Contract Theory: Nobel Offerings to Health Economics

The Nobel in Economics was awarded to Oliver Hart and Bengt Holmström for their research on Contract Theory. This blog reviews the contributions of contract theory to health economic issues.

The 2016 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly referred to as the Nobel Prize in Economics) has been awarded to Oliver Hart and Bengt Holmström for their contribution to Contract Theory. In the words of the Royal Swedish Academy of Sciences, “Oliver Hart’s and Bengt Holmström’s research sheds light on how contracts help us deal with conflicting interests”.

Economic transactions between self-interested economic agents (i.e. buyer-seller, worker-employer, lender-borrower, government-tax payers) can give rise to conflicts of interests. Contracts help to avoid economic losses and undesirable social outcomes by generating trustworthiness and enforcing cooperativeness between agents. Contract theory attempts to understand the nature of contracts and how they should be designed to achieve optimal and socially desirable outcomes, especially under conditions of uncertainty and asymmetric information. Contract theory has made significant contributions to the study of insurance, incentives, information and economic institutions. Within health economics, contract theory has guided policies aimed at improving health care systems’ performance. Contract theory is relevant to the implementation of co-payments in a health care system, how we incentivise health care providers, pricing agreements between health care systems and pharmaceutical firms, and the public-private health care provision debate.

Bengt Holmström in Moral Hazard and Observability demonstrated that rewards and punishments must be linked to those outcomes that can be influenced by the actions of relevant agents in order to avoid luck playing a role. This is the informativeness principle which means that incentives in optimal contracts must be linked to those outcomes that are informative about agents’ observable actions. Following the informativeness principle co-payments should be implemented for those health care goods and/or services whose demand is closely related to and a consequence of patients’ behaviour.

Contract theory is also relevant for the design of incentives for health care providers. Providers are agents of both patients and the health care system (principals), and they are potentially conflicted in terms of the care they provide due to a problem known as the principal-agent relationship. The Quality and Outcomes Framework (QOF) within the NHS is a good example of how the informativeness principle can work in relation to health care provision. The QOF rewards practices for providing ‘quality of care’ and helps to fund further improvements in health care (for example see Feng et al., 2014).

A defining feature of Oliver Hart’s contribution was the theory of incomplete contracts. Given contracts cannot specify every eventuality, Hart and his colleagues posited that it can be helpful to agree now to agree later. An example of incomplete contracts in health economics is Performance Based Risk-Sharing Agreements (PBRSAs) where pharmaceutical firms negotiate higher prices for those drugs that demonstrate higher value or less uncertainty ex post. When the value of a new medicine is difficult to ascertain ex ante at the initial contracting point between a payer and pharmaceutical company, an alternative is to track the performance of the product in a defined patient population over a defined time period, so that reimbursement is based on the health and cost outcomes achieved (Garrison, Towse et al., 2013). PBRSAs represent a mechanism for reducing uncertainty at product launch and incentivising investment in evidence collection while a technology is used within a health care system.

Incomplete contract theory can also be applied to the debate on public versus private health care provision. Should health care provision be privatised? Incomplete contract theory showed that this depends on the nature of non-contractible investments such as cost-reduction or quality improving investments. Hart and colleagues, in their article The Proper Scope of Government: Theory and an Application to Prisons, demonstrated that if incentives for cost reduction are strong then the privatisation of public sectors may be undesirable. This is because focusing on cost reduction alone may hurt the quality of the goods and services provided.

The examples outlined above highlight some of the contributions that contract theory has made to health economics. As a result of Oliver Hart and Bengt Holmström’s research we can improve the optimal design of contracts, such that health care systems can maximise efficiency and social welfare.