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2016 Nobel in Economics for Work on The Theory of Contracts to winners: Oliver Hart and Bengt Holmstrom

Reporter: Aviva Lev-Ari, PhD, RN

Oliver Hart and Bengt Holmstrom Win 2016 Nobel in Economics for Work on Contracts

By BINYAMIN APPELBAUMOCT. 10, 2016

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 an 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.”

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.

SOURCE

http://www.nytimes.com/2016/10/11/business/nobel-economics-oliver-hart-bengt-holmstrom.html?_r=0