Harvard’s Oliver Hart and MIT’s Bengt Holmstrom were awarded the 2016 Nobel Memorial Prize in Economic Sciences on Monday for their work on contract theory, the study of how people can efficiently enter into agreements. Their contributions have shaped thinking in a wide range of fields, from law to economics to political science.
British-born Hart, 68, teaches economics at Harvard, while Finnish-born Holmstrom, 67, teaches at MIT. They will share the prize evenly, splitting the 8 million Swedish krona award (about $925,000).
“Oliver Hart, I’m so glad that I won it with him. He’s my closest friend here,” Holmstrom said to reporters after learning of the decision.
Holmstrom’s work explores how best to monitor and reward people for doing their jobs. Paying for performance does not always encourage employees to work their hardest, because bosses cannot completely keep track of what everyone is doing. Holmstrom’s theories show how it makes sense to offer people fixed salaries instead of variable bonuses when measures of job performance are inadequate, as they often are. Performance pay can backfire, for instance, if it encourages CEOs to prioritize short-term gains, or if it forces teachers to teach to the test.
Hart has investigated how best to write contracts when the possible outcomes are hazy. He has changed the way economists think about corporations, highlighting how firms can increase efficiency not only through competition, but also through cooperation – by contracting with each other. Sometimes, he concluded, it is more efficient for companies to merge, because a single owner makes better overall decisions.
This relates to one of the central questions of modern government: How much the state should do itself, and how much it should delegate to outside companies? Hart’s theories argue that the private firms hired by the government often face strong incentives to cut corners, complicating the idea that the private market is always more efficient.
The field of contract theory demonstrates how economics and mathematics together can have profound real-world applications. “When you start thinking about it, contracts are really fundamental,” said Per Stromberg, chairman of the Economic Sciences Prize Committee. “We see them everywhere in society. All of us are engaged in different types of contracts.”
“This is a theory that really has given rise to lots of other applications,” he added. “In many, many fields, not just in economics but in law and politics, people actually use these theories to understand what they’re studying.”
Contract theory has felt particularly relevant in recent years. Holmstrom’s work has influenced how corporations determine CEO salaries, a process that is under renewed scrutiny as CEO pay continues to rise faster than the earnings of regular workers. Many companies compensate their CEOs according to how the stock performs, or directly in terms of stock options – but Holmstrom and his colleagues have argued that this practice sometimes rewards executives for getting lucky, not for doing a good job.
“When do you pay based on perceived effort, and when on the basis of observed outcomes, such as profits or share price? Holmstrom has been the No. 1 theorist in helping to address issues of this kind,” economist Tyler Cowen said in an essay Monday morning.
Hart has shown that government privatization has both upsides and downsides. On one hand, competition between private contractors can lead to both lower costs and higher quality. But if the government cannot adequately monitor them, companies will focus on cost-cutting.
These ideas were illustrated recently when the Obama administration decided to phase out the use of private prisons, citing their low quality. “They simply do not provide the same level of correctional services, programs, and resources,” Deputy Attorney General Sally Yates wrote in an August memo.