The 2016 Nobel Prize: Solving the Problem of Incomplete Information

Incomplete Information is a fundamental problem that people face when they write contracts. For example, consider a consumer who is going to buy a car. This consumer has some expectations about the car's performance (e.g., gas millage, acceleration, quality of the sound system, etc.): however, there is no certainty that the car will meet her expectations. Therefore, car sellers provide a warranty when consumers buy cars. This warranty is a special type of contract. And, since there are many different ways that a warranty can be written, car dealers want to find out which is the "best" way that this contract can be written.

This year's Nobel Prize in Economics is awarded to economists who study the relationship between Incomplete Information and Contract Design. Their contribution has brought a new set of questions to the field of Economics as, for example, what kind of incentives should be offered in a labor contract in order to maximize the firm's profits?

Since Contract Theory is based on dealing with Incomplete Information, it is a very complex field of study. But, in an effort to summarize the difficulty of studying Incomplete Information, I will divide the problem of Incomplete Information into two: uncertainty and unknown information. Uncertainty means that more than one event can happen. For instance, consider a car insurance, and assume there are only three possible events: nothing, the car gets dented, or the car gets totaled. The difficulty of designing this insurance is knowing the probabilities of each event, especially when the probabilities of each event depend on the type of driver the company is insuring. Thus, the company must write the correct incentives in the policy so the driver reveals the probabilities of each event. On the other end, the problem with unknown information is that there are events we are not even aware that they could happen. However, contracts must deal with those cases as well. This type of problem is known as writing Incomplete Contracts, because these are contracts that do not address every possible event. In these cases, some solutions to this problem require an active roll of the government in the economy, designing and enforcing the law, which is, by itself, another type of contract.

Mostly, no one in the profession was expecting to see these winners this year, because the academy gave the prize to Tirole for very similar reasons two years ago. However, this does not imply that the winners do not deserve the Nobel Prize. Their contributions have been picked up by all the top Economics Departments across the world; and, therefore, their papers have become standard knowledge in graduate programs.