On Monday, this year's Nobel Prize in Economics went to Oliver Hart and Bent Holmström. Hart, 68, was born in Britain and is a professor at Harvard, where he's taught since 1993. Holmström, 67, is from Finland, and is a professor at MIT, where he's been since 1994.
Here's what you need to know about their work:
Hart and Holmström won for separate but complementary theoretical work on how contracts shape economic relationships and outcomes, which they've been developing since at least the 1970s. "An eternal obstacle to human cooperation is that people have different interests," the Royal Swedish Academy of Sciences wrote in their explanation of the award. "In modern societies, conflicts of interests are often mitigated — if not completely resolved — by contractual arrangements. Well-designed contracts provide incentives for the contracting parties to exploit the prospective gains from cooperation."
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Holmström's work outlined how contracts can structure incentives — like pay, bonuses, or promotions — to encourage people to do the most productive work possible, while acknowledging the imperfect knowledge and information anyone providing those incentives will inevitably have, and how outcomes can sometimes be hard to measure.
For example, consider CEO compensation. Design a CEO's contract correctly, and you'll encourage her to build a better company. But design it incorrectly, and you'll get a CEO who still makes bank but does nothing to create a more prosperous or productive company — or even runs it into the ground. Most CEO pay is a mix of a fixed salary, performance-based pay like bonuses, and stock compensation that ties pay to the performance of the company's shares on the financial markets. Holmström's work dives into how important it is to get the mix right: If your business is one where performance can be concretely measured, performance-based pay could work. But even there, relying too much on stock compensation is tricky, since returns to stock on the financial markets are governed by a whole host of random forces far beyond the fiscal health of the company in question.
Conversely, if you're in an industry where the risks to the company are high, but for practical reasons it's hard to closely monitor your CEO's decision-making, you might be better off just abandoning performance-based pay and sticking with a fixed salary. (The financial industry seems like an obvious candidate, here.) On top of all that, there's the question of timing: Properly motivating a young CEO with a whole career ahead of them will require a different mix than an elderly CEO at the end of their run.
"Holmström clearly thinks companies have not been paying enough attention to his work," Larry Elliott wrote in The Guardian. "After hearing he was a joint winner of this year's prize, he said he thought bonuses were 'extraordinarily high' and the contracts too complicated."
While Holmström's work has actually inspired (or should have inspired) companies to behave differently, Hart's work, on the other hand, explains why companies behave the way they do and fits that into economics' broader theoretical frameworks.
For instance, Hart did breakthrough work on how "incomplete contracts" shape economic outcomes. The basic idea is that in some situations contracts simply cannot account for all possible outcomes, or precisely describe the service that will be delivered in all its particulars. In those situations, Hart's work shows, the most important thing to get right in contracts is laying out who gets to make what decisions, and the rules for how to resolve unforeseen disputes.
Consider financial and venture capital contracts, many of which allow the entrepreneur to maintain control rights over the firm so long as performance is good. In that case, investors reliably receive a fixed stream of payments out of profits. But if performance goes into the ditch and those payments stop, the contracts shift far more power to the investors, who can choose to restructure the company or even liquidate it. More broadly, most contracts governing loans to corporations work on a similar principle: As long as the debt payments get made, the shareholders retain control of the company. If those payments stop, the creditors gets to step in and start making the calls. Hart's work helped shed light on these complicated dynamics.
Sometimes economists need to come up with better models to better influence decision-making by actual human beings in the real world — which is basically what Holmström did. But sometimes economists need to improve their models simply so they better represent the decisions real-world human beings already make. And that's where Hart came in.
