Nobel Economics Prize 2016: Know what is Contract theory

Zee Media Bureau

New Delhi: British-born Oliver Hart and Finland`s Bengt Holmstrom have won the Nobel Economics Prize for groundbreaking research on contract theory.

Their research work has helped design insurance policies, executive pay and even prison management.

Contract theory explores the way employment contracts can shape behavior and reach mutually beneficial outcomes for the hirer and hiree.

Wikipedia explains, Contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information.

Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics.

In the field of economics, the first formal treatment of this topic was given by Kenneth Arrow in the 1960s.

Contract theory draws upon principles of financial and economic behavior as different parties have different incentives to perform or not perform particular actions.

Contract theory considers, for example, whether managers should get paid bonuses or stock options, or whether teachers or healthcare workers should be paid fixed rates or by performance-based criteria.