Nobel Prize in Economics Awarded to Two Professors for Work on Contracts

The Wired Word for the Week of October 16, 2016

In the News

"Modern economies are held together by innumerable contracts," said the Royal Swedish Academy of Sciences, this past Monday, in explaining why it had awarded the Nobel Memorial Prize in Economic Science to two professors employed in separate Boston-area universities for their work in improving the design of contracts.

One awardee, UK-born Oliver Hart, 68, has been a professor at Harvard since 1993. The other, Finland-born Bengt Holmstrom, 67, has been a professor at the Massachusetts Institute of Technology since 1994.

The Nobel Prize was given to the pair for work they had done collaboratively as well as for that which they had done separately, but all in the field of contracts. They will split an 8 million Swedish kroner ($924,000) award.

Hart's work starts from his observation that contracts are incomplete instruction manuals that cannot specify what to do in every case, since not everything that comes up can be anticipated. Instead, contracts can spell out how decisions should be made.

"His research provides us with theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and which institutions such as schools or prisons ought to be privately or publicly owned," the academy said in summarizing his work.

Holmstrom's focus has been on employment contracts, an area in which conflicts between owners and employees are inherent. He spelled out the benefits of simple contracts between an "agent" who is paid by a "principal" in order for the principal to achieve some "benefit." The most common example is an employee being paid by a business owner, but it is just as applicable to everyday life, such as a waitress being paid by a customer. He also pointed out that in compensation arrangements with executives and senior managers, there is value in deferring some remuneration until the results of that person's work had been evaluated.

However, Holmstrom also argued that executives shouldn't be rewarded for gains that reflect a broader change in the industry's fortunes, or punished for setbacks beyond their control. This principle has not been widely adopted in executive pay arrangements.

Similarly, many people will tip a waitress less when the food comes out prepared badly or is delayed -- and tip more generously when the food is more tasty, even though the cook, not the waitress, is responsible for the results.

In a 1986 paper the two men co-wrote, they observed that actual contracts are often much simpler than theory would predict, noting that companies do not include a complete set of expectations. To do so would be counterproductive, and would encourage too much reliance on results that are easily quantified versus those that may be less easily measured but which may be more important to the company overall.

This stems in part from Holmstrom's seminal work on the "moral hazard of teams," where only the team results can be measured, allowing a relative freeloader to benefit from the extra hard work of more industrious team members. This has been extended to multi-tasking, where there can be many different actions and a difficult-to-measure result. In all of these, specifying incentives in a contract is both difficult and complex, and may not be soluble.

In summary, the academy said, "The new theoretical tools created by Hart and Holmstrom are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design."

The Wired Word talked with Dr. Ed Schroeder, a retired professor of economics living in New Jersey. He said, "I'm familiar with Holmstrom's work -- I read some of it for my dissertation, back in the 1970s. I know Hart's name, but am not really familiar with his work in detail. What occurs to me, about both, really, is that they are trying to answer questions that really matter, unlike many economists."

More on this story can be found at these links:

Harvard and MIT Professors Win Nobel prize in Economics. CNN MoneyOliver Hart and Bengt Holmstrom: Contract Theory.  Royal Swedish Academy of SciencesOliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts. The New York TimesNobel Prize in Economics Awarded to Oliver Hart and Bengt Holmstrom for Work on Contract Theory. The Wall Street JournalIn a Bind: the Economics Nobel. The Economist

The Big Questions

1. What contracts or covenants do you currently live under? Which ones, if any, are directly connected to your life of faith? Which ones, if any, are not directly connected to your life of faith?

2. Do you consider any of the covenants of which you are a part flawed in their design? If so, how might they be improved, if at all? If they are not flawed, what makes them acceptable as they are?

3. In his work, Holmstrom argued that people shouldn't be rewarded for gains or punished for setbacks beyond their control. Where do you see this principle illustrated in covenants you live under? Where do you wish it was applied but isn't?

4. What are the differences between a covenant made between you and another person and one made between God and you? What are the similarities? What negotiating room, if any, do you have in a covenant with God?

5. The Bible is divided into the Old and New Testaments. Considering that "testament" is a synonym for "contract," "covenant" or "agreement," what do you understand to be the essence of the "old" covenant and of the "new" one? In what ways do you as a Christian live under both of them? Or do you live only under the new one?

Confronting the News With Scripture and HopeHere are some Bible verses to guide your discussion:

2 Samuel 5:3So all the elders of Israel came to the king at Hebron; and King David made a covenant with them at Hebron before the LORD, and they anointed David king over Israel. (For context, read 5:1-5.)

Although the other scripture texts included in this lesson refer to God's covenant with people, the same word is also used in the Bible for the contracts made between humans. In the verse above, for example, the contract is between the people of Israel and David, who until that point had been king only over the tribe of Judah (2 Samuel 2:4). Now, as this verse explains, the rest of the tribes of Israel agreed to his kingship over them as well. This was not a case of having no choice or being forced. These tribes sought this arrangement, and, in effect, they made a contract with David for him to be their king.

