By Julio Gil-Pulgar,

The Nobel Memorial Prize in Economic Sciences 2016 will go to professors Oliver Hart and Bengt Holmström, for their transformative work on contract theory. In doing so, the Royal Swedish Academy of Sciences recognizes how important contracts are in helping modern society function. 

The Power of Contract Theory

The laureates’ work has been fundamental to the understanding of contract design and regulating future actions. In turn, this has facilitated the development of blockchain-based smart contracts.

“The power of the contract theory is that it enables us to think clearly about the issues involved,” The Royal Swedish Academy of Sciences said in its decision.

“Contract theory provides us with a general means of understanding contract design. One of the theory’s goals is to explain why contracts have various forms and designs. Another goal is to help us work out how to draw up better contracts, thereby shaping better institutions in society.”

Incomplete Contracts in Economic Science

Economic theory divides the contracts field into incomplete contracts and complete contracts. Incomplete contracts refer to situations where there is an agreement of the deliverables, but it’s impossible to indicate precisely how to implement the agreement.

“An incomplete contract has gaps, missing provisions, and ambiguities and has to be completed (by renegotiation or by the courts) with strictly positive probability in some states of the world,” Hart explained.

Incomplete contract theory had been a largely unknown domain. Economics Professor Jean Tirole wrote in 1999, “Incomplete contracting arguably underlies some of the most important questions in economics and some other social sciences, and unquestionably has been left largely unexplored and poorly understood.”

However, thanks to Hart and Holmström, contract theory is now a rich subject of scientific research. Researchers now better understand how contracts help to handle conflicts of interest.

Hart and Holmström’s “analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions,” the academy added.

Szabo Used the Theory to Pioneer Smart Contracts

Incomplete-contract theory is important in applying financial contracts, privatization, property rights, and decision rights between parties.

Notably, one of the areas where Hart and Holmström’s theory has been influential is Bitcoin blockchain-based smart contracts, or smart algorithms.

Smart contracts are computerized algorithms that, independently of human intervention, execute, verify, and enforce the terms of a business agreement.

In this context, another important concept is smart property. Smart property is an asset whose ownership is controlled using smart contract.

Nick Szabo first pioneered the smart contracts concept, and name. He understood Hart and Holmström’s contract theory and integrated it into his work.

Specifically, Szabo’s paper “Formalizing and Securing Relationships on Public Networks” referred to Hart’s “incomplete contracting” approach when arguing that smart contracts reduce mental and computational transaction costs.

Szabo explained further, “Smart contracts utilize protocols and user interfaces to facilitate all steps of the contracting process. This gives us new ways to formalize and secure digital relationships which are far more functional than their inanimate paper-based ancestors.”

Contracts Between Machines, No Humans Required

Artificial intelligence, robots, and billions of smart devices dominate the emerging Fourth Industrial Revolution. These smart devices are intercommunicating and performing transactions among themselves, without human intervention, in the Internet of Things.

Smart contracts, or smart algorithms, already play an important role in the new digital economy. Additionally, Gartner predicted “By 2020, autonomous software agents outside of human control will participate in 5% of all economic transactions. Smart algorithms are already beginning to perform transactions without our help.”

Now, thanks to Professors Hart and Holmström’s pioneering work on contract theory, we have a robust framework for better designing and implementing blockchain-based smart contracts. These are becoming increasingly crucial to managing today’s ever-more complex business and human interactions.