Two econ­o­mists win No­bel for work with con­tracts

Daily Local News (West Chester, PA) - - BUSINESS - By Paul Wise­man and Karl Rit­ter Wise­man re­ported from Washington, Rit­ter from Stockholm. As­so­ci­ated Press writ­ers Keith Moore in Stockholm, Mark Pratt in Bos­ton and Philip Marcelo in Cam­bridge, Mas­sachusetts, also con­trib­uted to this re­port.

Let in­sid­ers eas­ily cash in stock op­tions, as En­ron did, and you risk see­ing ex­ec­u­tives aban­don a fail­ing com­pany. En­cour­age con­trac­tors to sac­ri­fice qual­ity to cut costs and you might cause prob­lems like those that led the U.S. Jus­tice Depart­ment to phase out pri­vately run pris­ons.

De­sign­ing con­tracts is a tricky busi­ness. For their ground­break­ing work on how to make con­tracts fairer and more ef­fec­tive, Oliver Hart of Har­vard Univer­sity and Bengt Holm­strom of the Mas­sachusetts In­sti­tute of Tech­nol­ogy won the 2016 No­bel prize for eco­nom­ics Mon­day. They will share the 8 mil­lion kro­nor ($930,000) award for their con­tri­bu­tions to con­tract the­ory.

For decades, the two men have stud­ied prac­ti­cal prob­lems in­volv­ing the count­less kinds of con­tracts that un­der­lie modern com­merce:

How should com­pa­nies pay their ex­ec­u­tives? What types of tasks should gov­ern­ment agen­cies out­source to pri­vate con­trac­tors? How best to write an auto in­sur­ance pol­icy to pro­tect driv­ers from fi­nan­cial loss with­out lulling them into care­less­ness?

Pay pack­ages, Holm­strom’s work sug­gests, are best tai­lored to avoid ei­ther pun­ish­ing or re­ward­ing CEOs for hap­pen­ings 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 Busi­ness School, 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.”

Like­wise, com­pa­nies fare best when they es­tab­lish pay pack­ages that in­cen­tivize ex­ec­u­tives to pri­or­i­tize the long term as much as the short term, to avoid fo­cus­ing too much on quar­terly profit ex­pec­ta­tions.

“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 To­mas Sjostrom, a mem­ber of the No­bel com­mit­tee. “We don’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 for­merly served on the board of the coun­try’s mo­bile phone com­pany Nokia. Econ­o­mists who have long known the two men and their work of­fered warm praise Mon­day.

“This is the No­bel Prize in eco­nom­ics at its best,” said George Ak­erlof of Ge­orge­town Univer­sity, who won the prize in 2001. “The char­ac­ter of both Bengt and Oliver shines through in their work and their char­ac­ter: They are true in­tel­lec­tu­als and truly great peo­ple.”

At a news con­fer­ence at MIT, Holm­strom de­clined to say whether he thought CEO pay — a hotly con­tentious is­sue in the United States and else­where — had be­come ex­ces­sive.

“It is some­what de­mand and sup­ply work­ing its magic,” he said.

But he said com­pa­nies can give ex­ec­u­tives the wrong in­cen­tives, as the en­ergy firm En­ron did, when it al­lowed in­sid­ers to un­load their stock op­tions as the com­pany fell into a death spi­ral.

“The prob­lem wasn’t op­tions,” Holm­strom said. “The prob­lem was the way peo­ple could sell out.”

The In­ter­nal Rev­enue Ser­vice used Hart as an ex­pert wit­ness in cases in­volv­ing Black and Decker and Wells Fargo. At is­sue was whether some of the com­pa­nies’ trans­ac­tions had had a le­git­i­mate cor­po­rate pur­pose or had been de­signed just to re­duce their tax bills.

Robert Gib­bons at MIT’s Sloan School of Man­age­ment notes that the term “con­tract the­ory” might make Holm­strom and Hart’s work sound nar­rower than it is. But, Gib­bons ex­plained, their re­search goes well be­yond legally bind­ing con­tracts. They have an­a­lyzed the prac­ti­cal ar­range­ments worked out be­tween many dis­parate play­ers — part­ners within a law firm, say, or com­pa­nies and their sup­pli­ers or gov­ern­ment agen­cies and pri­vate con­trac­tors.

Gib­bons says Holm­strom and Hart’s work is just now be­gin­ning to have a prac­ti­cal ef­fect as it evolves from aca­demic re­search to man­age­ment train­ing to real work­places.

“The real-world stuff is com­ing,” he said. “You’re start­ing to see it.”

In his writ­ing, Hart has ex­pressed con­cern about pri­vate pris­ons: Would profit-seek­ing con­trac­tors overem­pha­size cost-cut­ting over main­tain­ing qual­ity?

His con­cerns proved per­cep­tive: Af­ter dis­cov­er­ing that pri­vate pris­ons were marred by more safety and se­cu­rity prob­lems than gov­ern­ment-run ones were, the Jus­tice Depart­ment in Au­gust or­dered the Bu­reau of Pris­ons to re­duce and even­tu­ally end the use of pri­vate pris­ons.

The eco­nom­ics prize is not an orig­i­nal No­bel Prize. For­mally called the No­bel Me­mo­rial Prize in Eco­nomic Sciences, it was added to the oth­ers in 1968 by Swe­den’s cen­tral bank.

The No­bel Prizes in medicine, physics, chem­istry and the No­bel Peace Prize were an­nounced last week. This year’s No­bel an­nounce­ments will end Thursday with the lit­er­a­ture award. The lau­re­ates will col­lect the awards on Dec. 10, the an­niver­sary of prize founder Al­fred No­bel’s death in 1896.

At Har­vard, Hart said it “means a lot” to share the prize with Holm­strom.

“I’m glad I won it with him,” Hart said. “It’s go­ing to be fun to cel­e­brate in Swe­den with him.”

STINA STJERNKVIST — TT VIA AP

From left, To­mas Sjostrom, mem­ber of the Com­mit­tee for the Prize in Eco­nomic Sciences in mem­ory of Al­fred No­bel, Go­ran K. Hans­son, Sec­re­tary Gen­eral of the Royal Swedish Academy of Sciences and Per Stromberg, Chair­man of the Com­mit­tee for the Prize in Eco­nomic Sciences in mem­ory of Al­fred No­bel, at­tend a press con­fer­ence to an­nounce Oliver Hart and Bengt Holm­strom as the win­ners of the No­bel Me­mo­rial Prize in eco­nomic sciences.

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