2016 Nobel Memorial Prize in Economic Sciences
Reason for Award
for their contributions to contract theory
Laureates
United Kingdom of Great Britain and Northern Ireland, 
United States of America
Finland
Explanation
When we shop or work, we make "promises." A promise written on paper is called a "contract," and bad things can happen if it is not kept. Mr. Hart and Mr. Holmström used mathematics to study how to write good contracts. Even a rule like "if you finish your homework you get a treat" is a small contract. Thanks to their work, we now better understand how to decide wages or set up insurance in a fair way.
Related Keywords
contract theory
Contract theory models transactions between economic agents using formal mathematics, focusing on the principal–agent problem. It studies how asymmetric information and freedom of action shape optimal pay schemes and allocations of control rights. Expected-utility theory, probability, and game theory are core tools. The theoretical results inform CEO compensation, insurance design, public procurement, and more. Hart and Holmström’s work systematized the field and made it a cornerstone of modern microeconomics.
moral hazard
Moral hazard refers to the risk that, after a contract is signed, one party’s unobservable actions become less diligent or even dishonest. For example, with full insurance, policyholders may behave more carelessly. Holmström’s informativeness principle shows that cleverly chosen performance measures can mitigate moral hazard. In practice, audits, deductibles, and bonus schemes are used to cope with the problem. The ability to quantify moral hazard has improved the precision of policy design.
adverse selection
Adverse selection arises when asymmetric information before contracting causes lower-quality participants to dominate the market. The classic example is the "lemons" problem in used-car markets, where good cars exit if buyers cannot distinguish quality. Contract theory designs menu contracts and screening mechanisms that make different types reveal themselves. The models by Hart and Holmström incorporate type unobservability and derive optimal contracts under such conditions. Adverse-selection analysis is central in finance, healthcare, electricity markets, and many other areas.
incentive contract
An incentive contract uses rewards or penalties to steer a party’s actions toward desirable behavior. When effort is hard to observe, outcome-based pay serves as a proxy for effort. Holmström argued that the slope of pay on performance should depend on how informative the performance measure is about the agent’s action. In multitask settings the wrong metric can distort effort, so a flat salary can sometimes be optimal. The idea underpins commission pay for salespeople, stock options for CEOs, and evaluation systems for teachers.
incomplete contract
An incomplete contract cannot specify every possible future contingency. In such cases, the allocation of decision rights determines bargaining power and investment incentives. The Grossman–Hart–Moore model formalized the economic value of ownership through residual control rights. This perspective strongly influences the theory of the firm, privatization policies, and the design of venture-finance clauses. Researchers now examine how AI and blockchain technologies may change the degree of contract completeness.
property-rights theory
Property-rights theory links asset ownership to bargaining power ex post and investment incentives ex ante. Hart and co-authors propose that the party making the crucial non-contractible investment should own the asset to mitigate hold-up. When investments are distributed among parties, joint ownership or hybrid forms can be optimal. The theory quantifies the trade-off between vertical integration and outsourcing in supply chains. It serves as a foundational framework for analyzing M&A strategy, international joint ventures, and public-private partnership contracts.