Oliver S. Hart and Contract Theory: Why Doesn't a Perfect Contract Exist?

Professor Oliver S. Hart, land are bonuses to managers always justified?

It's a sunny day on the Harvard campus. Oliver Hart has chosen a dark suit for the occasion, as befits a British gentleman, and in keeping with another quintessentially British custom, he sips a good cup of Earl Grey tea. In an enlightening conversation, the Nobel Prize winner proves himself to be a fair and sincere academic, even when addressing the most controversial topics, such as the issue of disproportionate executive bonuses.

According to Hart, it all comes down to the right incentive plan: many contracts provide for performance-based compensation in the hope of incentivizing a CEO, for example, to act in the best interests of the company.

"But any incentive plan will have a cost, it exposes you to a certain risk," Hart says. "If performance is positive, you're fine; if performance is negative, the opposite happens. It's a hotly debated topic, but all measures are imperfect." 

The importance of a long-term perspective for employees

The Nobel Prize winner notes that there are numerous examples of the potential downsides of an incentive plan. Employees may lack a long-term perspective. "You can make a lot of money for a while by acting poorly, but it won't become apparent until later," Hart explains. "At some point, you leave the company, you've made a fortune, and it will be others who suffer when the damage is revealed." This is why, according to Hart, it's important to consider reducing bonuses and setting longer-term goals for day-to-day work, rather than "just focusing on making money without thinking about the bigger picture."

Can contract development anticipate future contingencies?

Drafting a contract that's supposed to last thirty or even fifty years is certainly a challenge. "So much can happen in the energy sector, all over the world. Any clause we put in the contract may no longer be appropriate." This, Hart explains, is what economists mean when they talk about incomplete contracts. We can't know what the future holds, which is why the parties will never be able to draft a perfect contract that takes all future eventualities into account. "We can't look that far ahead; that's our weakness, and I want to understand how the parties get around this obstacle."

Hart returns to his favorite example of the coal mine near the power plant. "It's a face-to-face situation, a situation that can be regulated by a contract we've drawn up beforehand, or I buy you. Right now, I'm not worried about becoming totally dependent on you. But a large portion of my work demonstrates that all of this presents a risk."

It's important to understand who owns things, because the owner of any asset has residual control over it. If I become the owner of your mine, you lose power. I can then take advantage of you, and you will have less incentive to come up with ideas that improve energy efficiency.

Public or private property?

Defining who has residual control rights is a key issue for Hart, who believes that this is also extremely relevant for the public sector and public-private partnerships.

There are certain services that an economy cannot provide efficiently. The question is, how should an activity be performed if the government funds it? It doesn't necessarily have to be publicly owned. Hart emphasizes that the incomplete contract framework is a good starting point for evaluating this aspect. "An ideal contract will specify everything, in full detail, without ambiguity. Difficulties arise when something is left out of the contract, and then the question is who gets to decide?"

For example, if governments decide to outsource prison administration, they could reduce the number of guards to maximize profits. "The result could be increased violence," the Nobel Prize winner argues. "We thought it could be a compromise, but when it came to maximum-security prisons, where controlling violence is a priority, the arguments in favor of public ownership proved quite strong."

Hart will never admit that the Obama administration's decision not to privatize prisons had anything to do with his arguments, but there may be a grain of truth in them.

It's clear that his work has had an impact on the real world. In his speech at the Nobel Prize banquet, he noted how economists can provide answers to the most pressing questions facing the world. Hart would never lock himself in his office and delve into books without considering the bigger picture or topics far beyond his expertise.

Outsourcing foreign policy

In his works, Hart has also discussed publicly run hospitals and schools, arguing, for example, that the privatization of waste collection is not even up for discussion. "In other situations, the balance might tip the other way. Can you imagine governments outsourcing foreign policy, awarding a contract for diplomatic activity?" he laughs, aware that the idea sounds a bit crazy. "But to understand its crazyness, you have to look at it through a framework of incomplete bargaining."

A new social contract for the world

Again at the Nobel Prize banquet, Hart emphasized the importance of opening doors to the persecuted. When he stated that "it's not a question of America first, Europe first, or anyone else first," his opinion on recent political movements in his current homeland and globally clearly shines through. We shouldn't selectively give weight to the rest of the world; we should do so constantly, every day. I would encourage young people to reflect on this very thing.

In times of rapid technological development, Hart remains in some ways a classical economist. "The message of economics is this: let the market do its thing to achieve efficient outcomes, and then the government will manage the atonalities. That's how it works and how it should work." Rather than doing things that will make the market less efficient, we should focus on the redistributive aspects. This is a point I believe very strongly.

Oliver S. Hart

Date and place of birth: 1948, London, United Kingdom.

Field of study: microeconomics.

Award winning workContract theory; theoretical tools for understanding real-life contracts and potential pitfalls in contract drafting.

Decisions for life: In the late 60s, Hart decided to study economics because he enjoyed discussing politics, but he often found it difficult to defend his theses because he knew nothing about the world economy.

Change the worldMany journalists claim that Hart influenced the U.S. government's decision to no longer use private contractors for prisons, although he claims there is no evidence of his influence.

Thanks UBS Nobel Perspectives.