes
home the dishes will be in the rack, but
how clean would they be, right. I mean
it's very difficult to specify, you know,
every aspect of the contract, right. So
there's moral hazard still in a lot of these
cases an adverse selection, you know,
people, I hate to think of the world in
black and white, but there's good people
and bad people, for example right. And
people may have different motives and
you don't know what kind of party you're
engaging in a contract with until
actions take place, right. So there still
could be some uncertainty in the, in the
time period which actions take place, but
one thing's for sure at the end of the
day payoffs will be made according to
the contract,
ok. Now the contributions made by Harden
Homstrom, um, you know a lot of this is really
mathematical, and I, I, really appreciate
the mathematics as we talked about the
prize and in the, in physics earlier.
Mathematics allows you to see things
very clearly, right, that are otherwise
difficult to understand. Well for
most of us, for, for, for well I guess I don't know why
I say for most of us, some of us mathematics
allows us to see things very clear that
are difficult to understand. So, I'm going
to put up just two equations here, just
to kind of set the, set the stage and I
promise you that we won't, uh, everything
else is pictures from here on out, I'm
that
I'm that kind of professor. But I just
want to get a simple understanding, this
looks really complicated but it's
actually not that, it's very simple in,
in a lot of ways. The, the letters here,
the superscripts and stuff, it all makes
it look fancy, right, and it's not mean to
be intimidating but this is just two
items that I couldn't leave out of the
presentation. So, the first is that with
this contract problem we had this
incentive compatibility constraint. This
is that, if you write a contract you
would hope that your contract is written
in a way that gets the parties that are
perfectly contract to behave in a
particular way, the way that you would
like. So, for example, with the dishwashing,
you know, if you think of EH being high
effort, and EL being low effort the
payoff, you know, to the spouse when they
take the good action, they put in the high
effort, should be higher than the payoff
that they get in they put the low effort.
Right, that's part of an optimal contract
could satisfy, any optimal contract
should satisfy this incentive compatibility
constraint. And the other one is this
participation constraint that, you know,
the payoff to being part of the contract
has to be better than your outside
option, right. And you know some people
you know they don't ever get married
because the outside options pretty good,
right. So, you know these things matter,
right. People don't enter into contracts
unless, unless they are certain, they're
properly motivated and probably
motivated take the appropriate actions
within the contract. So, what-what Hart
and Homstrom did is they took, you know, those
two, those incentive compatibility
constraints and the participation
constraint and expanded on them
in a number of different dimensions, okay.
And so, what we're going to do now is
instead of me showing you all the math, which
would be kind of fun for me, but maybe not for
you,
We're going to work with the, with an
example, ok, and so that I think a great
example for tonight is that we can all
imagine that's it's, it's the summertime
in Kelowna, okay, and you're getting ready
to go enjoy some time at the beach and
and I don't know about you guys in the
summer all I think about is starting
that mobile gelato business I've always
been dreaming about, right. And, you know
if you think about this is a simple
problem is, you know,
you need uh, you some capital, right. You
need to have your, your mobile gelato
stand that you can cart around the beach,
right, you need to have an employee
that's gonna ride the bike,
ok. So, what are some of the things that
we can think about is being potential
problems when contracting with this
employee in the mobile gelato business?
