All about Incentives
Posted On June 29, 2020
Oliver Hart andBengt Holmstrom were 2016 Nobel Memorial Prize winners in EconomicScience. The article will briefly discuss their work, which earnedthem the coveted prize.
The twoeconomists devoted much of their time developing what they referredto as contract theory. Their contract theory aims to explain how acontract operates, why a contract is important and how contracts canbe improved. The underlying importance of a contract as argued byHart and Bengt is to bind all parties to an agreed scheme. Thepurpose is to make sure individuals do not flagrantly violate theterms of the deal to the disadvantage of the other. An example ofOliver and Holmstrom model of contract theory is the lemonade –standdeal. Two people agree to set up a lemonade stand. One person is toprepare the lemonade while the other is to control the cashbox. Twoconsequences may occur from the contract. One person will be worriedthat the other might manipulate the content of the cashbox. On theother hand, the person controlling the cashbox knows the returns oftheir investment depend on the quality of the lemonade, which he hasno control over. Oliver and Holmstrom argue that the language of thecontract should set out clearly how each person should perform theirrespective work for a good return in business. Furthermore, theperson making the lemonade will be incentivized to make qualitylemonade for better returns (Ryan, 2016).
In conclusion,what I have learned from the work of the duo on the contract designis that individuals are self-centered. Therefore, in an economicopportunity, individuals must collaborate while finding ways ofaligning their interest to the success of the business.
Ryan, A. ( 2016).The Science of the Deal: The Economist