Oliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts

By BINYAMIN APPELBAUMOCT. 10, 2016

Nobel Prize in Economics Awarded

SUPPOSE that you and I are interested in opening a lemonade stand together. We agree that I will bring the materials we need (cups, stand and so forth) while you will make the lemonade. I’ll do the pouring while you mind the cashbox and at the end we will split the proceeds fairly. A doubt niggles, though. I am worried you might, at the end, try to hog the contents of the cashbox. We therefore decide to draw up a contract (common practice in the lemonade-stand industry) dictating that the returns to our operation must be split evenly. But then you start to worry: much of the success of our stand will depend on the quality of the lemonade, over which I have no control. What if I decide to slack off and piggyback on your lemonade-brewing genius, knowing that after you pour your sweat into the lemonade (not literally), the split is still an even 50-50? We therefore set to haggling over language in the contract setting out precisely how each of us should do our respective jobs.

Contracts play a critical role in the operation of the modern economy. They set out who is allowed to do what with the land they own, the people they employ and the songs they store on their smartphones. They underpin nearly all of the banking and insurance sectors. Individuals are self-interested, but to take advantage of economic opportunity people must often work together and find ways to align their interests (or minimise conflicts of interest). That’s where contracts come in. This morning, The Swedish Riksbank awarded this year’s Nobel prize for economic sciences to Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, for their work improving our understanding of how and why contracts work, and when they can be made to work better.

Their work focuses attention on the necessity of trade-offs in setting contract terms; it is yet another in a series of recent prizes which explores the unavoidable imperfections in many critical markets. Mr Holmstrom’s analyses of insurance contracts describe the inevitable trade-off between the completeness of an insurance contract and the extent to which that contract encourages moral hazard. From an insurance perspective, the co-payments that patients must sometimes make when receiving treatment are a waste; it would be better for people to be able to insure fully. Yet because insurers cannot know that all patients are receiving only the treatment they need and no more, they employ co-payments as a way to lean against the problem of moral hazard: that some people will choose to use much more health care than they need when the pool of all those being insured picks up the bill.

Mr Holmstrom applied a deeper analysis to the issue of performance pay, where hard work cannot always be observed properly. His work suggested that performance-based pay should be linked as much as possible to measures of managerial performance (such as the price of a company’s share relative to those of its peers rather than the share price in isolation). But the more difficult it is to find good measures of performance, the closer a pay package should get to a simple fixed salary.

Mr Hart’s complementary work explored cases in which contracts were necessarily incomplete because not all outcomes could be specified. In such cases, he reckoned, the allocation of decision rights became hugely important. In our lemonade stand contract, for instance, we might not specify what happens when a rival stand opens across the street, but we might agree that the chief executive is empowered to decide what to do in such cases and then choose one of us to fill that position. Decision rights often go hand in hand with ownership rights. Mr Hart’s work on the subject noted that who owns what is not simply important in determining what happens in various unexpected scenarios, but also matters in shaping day-to-day incentives. A scientist working in an R&D department will spend her time in different ways if promised an ownership share in whatever valuable intellectual property she generates than if her firm has full ownership rights to the innovations.

This work has had important applications. Work co-authored by Mr Hart compared the incentives to owners in public and private prisons, for example. In publicly owned prisons, managers might underinvest in quality-improving measures, but private owners face too strong an incentive to cut costs, leading to conditions for prisoners that are worse than those in public prisons. This research has informed recent public debates about private prisons in America.

A common and important thread in work by Messrs Hart and Holmstrom is the role of power in planning co-operative ventures. Individuals or firms with the ability to hold up arrangements—by withholding their service or the use of a resource they own—wield economic power. That power allows them to capture more of the value generated by a co-operative effort, and potentially to sink it entirely, even if the venture would yield big gains for all participants and society as a whole. Contracts exist to shape power relationships. In some cases, they are there to limit the exercise of hold-up power so that a venture can go forward. In others, they are intended to create or protect certain power relationships in order to encourage good behaviour: workers or firms with the right to exit a relationship, for instance, force other parties to that relationship to take their interests into account. The broader lesson—that power matters—is one economics too often neglects. Hats off to the Nobel committee for awarding a prize that puts power dynamics front and centre, and reveals the many, often unappreciated, ways in which they affect our lives.

Bengt Holmstrom, a Finnish-born economics and management professor at M.I.T, and Oliver Hart, a British-born economics professor at Harvard, won the 2016 Nobel Prize in Economics.

Oliver Hart and Bengt Holmstrom were awarded the Nobel Memorial Prize in Economic Science on Monday for their work on improving the design of contracts, the deals that bind together employers and their workers, or companies and their customers.

