NOBEL ECONOMISTS-2016

NOBEL ECONOMISTS-2016

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 was awarded jointly to Oliver Hart and Bengt Holmström "for their contributions to contract theory".Their findings on contract theory have implications in such areas as corporate governance, bankruptcy law and political constitutions, said the Royal Swedish Academy of Sciences, which announced the 8 million Swedish crown ($928,000) prize.
Oliver Hart, 68, a British economist teaching at Harvard, and Bengt Holmström, 67, a Finnish economist teaching at MIT
"This theory has really been incredibly important, not just for economics, but also for other social sciences," said Per Stromberg, a member of the prize committee and professor at the Stockholm School of Economics.
Contract theory considers, for example, whether managers should get paid bonuses or stock options, or whether teachers or healthcare workers should be paid fixed rates or by performance-based criteria.
Holmstrom, a 67-year-old professor of economics and management at the Massachusetts Institute of Technology, said he had been friends with Hart for decades and was thrilled to be sharing the award with him.
Hart, an economics professor at Harvard University, has focused on understanding which companies should merge and with what mix of financing, and when institutions such as schools, prisons and hospitals should be privately or publicly owned.
At Harvard since 1993, Hart has argued that the incentives for cost reductions in privatized services, such as private prisons in the United States, are typically too strong.

Holmstrom has studied the setting of contracts for workers from teachers to corporate bosses. He concluded that in high-risk industries, pay should lean toward a fixed salary, while in more stable sectors pay should be more biased toward performance rewards.

Asked at a Cambridge, Massachusetts, news conference about the current high level of executive pay, Holmstrom said, “It is somehow demand and supply working its magic.”

But he said he was concerned about the state of income distribution and the unhappiness of many workers about stagnant wages and incomes.

“I’d much rather live in a society where this wasn’t happening,” he said. “But I’m not prepared to speak about the question about how to repair it” because it would mean tinkering with complex markets.

Most of us sign contracts. Why do we do so? Take the contracts we enter into with our employers, for example. There are two main reasons.

First, a contract helps the two sides of the deal work together over a long period of time. Think of what would happen if each company would have to search for new employees at the start of every day, or vice versa.

Second, the contract creates rules that allow agents with different interests to cooperate to achieve some goal. No market economy can work without such cooperation premised on trust but also backed by the law. How contracts are designed defines our incentives in various situations in the real world.

There are various nuances in our contracts. They could be formal or informal, depending on whether they are enforced by law or social norms. They could be complete or incomplete, which is based on whether they take into account all possibilities that lay in the future.

One side of a contract may know more than the other because of information asymmetry, so insurance companies, for example, may end up covering people with health problems rather than the healthy, through what is called adverse selection.

There are also agency problems—as when managers who are under contract with shareholders actually try to maximize their own earnings rather than those of their shareholders.

Contract theory helps us understand these problems. And helps us solve them through better contract design. Take a simple informal contract. A harried mother has to leave the house for a couple of hours. She is worried her two children will bring the house down by fighting over a large piece of cake in the refrigerator.

The mother leaves a simple instruction—the elder child will cut the cake while the younger one will choose which piece to eat. Now, the elder child cannot cheat. The mother has aligned their interests—or achieved incentive compatibility—through an informal contract.

Contract theory is not just about such parlour games. In two landmark papers written in 1979 and 1991, Holmstrom provided the principles that can help companies draw up contracts to ensure that managers do not sacrifice the long-term health of the firm in pursuit of bonuses linked to short-term performance.

The fact that the 2016 Nobel Prize in economics has gone to two giants of contract theory tells us something else as well. Most of the public attention is lavished on macroeconomics and the related dark art of forecasting. This is where the crisis of economics is the deepest.