Two U.S.-based professors won the Nobel prize in economics on Monday for studying how to best design contracts, work that sheds light on when it makes sense to give a CEO a bonus or privatize public services like schools, hospitals and prisons.
British-born Oliver Hart of Harvard University and Finnish economist Bengt Holmstrom of the Massachusetts Institute of Technology Finland will share the 8 million kronor ($1.2 million Cdn) award for their contributions to contract theory.
That's a field of research that deals with incentives and risks involved in contracts drawn up between companies and employees, banks and lenders or insurance agents and their customers.
In research in the 1970s, '80s and '90s, Hart and Holmstrom created "new theoretical tools" that shed light on how contracts help people and companies deal with conflicting interests and the "potential pitfalls" that occur when contracts are poorly designed, the Royal Swedish Academy of Sciences said.
"These kinds of insights into how we should design contracts are very important because we don't want to give the wrong incentives to people," said Nobel committee member Tomas Sjostrom. "We don't want to reward them for things that they were not responsible for. We want to reward the right thing."
Hart, 68, is a London-born U.S. citizen who has taught at Harvard since 1993. Holmstrom, 67, is an academic from Finland who used to serve on the board of the country's mobile phone company Nokia.
Speaking to reporters in Stockholm by telephone, Holmstrom said he felt very lucky and grateful.
"I certainly did not expect it, at least at this time, so I was very surprised and very happy, of course," he said.
In the 1970s Holmstrom showed how a principal, for example a company's shareholders, should design an optimal contract for an agent, like the CEO. His "informativeness principle" showed how the contract should link the agent's pay to information relevant to his or her performance, carefully weighing risks against incentives, the academy said.
When to reward CEOs
Pay packages, for example, should avoid holding CEOs responsible — or rewarding them — for events beyond their control.
"You don't want to reward the CEO because the S&P 500 (stock index) has gone up 20 per cent," said Patrick Bolton of Columbia University's School of Business, who studied under Hart and has written a textbook on the economics of contracts. "You want to reward the CEO when his company outperforms the S&P."
Bolton described Hart has a rigorous but open-minded thinker who challenges his students' ideas: "He's very determined to think for himself. He will not let go until he is persuaded, but he can be persuaded."
Holmstrom said his incentive to study contract theory came before he was an academic, when he was working for a company in the 1970s that tried to use computers to figure how to make strategic plans.
"That's when I realized that the issue wasn't really about the difficulty of coming up with the best plans," he said. "The bigger issue was also to create incentives for people to give the right information that is needed for these plans and incentivize them in general."
“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” O. Hart— @NobelPrize
“My first action was to hug my wife, wake up my younger son ... and I actually spoke to my fellow Laureate” Oliver Hart #NobelPrize— @NobelPrize
Hart made fundamental contributions to a new branch of contract theory in the mid-1980s. His findings on "incomplete contracts" shed new light on the ownership and control of businesses, the academy said.
"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.
It cited a 1997 article co-authored by Hart which highlighted how private contractors have stronger incentives for investing in both quality and cost reduction. The authors argued that the incentives for cost reduction sometimes is too strong, and expressed particular concern about privately-run prisons, the academy said.
The U.S. Department of Justice recently decided to stop using private prisons after a report showed the conditions are worse than in government-run prisons.
Hart and Holmstrom so obviously deserving that my first thought was "didn't they have it already?" https://t.co/tdr52WYU3y— @paulkrugman
Pennsylvania State University economist Ran Shorrer, who taught contract theory as a graduate student at Harvard, said Hart and Holmstrom have had a huge influence on the way corporations decide to pay executives.
"Any modern compensation scheme is informed by their work," he said.
The economics prize is not an original Nobel Prize. Formally called the Nobel Memorial Prize in Economic Sciences, it was added to the others in 1968 by Sweden's central bank.
The Nobel Prizes in medicine, physics, chemistry and the Nobel Peace Prize were announced last week. This year's Nobel announcements will finish Thursday with the literature award. Each award is worth 8 million kronor, or about $1.2 million Cdn. The laureates will collect them on Dec. 10, the anniversary of prize founder Alfred Nobel's death in 1896.