2 U.S.-based pro­fes­sors win No­bel in eco­nom­ics

Baltimore Sun - - MARYLAND NATION & WORLD - By Karl Ritter

STOCK­HOLM — Two U.S.-based pro­fes­sors won the No­bel Prize in eco­nom­ics on Mon­day for study­ing how to best de­sign con­tracts, work that sheds light on when it makes sense to give a CEO a bonus or pri­va­tize pub­lic ser­vices such as schools, hos­pi­tals and pris­ons.

Bri­tish-born Oliver Hart of Har­vard Univer­sity and Fin­nish econ­o­mist Bengt Holm­strom of the Massachusetts In­sti­tute of Tech­nol­ogy will share the $930,000 award for their con­tri­bu­tions to con­tract theory.

That’s a field of re­search that deals with in­cen­tives and risks in­volved in con­tracts drawn up be­tween com­pa­nies and em­ploy­ees, banks and lenders or in­sur­ance agents and their cus­tomers.

In re­search in the 1970s, ’80s and ’90s, Hart and Holm­strom cre­ated “new the­o­ret­i­cal tools” that shed light on how con­tracts help peo­ple and com­pa­nies deal with con­flict­ing in­ter­ests and the “po­ten­tial pit­falls” that oc­cur when con­tracts are poorly de­signed, the Royal Swedish Acad­emy of Sciences said.

“These kinds of in­sights into how we should de­sign con­tracts are very im­por­tant be­cause we don’t want to give the wrong in­cen­tives to peo­ple,” said No­bel com­mit­tee mem­ber To­mas Sjostrom. “We­don’t want to re­ward them for things that they were not re­spon­si­ble for. We want to re­ward the right thing.”

Hart, 68, is a Lon­don­born U.S. cit­i­zen who has taught at Har­vard since 1993. Holm­strom, 67, is an aca­demic from Fin­land who used to serve on the board of the coun­try’s mo­bile phone com­pany, Nokia.

Holm­strom said he felt Oliver Hart, 68, is a pro­fes­sor at Har­vard Univer­sity. very lucky and grate­ful.

“I cer­tainly did not ex­pect it, at least at this time, so I was very sur­prised and very happy, of course,” he said.

In the 1970s, Holm­strom showed how a prin­ci­pal, for ex­am­ple a com­pany’s share­hold­ers, should de­sign an op­ti­mal con­tract for an agent, such as the CEO. His “in­for­ma­tive­ness prin­ci­ple” showed how the con­tract should link the agent’s pay to in­for­ma­tion rel­e­vant to his or her per­for­mance, care­fully weigh­ing risks against in­cen­tives, the acad­emy said.

Pay pack­ages, for ex­am­ple, should avoid hold­ing CEOs re­spon­si­ble, or re­ward­ing them, for events beyond their con­trol.

“You don’t want to re­ward the CEO be­cause the S&P 500 (stock in­dex) has gone up 20 per­cent,” said Pa­trick Bolton of Columbia Univer­sity’s School of Busi­ness, who stud­ied un­der Hart and has writ­ten a text­book on the eco­nom­ics of con­tracts. “You want to re­ward the CEO when his com­pany out­per­forms the S&P.”

Bolton de­scribed Hart as a rig­or­ous but open-minded thinker who chal­lenges his stu­dents’ ideas.

Holm­strom said his in­cen­tive to study con­tract theory came be­fore he was an aca­demic, when he was work­ing for a com­pany in Bengt Holm­strom, 67, is a pro­fes­sor at MIT. the 1970s that tried to use com­put­ers to fig­ure out how to make strate­gic plans.

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

Hart made fun­da­men­tal con­tri­bu­tions to a new branch of con­tract theory in the mid-1980s. His find­ings on “in­com­plete con­tracts” shed new light on the own­er­ship and con­trol of busi­nesses, the acad­emy said.

“His re­search pro­vides us with the­o­ret­i­cal tools for study­ing ques­tions such as which kinds of com­pa­nies should merge, the proper mix of debt and eq­uity fi­nanc­ing, and which in­sti­tu­tions such as schools or pris­ons ought to be pri­vately or pub­licly owned,” the acad­emy said.

It cited a 1997 ar­ti­cle co-authored by Hart that high­lighted how pri­vate con­trac­tors have stronger in­cen­tives for in­vest­ing in both qual­ity and cost re­duc­tion. The au­thors ar­gued that the in­cen­tives for cost re­duc­tion some­times are too strong and ex­pressed par­tic­u­lar con­cern about pri­vately run pris­ons, the acad­emy said.

MICHAEL DWYER/AP

SCOTT EISEN/GETTY

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