Oliver Hart and Bengt Holmstrom were awarded the Nobel
Memorial Prize in Economic Science on Monday for improving the
design of contracts, the deals that bind together employers and their workers,
or companies and their customers.
Dr. Hart, a professor at Harvard, and Dr. Holmstrom, a
professor at the Massachusetts Institute of Technology, have sought to
determine how contracts can encourage mutually beneficial behavior.
Their work has helped to shape the way companies pay senior
executives and when governments decide to hire private companies to provide
public services.
Dr. Holmstrom’s work has focused on employment contracts.
Companies would like employees to behave as if they owned the place: working
hard, minding costs but also taking smart risks. Employees, on the other hand,
would like to be paid as much as possible, for as long as possible, while
working no harder than necessary. And performance is difficult to assess.
Dr. Hart’s work has focused on a related issue: Contracts
are incomplete instruction manuals. They cannot specify what should be done 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 Royal Swedish Academy of
Sciences, which awarded the prize, said in a news release, referring to Dr.
Hart.
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 then spoken by phone with Dr. Holmstrom, whom he has known for years.
Both scholars teach in Cambridge, Mass.
“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.
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.
One important implication of his work is that it makes sense
to wait and see how things turn out. That can be done by setting aside a
portion of compensation. If the company benefits, the value of the bonus set
aside can be increased. If the company does not, it can be reduced.
Companies have turned increasingly to this kind of deferred
compensation, particularly for senior executives, a trend Dr. Holmstrom noted
with satisfaction on Monday morning.
He has also found that companies should tie pay to the share
price of other firms in the same industry. It makes little sense to reward an
executive for an increase that reflects broader economic factors, or to punish
them for setbacks beyond their control.
Much of Dr. Holmstrom’s subsequent work has focused on a
variety of important wrinkles. He noted, for example, that measuring results
can cause problems, too, by encouraging employees to focus on those parts of
their jobs. Paying teachers based on test results, for example, may lead them
to devote less time to teaching other skills. This suggests that employers
should balance fixed pay with performance incentives.
One of Dr. Hart’s most important insights is that the power
to make decisions is, in effect, a form of compensation. His work has shown
that it makes sense to give the decision-making power to the parties whose
performance is most difficult for the owners to assess and reward.
Investors in a company, for example, are well served by
giving money and control to the executives in exchange for the promise of a
fixed return and the right to seize control if things go badly. This
illuminates the underlying logic of most lending.
“Incomplete-contract theory predicts that entrepreneurs
should have the right to make most decisions in their firms as long as
performance is good, but investors should have more decision rights when
performance deteriorates,” the academy said in an explanation of Mr. Hart’s
work.
Who Are the Winners?
Dr. Hart, 68, was born in London. He studied at
University College London, Cambridge University and Warwick University, all in
England, before receiving his Ph.D. in 1974 from Princeton. He has been a
professor of economics at Harvard since 1993.
Dr. Holmstrom, 67, was born in Helsinki, Finland. He
received his Ph.D. in 1978 from Stanford and has been a professor of economics
and management at M.I.T. since 1994. He previously taught at
Northwestern and Yale.
Press HERE to read Oliver Hart’s and Bengt Holmström’s 6-page Contract Theory, the Nobel Memorial Prize in Economics Sciences
