This month MIT Press authors Bengt Holmström and Oliver Hart were award the Nobel Prize for their research in contract theory. In this post, economics acquisitions editor Emily Taber reflects on how their published works help make sense of our modern world.
On October 10, 2016, Bengt Holmström was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. He became the fifth member of the MIT economics department and the latest in a long line of MIT Press authors to earn the prize.
Holmström was awarded jointly with Oliver Hart at Harvard for their work in contract theory. While they were not frequent collaborators, their individual research in this area beginning in the 1970s and 1980s set the stage for contract theory to become a significant field of study.
Holmström’s research has focused on various issues related to compensation. One of his significant contributions is the informativeness principle, which is used in situations where a company must decide how to compensate an executive. Focusing on metrics like stock price may end up rewarding (or punishing) things outside the executive’s control—as in the case of a global financial crisis, for example. Instead, one firm’s performance should be compared to other firms, and this information should be taken into account when determining an executive’s compensation. The goal of doing this is to avoid rewarding good luck over strong leadership. In situations where an executive’s effort is hard to observe, pay-for-performance models may be less desirable than a fixed salary.
Similarly, later research by Holmström and Paul Milgrom shows that it may be better to eliminate performance-based incentives in favor of fixed pay in circumstances where some elements of performance are easier to quantify than others. Teachers, for example, may find themselves “teaching to the test” if their financial incentives are strongly linked to their students’ test scores.
Firms may worry that fixed-wage contracts are not effective at retaining top talent, but Holmström’s work shows that incentives for strong performance still exist, even without a formal incentive plan. As long as performance today is linked to future earnings, early-career workers tend to work hard. This effort can either be rewarded by a higher salary at their current firm or a higher salary at their next firm. It is not always necessary for a firm to institute a formal bonus structure in these cases, although such incentives may be more useful for later-career employees. These results have been applied with similar results to politicians’ efforts to get re-elected.
The fact that Holmström’s 2011 MIT Press book, Inside and Outside Liquidity, coauthored with Jean Tirole (another Nobel laureate), does not directly relate to contract theory is a testament to his many contributions to economic theory. Inside and Outside Liquidity provides a theory for the supply and demand of liquid assets, a major contribution to macroeconomics and finance. Previous economic models could not sufficiently explain the phenomenon of financial institutions, firms, and households carrying short-term, low-yield assets. Holmstrom and Tirole’s work demonstrates the circumstances under which liquidity is desirable and the role of government in managing liquidity.
Oliver Hart has also contributed to the MIT Press publishing program. He is a coeditor of 1992’s Economic Analysis of Markets and Games: Essays in Honor of Frank Hahn, along with Partha Dasgupta, Douglas Gale, and Eric Maskin. Frank Hahn was a noted macroeconomist, and this festschrift collects papers from leading economists on topics as varied as the microfoundations of macroeconomics, game theory, and missing markets.
Oliver Hart was recognized by the Nobel committee for his contributions to contract theory, particularly with regard to incomplete contracts and rights. He and his coauthors determined a model for establishing decision rights for handling eventualities not explicitly covered by the original contract. Later work also addressed ownership rights in situations where two parties cooperate to produce a good. These models were later applied to make a case against privatization of public goods (e.g. schools, hospitals, and prisons), as the incentive structure of privatization agreements often favors cost-reduction while also de-incentivizing quality improvements.
Bengt Holmström and Oliver Hart’s work has helped economists make sense of the world we live in. We at the MIT Press send them our heartiest congratulations on receiving the Nobel Prize!