Oliver Hart and Bengt Holmström finally got the Nobel Prize in economics! The contributions of the two are so enormous and fundamental that it was rather astonishing that they were not on the list yet.
Holmström’s work is in the field of studying the behaviour of employees in a firm and designing optimal reward schemes to incentivize them. Imagine the executive board of a company trying to decide its chief executive officer’s compensation. Should it reward the CEO if the stock price goes up? Imagine a bad CEO heading a company in a booming industry. Most likely, his company would do quite well despite him. In a seminal paper titled Moral Hazard And Observability, written in 1979, Holmström proposed the “Informativeness principle”. It says that the optimal contract should reward the CEO by linking his compensation to every outcome that can convey meaningful information about his effort.
This may sound obvious but notice that rewarding the CEO for his firm’s stock price is suboptimal. And yet, this is how it happens in practice. In an empirical paper, Marianne Bertrand and Sendhil Mullainathan found that most firms reward the CEOs for luck. Only a few, the better-governed ones, do a good job of designing the right compensation scheme.
Another seminal contribution by Holmström is in the field of “career concerns”. Eugene Fama (Nobel Prize winner of 2013) had argued that market forces would offer strong incentives for the managers to work hard even if their current compensation scheme was not optimal. Holmström called this idea “rather provocative but interesting” in his paper Managerial Incentive Problems: A Dynamic Perspective. He showed that Fama’s intuition was correct only under very restrictive conditions; for example, if the market could observe the manager’s performance within the firm. Besides giving a formal model to explore the idea that Fama verbally proposed, Holmström’s contribution was to throw light on the conditions when the market could provide enough incentives for the employees to work hard.
In passing, I will mention a few other great contributions of Holmström. For example, we rarely see very complex contracts in real life. Holmström and Paul Milgrom, in 1987, showed how that might happen in a world where the agent is rewarded over a period of time and he enjoys greater freedom of action. Holmström and Milgrom, in their work on multitasking, showed that when the employee could allocate his time between activities, it might be optimal to not offer performance pay. One example is rewarding teachers on students’ test performance. This would make the teachers focus only on test-relevant topics. In his work on incentives in a team, Holmström showed that when we can only monitor the team output and not every individual’s output in a team, it may be very difficult to achieve the maximum output the team could have produced.
Hart took a different perspective on contracts than Holmström. In reality, contracts are often “incomplete”, i.e., we cannot write contracts contingent on every possible outcome. Yet, little was known about them. In an extremely influential paper, The Costs And Benefits Of Ownership: A Theory Of Vertical And Lateral Integration, Sanford Grossman and Hart gave an elegant theoretical framework to capture ideas like costs and benefits of integration built on incomplete contracts. This work proved that when performance-based contracts could not be written, property rights would produce good enough incentives.
Think of an innovation that requires some combination of a machine and a distribution channel. Who should own the machine and who should own the distribution channel? Grossman and Hart proposed that the ownership should be given to the party that makes the most important “non-contractible” investment. Various empirical studies broadly withstand this hypothesis that upstream integration by manufacturers grows as their technology improves.
Hart’s work has also shed light on perhaps the most important economic question—why do firms exist? And what are the boundaries of a firm? These questions intrigued a number of economists. Starting from the legendary Ronald Coase (Nobel Prize winner of 1991) to Oliver Williamson (Nobel Prize winner of 2009), they offered explanations surrounding transaction costs and other inefficiencies. But it was Grossman and Hart who gave a simple theoretical framework that talked about both the costs and benefits of integrating economic activities in a firm. Most importantly, they answered a much bigger question—who should own a particular asset when two parties interact?
Interestingly, Hart himself has moved on to more behavioural approaches to investigate the foundations of incomplete contracts. As he and John Moore wrote in 2006, “Although the incomplete contracts literature has generated some useful insights about firm boundaries, it has some shortcomings.” Besides intellectual honesty, what stands out here is the genuine commitment towards gaining a deeper insight. It is this trait, besides their work, that connects the two winners.
Hart and Holmström have given simple and elegant models enabling us to answer some of the fundamental economic questions. Their work has served as a platform for countless researchers who worked on these topics. This is a prize for two giants whose work will continue to shape our understanding of incentives and contracts for decades.
Aditya Kuvalekar is a PhD candidate at New York University.
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