Main works of Holmström

of human capital vis-à-vis physical capital in the application of incomplete contracts. For example, if there is a backward integration of a power plant buying out a coal mine to avoid dependence on the whims and fancies of the coal mine, such an integration would only be worthwhile because the power plant would have better control over the coal mine manager.

Hart applied his general theory of incomplete contracts to financial contracting (corporate takeovers and the balance of debt and equity financing) and whether goods and services should be provided by the public or private sector. Hart’s research also suggested that prisons should be run by the government, whereas municipal services such as garbage collection and defence production services such as weapon production should be privately contracted.

Holmström is best known for his work on one aspect of the principal-agent problem — the design of employment contracts. His work focussed on the design of contracts where the output of the employee is not perfectly observable. He proposed the ‘informativeness principle’ which says that an employee’s compensation should depend on the quality of performance. Holmstrom’s objective was to design the most optimum contract, which would weigh risks and incentives when an employee’s output was unobservable or difficult to measure. A corollary of this principle is that CEOs should not be paid solely on the basis of their company’s stock price, which can be influenced by industry-wide factors that are out of any executive’s control, but rather by the company’s stock price relative to the stock prices of other companies in the same industry.

Holmstrom extended his work to suggest a general framework which was closer to the real world — it covered promotion, division of compensation, shirking and the free-rider problem and whether to carry out tasks inside the firm or outsource it. In the 1980s, he suggested that equal division of compensation among team members would lead to free riding by the shirkers. Taking this theme further, he coauthored two papers with Paul Milgrom — ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’ (1991) in the ‘Journal of Law, Economics and Organisation’ and ‘The Firm as an Incentive System’ (1994) in the ‘Journal of Economic Literature’.

In the 1991 paper, they laid down the multitask principal-agent model, which studied incentives and their implications when workers have competing activities. In the 1994 paper, the authors used this model to look at various incentives that the workers may be offered — performance-based incentives, asset ownership by workers, or the workers having better control over their jobs. The interplay of these incentives determines whether the firm will ‘make or buy’ — i.e., the firm will either take up production in-house or outsource the procurement. Another aspect brought out by the authors was that a worker carries out multiple tasks, all of which are not easily observed or evaluated. If the incentives are given only for the easily observed or evaluated tasks, the worker would tend to neglect other tasks and focus only on the incentivised tasks. In fact, Holmstrom suggested that incentives can sometimes be dysfunctional. To quote from his Nobel lecture:

Today, I know better. As I will try to explain, one of the main lessons from working on incentive problems for 25 years is that within firms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the firm are generally misguided. Typically, it is best to avoid high-powered incentives and sometimes not use pay-for-performance at all. The recent scandal at Wells Fargo explains the reason (Tayan 2016). Monetary incentives were powerful but misaligned and led some managers to sell phony accounts to enhance their bonuses.

Holmstrom got his initial insights on incentives when he worked for the Finnish company Ahlstrom as a corporate planner. His main job was to collect data on factories. While doing so, he found that giving incentives to workers is not always productive.

Conclusion

Hart and Holmström worked on different aspects of contract theory. While Hart shed light on the importance of incomplete contracts and the importance of residual rights, Holmström taught us how to design a contract where the employee’s output was difficult to observe or evaluate. Their works have helped in designing public policies in varied areas such as municipal governance, prison reforms, corporate governance and labour contracts.