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Oliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts Oliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts
(about 5 hours later)
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. 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. 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. 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.
Their work has helped to shape the way companies pay senior executives and when governments decide to hire private companies to provide public services. “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.”
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. 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.
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. “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.”
“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’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. 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, whom he has known for years. Both scholars teach in Cambridge, Mass. 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.“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 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.
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.
Companies have turned increasingly to this kind of deferred compensation, particularly for senior executives, a trend Dr. Holmstrom noted with satisfaction Monday morning. 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.
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. 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.
Much of Dr. Holmstrom’s subsequent work has focused on a variety of important wrinkles. He noted, for example, that measuring results could cause problems, too, by encouraging employees to focus on those parts of their jobs. Paying teachers based on test results, for example, couldlead them to devote less time to teaching other skills. This suggests that employers should balance fixed pay with performance incentives. Dr. Hart, in his own work, has explored the limits of contractual relationships.
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. 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.
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. In other cases, contracts make more sense than ownership. Cities should outsource garbage collection, for example, Dr. Hart said in an interview on Monday.
“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. 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.
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. “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.”
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. 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.
■ Yoshinori Ohsumi, a Japanese cell biologist, was awarded the Nobel Prize in Physiology or Medicine on Monday for his discoveries on how cells recycle their content, a process known as autophagy, a Greek term for “self-eating.” Dr. Holmstrom, 67, was born in Helsinki, Finland, and speaks Swedish well enough to answer questions in that language at Monday’s news conference.
■ David J. Thouless, F. Duncan M. Haldane and J. Michael Kosterlitz shared the Nobel Prize in Physics on Tuesday for their research into the bizarre properties of matter in extreme states. 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.”
■ Yoshinori Ohsumi, a Japanese cell biologist, was awarded the Nobel Prize in Physiology or Medicine on Oct. 3 for his discoveries on how cells recycle their content, a process known as autophagy, a Greek term for “self-eating.”
■ David J. Thouless, F. Duncan M. Haldane and J. Michael Kosterlitz shared the Nobel Prize in Physics last Tuesday for their research into the bizarre properties of matter in extreme states.
■ Jean-Pierre Sauvage, J. Fraser Stoddart and Bernard L. Feringa shared the Nobel Prize in Chemistry on Wednesday for development of molecular machines, the world’s smallest mechanical devices.■ Jean-Pierre Sauvage, J. Fraser Stoddart and Bernard L. Feringa shared the Nobel Prize in Chemistry on Wednesday for development of molecular machines, the world’s smallest mechanical devices.
■ President Juan Manuel Santos of Colombia was awarded the Nobel Peace Prize on Friday for pursuing a deal to end 52 years of conflict with the Revolutionary Armed Forces of Colombia, or FARC, the longest-running war in the Americas.■ President Juan Manuel Santos of Colombia was awarded the Nobel Peace Prize on Friday for pursuing a deal to end 52 years of conflict with the Revolutionary Armed Forces of Colombia, or FARC, the longest-running war in the Americas.
Angus Deaton was awarded last year’s prize for improving the data that shape public policy, including measures of wealth and poverty, savings and consumption, health and happiness. Angus Deaton was awarded last year’s prize for improving data that shape public policy, including measures of wealth and poverty, savings and consumption, health and happiness.
The Nobel Prize in Literature will be announced on Thursday in Sweden. Read about last year’s winner, Svetlana Alexievich. The Nobel Prize in Literature will be announced on Thursday in Sweden. Last year’s winner was Svetlana Alexievich, a Belarussian journalist and writer known for deeply researched works about female Russian soldiers in World War II and the aftermath of the Chernobyl nuclear disaster.