The 2016 Nobel Prize for economics goes to UK-born Oliver Hart from Harvard University and Finland-born Bengt Holmström from MIT for their work on contract theory. The duo has covered issues ranging from employer-employee contracts to public-private partnerships and executive pay. Their work has helped improve the design of contracts, which hold together modern economies.
The committee said the prize reflected the pair’s role in advancing contract theory as “fertile field of basic research” and their subsequent work, which many regard as the foundation on which many policies and institutions were created. The Royal Swedish Academy of Sciences called their work the key to understanding how real-life institutions and contracts sustain modern economies.
“Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions,” the Royal Swedish Academy of Sciences said.
“This year’s laureates have developed contract theory – a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.”
Hart focused on contract theory. In his view, contracts work as instruction manuals, but they were incomplete. His assessment of the US prison system, showing that the pressure to cut costs was so great it led to unacceptable drops in quality, found that the issue stems from “incomplete contracts”. As these agreements can’t specify what needs be done in every case, they should say how decisions should be taken.
“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 Royal Swedish Academy of Sciences, which awarded the prize, said in a news release, referring to Dr. Hart.
Holmström’s work has focused on employment contracts, reaching into issues such as executive pay. In the news conference that marked the award, he was asked what the thought of the huge bonuses awarded under modern contracts.
“My personal view is they are too complicated today,” he said.
Where a company wants its employers to act as if they have a stake in the winnings — working hard, minding costs but also taking calculated risks — employees don’t. They want to be paid as much as possible, for as long as possible, while not working harder than needed, and assessing performance becomes difficult. So Holmström showed that companies should pay employees following the broadest possible evaluation of his or her performance.
He said one big part of this is to set aside a portion of compensation. If an employee is efficient and the company profits, this bonus can be increased. If not, it can be reduced. He also said that companies should tie pay to the share price of other firms in the industry — it wouldn’t make sense to reward or punish executives for fluctuations tied to broader economic factors. And, companies are increasingly opting for this kind of deferred payment, particularly for executives, Dr. Holmstrom noted with satisfaction Monday morning.