Some other biblical examples of contracts between human beings include Genesis 21:32; Joshua 9:6; Ruth 4:7-8; 1 Samuel 18:3; and Ezekiel 17:13-14. There are others as well.

Questions: In terms of agreements between yourself and others, when would you be likely to use the term "covenant" rather than "contract"? Why? Is there any "feeling" difference between the two words, and if so, what is it?

James 5:4
Listen! The wages of the laborers who mowed your fields, which you kept back by fraud, cry out, and the cries of the harvesters have reached the ears of the Lord of hosts. (For context, read 5:1-6.)

Here James chides certain "rich people" (v. 1) for in effect, breaking a contract between themselves and laborers they have hired to mow their fields. Even if the contract was not in writing, it was binding: The laborers would do the requested work and the owners would pay an agreed-upon wage. But some owners, knowing the laborers did not have the resources to force the payment of those wages, simple did not pay them.

Questions: For what kinds of arrangements are contracts essential today? When is a verbal contract enough? Is it better to have most arrangements under actual contracts? Why or why not?

Psalm 105:8-11
[God] is mindful of his covenant forever, of the word that he commanded, for a thousand generations, the covenant that he made with Abraham, his sworn promise to Isaac, which he confirmed to Jacob as a statute, to Israel as an everlasting covenant, saying, "To you I will give the land of Canaan as your portion for an inheritance." (For context, read 105:1-45.)

These verses refer to the "big" covenant of the Old Testament, the one for which the Old Testament is named -- the "contract" between God and the people of Israel. This psalm is a hymn of praise for God's faithfulness to the covenant and his care for the people.

The covenant itself, as given by God through Moses at Mount Sinai, is contained in Exodus 19--24 and more expansively in Exodus 19:1--Numbers 10:10. It is sometimes called the Mosaic covenant, the law of Moses, the Sinaitic covenant, or, in the recent wording of the Common English Bible, the "Instruction scroll" (e.g., Deuteronomy 28:61; Joshua 1:8).

This covenant has the Ten Commandments at its center and includes other God-given commands and conditions by which Israel was to live. Most importantly, however, it is the God-initiated act by which the God of all creation unilaterally made an abiding commitment of fidelity to the people he had chosen: Israel. Rather than primarily being a set of rules, the covenant was the basis for a lively relationship between God and his people.

This covenant did call for an oath of fidelity from the people as well, but as subsequent events in scripture show, the covenant could not be broken by Israel's disobedience. That said, the people of Israel later came to understand their sinfulness as a serious violation of their side of the covenant. In fact, after the fall of Judah, many of the people felt that God had abandoned them because of their sins. But they later discovered, and the prophets declared, that God had not terminated his covenant; on the contrary, God considered himself still bound to it.

God's covenant with Israel differs from those made between human parties (see, for example, 1 Samuel 18:3, where Jonathan made a covenant with David). Human-to-human agreements are usually parity covenants and are bilateral, where both parties essentially have equal status. Divine-human covenants, however, are more like an ancient suzerainty treaty where one party is a more powerful entity than the other, and where the terms of the agreement are stated unilaterally by the more powerful party and imposed on the weaker party. In the case of God's covenant with Israel, however, the imposed terms were for the well-being and health of the people.

Questions: Do you consider the Ten Commandments binding for you? Why or why not?

Hebrews 8:6-8, 10
… [Jesus] is the mediator of a better covenant, which has been enacted through better promises. For if that first covenant had been faultless, there would have been no need to look for a second one. God finds fault with them when he says: "The days are surely coming, says the Lord, when I will establish a new covenant with the house of Israel and with the house of Judah …. I will put my laws in their minds, and write them on their hearts, and I will be their God, and they shall be my people." (For context, read 8:1-13.)

The words within the quote marks in the passage above are from Jeremiah 31:31-34 (we've abbreviated the quote here). The writer of Hebrews, however, is quoting them to show a scriptural basis for the idea of a new covenant, one different from the old one discussed in the Psalm 105 verses above. In the Jeremiah context, the quoted material is a looking-ahead view where God promises the people of Israel and Judah that he will make a "new" covenant with them after their fall into captivity and exile. In that sense, God was really promising a renewal of the existing Sinaitic covenant rather than an altogether new one.

Nonetheless, the unidentified New Testament writer who authored the book of Hebrews, looking back at these words from Jeremiah through the lens of the risen Christ (and perhaps remembering Jesus' words at the Last Supper about the "new covenant in my blood" [Luke 22:20]), heard in them the promise of a covenant that was truly new and was extended beyond Israel and Judah to Christians. (The apostle Paul did as well: See 2 Corinthians 3:5-6, below.)