Well, first of all if we go back just to these
two equations, we know that we need to
make sure that we pay the person who
bought driving the bike around enough to
be more than what they would otherwise
get, right. So, you're paying them at least
what they're going to get from some
other job, right. But if you really care
about the profits of your gelato
business, you want to pay them such that
when they take the actions that would
lead to more profits, you're paying them
more than when they take the actions
that lead to lower profits,
ok. So, one of the things that Hart, that
Holmstrom wrote in particular what about, was
performance pay, right. And uh, I mean, we could
talk about CEO contracts, but I find that
a little boring compared to the ice
cream, uh but 2, 2 problems that come up with
performance pay are multitasking and
printing production. So, multitasking is
simply the fact that there are multiple
dimensions to a lot of the outcomes that
are desirable from a contract, okay. In
the, in example with the ice cream
stand, you know, there may be someone needs to,
you may want the worker to scoop out the
ice cream and to take the money, for
example,
ok. Um, it's pretty easy in that case to say
well we can pay this person based on the
profits or the revenue of the gelato
business, performance-pay should work well,
but there are other examples such as
teaching, for example, where performance
pay may not work very well. You know,
there's a big debate in the United
States and Canada about paying teachers
based on the scores of standardized
tests for their students, right. But if we
think about education being something
that's probably more multi-
dimensional than just being about a simple
standardized test score, if we were to
pay, uh, performance-pay to teachers,
they may place too much weight on the
standardized test preparation and not
enough
weight on other tasks that we also think
are important educational outcomes,
ok. The other problem is, is team
production, right, if uh, if imagine
that there's these two tasks so you
think to yourself well let's take that
mobile gelato bike and make it into a
tandem bicycle, have two workers go
around, one can take the cash the other
one can scoop the ice cream,
ok. But in this team production problem
was with this team production
process, if we're paying them both, uh, based
on the performance of the company, you
know how much revenue we raise, they both
have incentives to under-invest and put in
lower effort,
ok. That's a team production problem, and this
is what, I think, the more, the more
groundbreaking uh, insights that Holmstrom
had, this it's not, I mean, it's clear to all
with anyone who's married knows that
team production problems happen, right.
That you know everyone in there, if
you're, if you both share this the, the
benefits equally then you both have an
incentive to underinvest, right, but what Holmstrom
showed is that we think about the
team production process, um, in this this
this problem shows us why we see, for
example, capital hiring labor and not the
other way around. Why don't the two
ice cream uh, product producers rent out
the ice cream cart, right. The simple
reason why is that they cannot properly
incentivized themselves as a team.
What you would need to have is a manager
who can, you know, impose penalties or
provide rewards in terms of bonuses,
okay. So something that's, that was very
insightful, ok. Oliver Hart, you know
keeping on with our ice cream example
here, um he, he his contribution focuses on two
other aspects of contracts. Um, one is the
idea of incomplete contracts and the
other is the idea of privatization, ok. So
in terms of incomplete contracts, think
about it, if you have this person you hire
to drive your ice cream cart around and
sell ice cream on the beach,
um do you want to write into that contract
exactly where that person is going to go,
okay.
Chances are you won't want to. There
could be a flash mob over by Prospera
Place, if you tell him he has to
go to the beach in a particular location
on the beach, then he's not gonna go to
the other location where there may be more people,
right. So, part of it, so what Hart demonstrated
uh, in his research is that oftentimes the
optimal contracts are going to be
incomplete, you know. Contracts are always
going to be incomplete, by construction,
because we can't write a contract about
everything. But, sometimes even we can
write it in everything to the contract,
we still might want to leave some room
and what really matters is who gets the
decision rights in that event. It's the
assignment of authority, who gets to
decide, um that really matters to the
profitability of the firm and the
performance of the workers, in that case.
And the, the last insight that we can see
from Hart here is on privatization, and
so you now thinking with our ice cream
example, just extending it as academics
like to do this until it becomes absurd,
right. So imagine, you, imagine that the
city of Kelowna decides that they think
everyone should have ice cream, you
know, it should be free like healthcare, like
education, you know, this publicly
provided good, everyone gets ice cream.
The question is how should it be produced?
Hart has has suggested that
privatization can be beneficial when the
trade-offs between uh, quality and
cost-cutting are not too strong,
ok. So in other words if it's the case
that you can still get ice cream that
looks delicious like this, when it's
privatized then maybe that's a good
idea, because the private sector may have some
advantages in terms of having decision
rights over certain pros, for certain parts of
the production process. If the private
entity that would produce the ice cream
would be rewarded highly in terms of
profits by cutting costs and those cost
reductions would lead to a lower quality
product, the ice cream would be not as
delicious or not as pleasant look at,
well then um, public provision is
optimal, right. So what really matters here,
again, is who has a decision rights and
recognizing that the outcomes that we
think are desirable oftentimes cannot be
accurately articulate into the contract.
So, just to sum up contributions were for
a large body of work, performance pay is
hazardous when multitasking is important,
when teamwork is involved an owner or
manager is often necessary for
efficiency, many that's why people hire
life coaches. Optimal contracts are often
incomplete and efficient privatization
of public service provision requires not
too strong a trade-off between quality
and costs.