Dr. Holmstrom, a professor at the Massachusetts Institute of Technology, has had a particular influence on executive pay practices. Dr. Hart, a professor at Harvard, has contributed to the debate about the outsourcing of public services like prisons and garbage collection.

“Modern economies are held together by innumerable contracts,” the Royal Swedish Academy of Sciences, which awarded the prize, said Monday morning. “Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.”

The prize committee in recent years has shied away from grand economic theories, instead rewarding economists who develop careful insights about smaller questions. Macroeconomics, the field devoted to those broader questions, has fallen into something of an existential crisis in recent years. There is, for now, greater certainty about the value of work on a smaller scale.

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“Much of economics from the noneconomist perspective is about how governments run fiscal policy and monetary policy,” said Patrick Bolton, an economist at Columbia University. “This is really thinking about economics from the ground up, from the small to the large.”

Why They Won

Dr. Holmstrom’s work has focused on employment contracts. Companies would like managers to behave as if they owned the place: working hard and minding costs while taking smart risks. Employees, on the other hand, would like to be paid as much as possible while working no harder than necessary. And performance is difficult to assess.

Economists since Adam Smith have grappled with the conflicts inherent in the relationship between owners and employees. Dr. Holmstrom’s work, beginning in the late 1970s, presented evidence that companies should tie pay to the broadest possible evaluation of an employee’s performance. In later work, he focused on the benefits of simple contracts that mixed base pay with limited incentives.

Dr. Hart’s work begins from the observation that contracts are incomplete instruction manuals. They cannot specify what to do in every case. Instead, they must stipulate 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 a summary of his work.

Dr. Holmstrom, speaking via an audio connection to a news conference hosted by the academy, said he had been “very surprised and very happy” to get the news. Asked how his day was going, he said there was “a sense of things being surreal.”

Dr. Hart said he had hugged his wife, roused his son from sleep and spoken by phone with Dr. Holmstrom, a close friend whom he has known for years.

“I woke at about 4:40 and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang,” Dr. Hart said.

Why the Work Is Important

One implication of Dr. Holmstrom’s work is that it makes sense to withhold some compensation for a time, to evaluate the results of a manager’s work.

Companies have turned increasingly to this kind of deferred compensation, particularly for senior executives.

But his influence on compensation practices is limited. He has argued, for example, that companies should tie such evaluations to the stock market performance of their industry rather than focusing solely on the company’s own stock price. It makes little sense to reward an executive for gains that reflect a broader change in the industry’s fortunes, or to punish executives for setbacks beyond their control. But such advice has not become common practice.

In an influential 1986 paper, Dr. Holmstrom and Dr. Hart — writing together for the first time in their careers — also underscored important limitations on performance-based pay. The two men observed that contracts are generally much simpler than theory might predict. Companies do not try to write down a complete set of expectations. The reason, they suggested, is that specific instructions can be counterproductive, encouraging too much focus on whatever happens to be easily quantified.

Dr. Hart, in his own work, has explored the limits of contractual relationships.

Consider the case of an electric company that needs to rewrite its contract with a coal mine because its needs have changed. Under some circumstances, Dr. Hart has shown, the utility would have been better off owning the mine from the beginning, to control the relationship.

In other cases, contracts make more sense than ownership. Cities should outsource garbage collection, for example, Dr. Hart said in an interview on Monday.

There is always a balance, he said, between saving money and losing control. The critical issue, he said, is often the extent to which a contract can account for unexpected challenges.

“A government wouldn’t contract with a private company to carry out its foreign policy because it’s just too difficult to specify in a contract how to carry out foreign policy,” he said. “That would be crazy.”

The federal government turned to Dr. Hart in a pair of recent tax cases. Two companies — Black & Decker and Wells Fargo — claimed tax benefits related to spinning off some lines of business. The government leaned on Dr. Hart’s theory, arguing that companies retained control of decision-making, and therefore they could not simultaneously lay claim to the cost savings.

About the Winners

Dr. Holmstrom, 67, was born in Helsinki, Finland, and speaks Swedish well enough to answer questions in that language at Monday’s news conference.

In the early 1970s, he was working for a Finnish company that wanted to use computers to improve productivity. Dr. Holmstrom, sent to Stanford on a one-year fellowship, concluded that the real challenge was not programming but providing employees with proper incentives.

He stayed to earn a Ph.D., and has been a professor at M.I.T. since 1994.

Dr. Hart, 68, was born in London and came to the United States to earn his Ph.D. in 1974 from Princeton. He has been a professor of economics at Harvard since 1993.

“He will not let go until he’s understood what you have to say,” Dr. Bolton said. “And most of the time, your argument fails. Which is an unpleasant experience as a student. But when you succeed, it gives you an incredible confidence.”