Thus, the writer of Hebrews quotes these words from Jeremiah but then adds his own understanding: "In speaking of 'a new covenant,' [God] has made the first one obsolete. And what is obsolete and growing old will soon disappear" (8:13). The writer of Hebrews also identified Jesus as "the mediator of a new covenant, so that those who are called may receive the promised eternal inheritance, because a death has occurred that redeems them from the transgressions under the first covenant" (9:15).

Questions: What do you understand the "terms" of the new covenant to be? Do you trust yourself to know the difference between right and wrong in all circumstances, such as in a covenant written on the heart? Do you trust others to know? If so, who?

2 Corinthians 3:5-6... our competence is from God, who has made us competent to be ministers of a new covenant, not of letter but of spirit; for the letter kills, but the Spirit gives life. (For context, read 3:1-18.)

The apostle Paul, speaking of himself and his coworkers, wrote the words above. He goes on in the context verses to speak of how the old covenant in a sense serves as a veil that obstructs the view of Christ (see especially v. 14).

We can perhaps make a connection with the news story in that Paul here spoke of the original covenant as being superseded by a new one that was less dependent on things that can be quantified -- like keeping the letter of the commandments -- and more dependent on matters not quantifiable -- like the things of the Spirit.

Questions: In what ways have you found that the "Spirit gives life"? What is the essential difference, as Paul sees it, between the old and new covenants?

For Further Discussion

1. What contracts have you signed without reading? When, if ever, has this omission caused you a problem? (End User agreements for instance).

2. Bearing in mind that a contract is essentially a formal form of promise-making, respond to this, from author William Willimon: "One of the difficult characteristics of all promises … is that they have an inherently future quality about them. A promise is not kept until it is fulfilled. … My promise places me at the mercy of the future, indicating that I will so order my life between now and then as to keep my promise, come what may. For me to quibble over the way the future shapes up and then to advance this as a reason for breaking my promise is unfair. … One cannot have control over a promise. One must put oneself at the mercy of it." (From "Promises to Keep," Quarterly Review, Winter, 1981.)

3. Comment on this, from Frederick Buechner, from his book Wishful Thinking: Some people "claim that whereas to respond to the Old Covenant is to become righteous, to respond to the New Covenant is to become new. The proof, they might add, is in the pudding."

4. Discuss this, from TWW team member Stan Purdum's sermon "El Shaddai": "From time to time in the Bible, God introduced himself by a new name, and in Genesis 17, God does just that. He says to Abram, 'I am God Almighty' -- or at least that's how most English translations of the Bible render the new Hebrew name for God that appears there. The actual Hebrew term is El Shaddai. Unlike the more general name for God, this one appears only 48 times in the Old Testament, and when it does, it is usually at times of significant emotion for the people involved.
            "If you had been in Abram's place -- desperately wanting a child and wanting to believe God but thinking that what he had promised would no longer come about -- how would you feel? Would you not be feeling very vulnerable and perhaps worried that somehow you had done something to displease God? Might you not be feeling the need for some tenderness?
            "It was at such a moment for Abram that God introduced himself by this new name,El Shaddai. The El part of the name, which is the shortened form of Elohim, means 'God,' but the precise meaning of the Shaddai part of this name is uncertain. Bible scholars say that translating it as 'Almighty' is only a reasonable guess at its meaning. It's possible that it is related to the ancient term, shadu, which means mountain -- thus 'God of the mountains.' It is also possibly derived from the Hebrew word shadad, meaning 'to plunder,' 'overpower' or 'make desolate.' This would give Shaddai the meaning of 'destroyer,' representing one of the aspects of God, and in that context it is essentially an epithet. But Shaddai may in fact be derived from the Hebrew word shad, which is invariably used in scripture for a woman's breast, the place where a child is cuddled and nursed. As applied to God, it conveys a side of God that is tender and nurturing, the way a mother cares for her child.
            "Whatever its precise meaning, it is significant that the Bible first mentions this name for God in the context of his promise-keeping. When God comes to Abram and introduces himself as El Shaddai, he comes for a specific purpose -- to remind Abram that he keeps his promises. God comes with comfort, but it is comfort with substance -- a covenant. Abram, now renamed Abraham as a reminder that God will keep his promise, will be the father of a great nation, through a son who is yet to be born.
            "This reality of a kept promise is vital to understanding anything about God at all. In fact, without the idea of promise, God is the impersonal Creator, but not Someone to whom we mere humans can relate.
            "But kept promises are part of what define God's character. It's been rightly said that the Bible is largely a record of humans breaking their promises and God keeping his. 
            "The two major divisions of the Bible, the Old Testament and the New Testament are essentially other terms for the Old Promise and the New Promise. And yet, from God's side, they are the same promise -- he will be our God. The 'old' and 'new' refer to how we connect with God's promises. Under the old testament, it was by rule keeping and sacrifice. Under the new testament, it is through Jesus Christ."

Responding to the News

This is a good time to think about promises we have made, and what we need to do to be faithful to them.

Prayer

O Lord, our great Promise-Keeper, help us to be faithful people who live by promise. In Jesus' name. Amen.