Harvard and MIT Economists Share Nobel for Contract Theory

  • Harvard’s Hart and MIT’s Holmström studied contract theory
  • Holmström voices concern over stagnant U.S. middle class wages

Harvard, MIT Economists Share Nobel Prize

Harvard University’s Oliver Hart and Bengt Holmström of the Massachusetts Institute of Technology won the 2016 Nobel Prize in Economics for laying the groundwork for contract theory and its role in shaping everything from executive pay to privatizations.

Work by the 67-year-old Holmström in the 1970s, and later by Hart, 68, helped establish contract theory “as a fertile field of basic research,” the Royal Swedish Academy of Sciences said on Monday. They will share the 8 million-krona ($926,000) prize.

Hart and Holmstroem announced as Nobel economics winners on Oct. 10.

Photographer: Stina Stjernkvist/TT via AP Photo

The two “so obviously” deserve the prize, Paul Krugman, who himself won a Nobel economics prize in 2008, wrote on his twitter account. Krugman said his first thought was: “Didn’t they have it already?”

Contract theory has “greatly influenced many fields,” the Royal Swedish Academy said. These include everything from corporate governance to constitutional law. Because of Hart and Holmström “we now have the tools to analyze not only contracts’ financial terms, but also the contractual allocation of control rights, property rights, and decision rights between parties.”

Designing Contracts

Holmström’s theories in the 1970s helped companies design compensation contracts for employees where performance can only be partly measured. His “informativeness principle” argues that pay should also depend on outside factors, such as linking a manager’s pay to the share price relative to competitors. This helps to avoid rewarding people for “good luck” and punishing them for “bad luck,” the academy said.

Holmström said he was “very happy, very grateful, and overwhelmed” during an event at MIT to mark the award, after first apologizing for disturbing his colleagues on Columbus Day, a federal holiday in the U.S. While declining to lecture his audience on his work because “those who understand know it already, and those who don’t understand won’t be wiser if I tell it,” he did voice concern about stagnant U.S. middle-class wages.

“What we are seeing right now in the way market economics is playing itself out is of great concern. I would much rather live in a society where this isn’t happening,” he said in response to a question, though he declined to take a stand on whether the compensation of top executives was too high. “Economics doesn’t really have an opinion on the level.”

Hart has focused his research on the division of power in economic relationships, including in contracts. As part of this work, he in the 1980s developed a “major breakthrough” in analyzing the domain of “incomplete contracts,” according to the academy.

Hart’s idea is that the very basic contract, since the future is uncertain, must spell out who has the right to decide what to do when the parties can’t agree, the academy said.

Patrick Bolton, a Columbia Business School professor who has written a textbook on contract theory that touches on the work of both winners, said their work has broad applications “from how you incentivize an employee to how you incentivize a CEO.”

Bolton said one area where Hart’s work is particularly relevant is the complex incentives and trade-offs of government contractors. In the area of defense, for example, there are frequently questions about who will own the intellectual property and technology in the development of a fighter jet or other complex systems.

“What is important about Oliver Hart’s work is that it shows there is no clear-cut, simple answer up front,” Bolton said in an interview. “It depends on the specifics of the deal and the investments you need to protect. You have to think about who has property rights over the innovation.”

Academic Beginnings

A British-born U.S. citizen, Hart received a bachelor’s degree in mathematics from Cambridge University’s King’s College in 1969, a master’s in economics from the University of Warwick in 1972 and a doctorate from Princeton University in 1974. He joined Harvard in 1993 and was chairman of the economics department from 2000 to 2003. He’s also a visiting professor at the London School of Economics and Political Science.

Holmström, who was born in Finland, has also helped develop the theory of moral hazard, the notion that banks and other economic agents take unwarranted risks because they know they won’t face the full cost of failure. He served on the board of Nokia Oyj from 1999 until 2012.

His recent work has concentrated on liquidity problems and financial markets. Holmström has argued that “ignorance is bliss” at times during financial crises, allowing markets to remain liquid as banks and other participants continue to trade with each other in spite of the troubles each might face.

Holmström received a bachelor’s degree in mathematics and physics from the University of Helsinki in 1972, a master’s degree in operations research from Stanford University in 1975 and a doctorate in business, also from Stanford, in 1978. He joined MIT in 1994 and was chairman of its economics department from 2003 to 2006.

‘Incidental’ Career

At a press conference arranged earlier Monday by the academy, Holmström said it was “incidental” that he became an academic. In the 1970s, a company he was working for tried to use computers to help it make decisions and set strategy.

“That’s when I realized that the issue wasn’t really about you know the difficulty of coming up with the best plan,” he said. “The bigger issue was also to create incentives for people to give the right information that is needed for these plans.”

Annual prizes for achievements in physics, chemistry, medicine, peace and literature were established in the will of Alfred Nobel, the Swedish inventor of dynamite, who died in 1896. The prize in economic sciences was added by Sweden’s central bank in 1968.

Last year’s award went to Angus Deaton of Princeton University, who won recognition for his analysis of consumption, poverty and welfare. The prestige of getting a Nobel has helped previous winners bring their economic theories closer to policy making. Past laureates include Milton Friedman, James Tobin and Friedrich August von Hayek.

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