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.
