Oliver Hart and Bengt Holmström have been awarded the Nobel Prize for Economics in 2016 for their work on the theory of making contracts work to optimise the incentives faced by people.
Mr Hart, a Briton at Harvard University, and Mr Holmström, a Finn who teaches at the MIT, are the 48th recipients of the Nobel, which was announced by Royal Swedish Academy of Sciences in Stockholm today. They will share a prize of 8m Swedish krona ($920,000) between them.
Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research, said the Nobel committee, adding: Over the past few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.
He made his mark developing the theory of incomplete contracts in circumstances where it is impossible to specify every aspect of a contract. Much of his work aims to find out whether services should be run by the public or private sector.
Mr Harts model does not say whether private or public ownership was better, but specifies the conditions under which certain government services should be privatised while others should be left in the public sector.
Works
The Academys award cites multiple aspects of Holmstroms work on contracts that have contributed significantly to our understanding of the issue, dating to the 1970s.
One of these, the informativeness principle, was developed and published by Holmstrom in 1979, addressing the principal-agent problem (the structure of contracts between employers and employees). This principle suggests that optimal contracts should structure compensation based on all outcomes that can potentially provide information about actions that have been taken, as the Academy observes.
In the case of setting an executives compensation, for instance, that means a firm would reward the executive based on not just its own performance but also the performance of other firms in that sector as way of evaluating not just the actions the executive took but those that he or she could have taken. Holmstroms 1979 paper on the subject, Moral Hazard and Observability, has been widely cited in the years since.
The Academy also cites a pair of insights about contract structures that Holmstrom developed in the early 1980s. In the 1982 paper Moral Hazard in Teams, he concluded that dividing a firms income among its workers could lead to a free-rider problem, in which some employees contribute less than others, relative to their compensation. In this case, Holmstrom suggested, outside ownership of firms can produce more flexible compensation and boost individual incentives.
Holmstrom co-authored another 1982 paper, Managerial Incentive Problems: A Dynamic Perspective, whose model of career trajectories was highlighted in the Academys announcement. As Holmstrom noted in the paper, current salaries do not necessarily neatly match employee performance; instead, firms may reward current performance with higher salaries to prevent employees from switching firms in a competitive labor market. However, these dynamics may not apply as effectively to later-career employees.
The prize announcement also cited an influential Holmstrom paper from 1991, Multi-Task Principal-Agent Problems: Incentive Contracts, Asset Ownership and Job Design," co-authored with Paul Milgrom, as having changed how economists think about optimal compensation schemes and job design. This line of research observes that employees often have many tasks, not all of which are equally simple to measure, and that compensation can be structured to incentivize performance in all tasks, not just the most easily quantifiable.
Reaction
Reacting to the news, Mr Hart said: I woke at about 4:40am and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang.
Contracts are just an incredibly powerful way of thinking about parts of economics. Theyre just fundamental to the whole idea that trade is a quid pro quo and that there are two sides to a transaction, said Mr Hart.
US economist Justin Wolfers described the pair as an unarguably splendid pick. He tweeted that Mr Hart was brilliant, engaging and thoughtful.
Hart and Holmströms work is all about our messy reality, he added.
I feel very luck and grateful, said Mr Holmström, who is the Paul A. Samuelson professor of economics at MIT. I certainly did not expect it, at least at this time. I was very surprised and very happy, of course.
Contract theory informs everything from the nature of insurance contracts to the behaviour of politicians, said the Nobel committee.
