Dear All:

Well, who won?

The Nobel prize for economic sciences for 2016 was announced today, October 10, 2016. It went to Oliver Hart and Bengt Holmstrom.

Hart is 68 years old and was born in London, England.   He obtained his BA from Cambridge University, his MA from Warwick University, and his Ph.D. from Princeton University. Although he did work in general equilibrium theory early in his career, the work that won him the Nobel Prize was done while a professor at MIT. He is now a professor at Harvard University.

Holmstrom is 67 years old and was born in Helsinki, Finland.   He obtained his BA from the University of Helsinki and his MA and Ph.D. from Stanford University. The important work that defined his career and led to his Nobel Prize was started at the Swedish School of Economics and at Northwestern University. He has been a professor at MIT since 1994.

I have been saying for years (see my blog) that contract theory would eventually win and it finally did.

So what did these guys do to make them so Noble?

The Nobel committee wrote that the duo received the prize “for their contributions to contract theory”.

Almost all people are driven by incentives. An incentive is something that motivates or drives a person to do something. Incentives are not the same for all people and they can often be conflicting for two different people. When people engage in transactions with one another, they would ideally like that each person or institution in the transaction perform the way they expect them to perform.

For example, if I hire someone to manage my bookstore, I would like this person to manage the bookstore in such a way that I make the most profit. In an ideal world, the store manager would listen to my request and do just that. However, in the real world, the manager doesn’t have the same incentives as I do. The manager doesn’t get to keep the profits and thus might just sit back and do very little. Since it’s very hard for me to watch the manager and determine his effort in making profits, I won’t really ever know whether he’s a good manager or not. Economists call this the principal-agent problem. The manager is the agent that acts on behalf of the principal, which in this case, is the owner.

One of the ways that I might get the manager to act in a way that achieves my objectives is to write a contract with that manager that changes his incentives. Ideally, I would like to write a contract that encourages the manager to exert the most effort to achieve my goal of high profits.

Both Holmstrom and Hart worked on research to understand how contracts could help in this task of aligning incentives and also why contracts already in existence in the world made sense.

Holmstrom contributed to this area with his informativeness principal. This idea is that when a contract is written between two parties, you should use information about the measurable outcomes of the project in the actual contract. In my book store example, I could write a contract that pays the store manager a fixed wage plus a bonus based upon the profits of the store. The contract could even be more complicated and based upon the difference between profits of my store and other book stores in the area. This would help provide incentives for the manager. He now knows that if he works harder to make my bookstore successful, he will earn more money. Even though I still can’t observe his actions, I’ve at least provided a contract for him that might increase his efforts.

Of course, the real world can get much more complex than a simple bookstore. What if it’s really hard to specify the outcomes in advance? Suppose I’m a young researcher working for a University or a company. The potential outcomes of my research are generally unknown. It’s also very hard to link the effort I employ to the outcomes of that research. In such a case, it might be easier to allocate property rights rather than base contracts on performance. For example, the employer might pay a fixed fee to the researcher plus grant him partial ownership of any patent that results from his research. In fact, many reasonable employers offer this sort of arrangement.

Hart’s work focused primarily on the issues and outcomes surrounding these type of incomplete contracts. That is, contracts where the parties cannot specify the future in sufficient detail. Hart’s work also extended to questions of whether or not certain institutions should be privately or publicly held.

There is no doubt that correctly specified contracts can help lead to better outcomes. Imagine if we could have very detailed marriage contracts with the right incentives — maybe the divorce rate would be a lot lower?

So what about the Nobel choice?

Oliver Hart was my teacher at MIT. During one of his classes on general equilibrium theory, he had spent the first hour filling four chalkboards with equations about general equilibrium theory. He then turned and said “That’s the proof.” I raised my hand and said something like “Very interesting. Professor Hart could you give us a real-world example of what that means and how it might be applied?” He turned to the chalk board and looked at all of the equations, turned around and paused. Then, in his clever British accent, he said something like, “I’m sorry, but no one believes this stuff anyway.” The class started laughing.

During the annual skit party, Austan Goolsbee and I worked on writing the skits for our class. In one of the skits we wrote a part about Oliver Hart. I played Oliver. It was basically a slap stick comedy about an Englishman with a sweater trying to teach general equilibrium theory, which no one believed anyway.

Bengt Holmstrom was the Department Chair of Economics at MIT from 2003 to 2006. During that time, he thought carefully about providing the right incentive schemes within the department of economics. He also spent considerable time thinking about the best advice he could give to his undergraduate advisees at MIT.

In the last few years, he has been working on issues related to the financial crisis. In one of his recent papers about money markets, he compared REPO markets to pawn shops in his attempt to understand the dark side of liquidity.  I’m hoping this will merge into research on crowding.

So is that it?

It should always be remembered that even though Hart and Holmstrom did some great research to help us understand contracts, there were many other researchers that contributed and continue to contribute to our understanding of contracts.

Some of the notable people are John Moore, a long-time collaborator with Hart, Steven Shavell, who wrote about similar concepts to Holmstrom in the same year as Holmstrom, and Sanford Grossman, another co-author with Hart.

Glenn Ellison of MIT was happy about the prize “It’s really great to see the prize go to such a nice person as Bengt. Basically, the prize went to Bengt for incentive theory and incentive schemes, while it went to Hart for his work with how you use organizational solutions when incentive schemes don’t work very well.”

Despite all the great work that these Nobels and others have done, contract theory is far from complete.  There are so many real world situations in which the principal-agent problem is severe. 

For example, many government employees and leaders aren’t performing their jobs efficiently, perhaps in part because their incentives are so radically different from their principals – the citizen.  We should work to fix this.

In other situations, the cost of time and lawyers to draft contracts overwhelms individuals and they abandon contracts or one party has severely more negotiating power and forces the other party to not contract in their best interest.

Even when contracts are in place, fine tuning them is always difficult. For corporate CEOs, stock options are one way of incentivizing them to perform well for shareholders.  However, the exact timing and nature of those stock options might lead to maximization of short-term gains at the expense of longer-term gains.

And sometimes, career concerns and one’s reputation create a naturally existing incentive mechanism that removes the need for an explicit one.

For more information on the winners:

https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/

From MIT: http://news.mit.edu/2016/economist-bengt-holmstrom-nobel-prize-1010

From Harvard: http://news.harvard.edu/gazette/story/2016/10/harvards-oliver-hart-wins-economics-nobel/

Congratulations to Oliver and Bengt, their pursuit of knowledge, and the armies of other researchers who walked with him.

Enjoy!

Ludwig

P.S. Feel free to email me your thoughts and indicate whether you wish them to remain anonymous or not.

October 10, 2016