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Harvard, MIT professors win Nobel in economics for research on contract theory

The winner of the Nobel Prize in economics, officially called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, is announced. (Video: Reuters, Photo: Stina Stjernkvist/TT via AP/Reuters)

Harvard's Oliver Hart and MIT's Bengt Holmström were awarded the 2016 Nobel Memorial Prize in Economic Sciences on Monday for their work on contract theory, the study of how people can efficiently enter into agreements.

Their contributions have shaped the thinking in a wide range of fields, from law to economics to political science, affecting how scholars think about relationships employers and employees, between entrepreneurs and investors, and between governors and the governed.

British-born Hart, 68, teaches economics at Harvard University, while Finnish-born Holmström, 67, teaches at the Massachusetts Institute of Technology. They will share the prize evenly and split the kr8 million Swedish krona award (about $925,000).

“Oliver Hart, I’m so glad that I won it with him. He’s my closest friend here,” Holmström said to reporters shortly after learning of the Nobel decision.

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Holmström’s work explores how best to motivate people — how to monitor and reward them for doing their jobs. As he notes, paying for performance does not always encourage employees to work their hardest, because bosses cannot completely keep track of what everyone is doing. Holmström has shown how it can make sense to offer people fixed salaries instead of variable bonuses in situations where measures of job performance are inadequate, as they often are. Performance pay can backfire, for instance, if it encourages chief executives to prioritize short-term gains, or if it forces teachers to teach to the test.

“I think it’s just such a richly deserved prize,” said Glenn Ellison, the head of MIT’s economics department. “Bengt’s work is outstanding both for answering really important questions, and for how beautifully crafted it is mathematically.”

Hart has investigated how best to write contracts when the possible outcomes are hazy. He changed the way that economists think about corporations, highlighting how firms can increase efficiency not only through competition, but also through cooperation — by contracting with each other. And sometimes, he concluded, it is more efficient for companies to simply merge because a single owner would make better overall decisions.

This relates to one of the central questions of government: How much should the state do itself, and how much should it delegate to outside companies? Hart's theories argue that the private firms hired by the government often face strong incentives to cut corners, complicating the idea that the private market is always more efficient.

"Oliver is a fantastic economist," said Alberto Alesina, an economist and Hart's colleague at Harvard. "I don't think anyone was surprised. Everybody was just waiting for when it would happen."

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Holmström's and Hart started publishing their seminal work a time when economics was quickly becoming more and more mathematical — and some say, more arcane. But their theories demonstrate how math and economics can work together to clarify profound ideas with real-world applications.

If some of their research seems like conventional wisdom, that goes to show how deeply these ideas have seeped into society. At the same time, much of their contribution also lies in how they — along with colleagues including Paul Milgrom, Robert Wilson, John Moore, and Sandy Grossman — pioneered the use of math to rigorously examine previously foggy notions about incentives and contracts.

“An unarguably splendid pick," University of Michigan professor Justin Wolfers tweeted. “The Hart-Holmstrom Nobel is all about economic theorists who re-engaged with the real world and all its imperfections,” he added, describing the win as “long overdue."

“Hart and Holmstrom so obviously deserving that my first thought was 'didn't they have it already?'” economist and Nobel Laureate Paul Krugman said Monday morning on Twitter.

Contract theory has felt particularly relevant in recent years. It can be invoked, in part, to explain:

  • Why "gig economy" jobs like Uber and TaskRabbit have taken off. (Better performance monitoring makes it easier for companies to cultivate a workforce of at-will employees.)
  • The pitfalls of Obamacare's efforts to reward doctors for better performance. (Measuring health outcomes is nebulous, and doctors may try to game the system.)
  • How to more efficiently invest in start-ups, and how to unwind companies that nose-dive into bankruptcy. (Focus on who is in control, not necessarily who is owed what.)

“When you start thinking about it, contracts are really fundamental,” said Per Strömberg, chairman of the Economic Sciences Prize Committee. “We see them everywhere in society. All of us are engaged in different types of contracts.”

“This is a theory that has really has given rise to lots of other applications,” he said. “In many, many fields, not just in economics but in law and politics, people actually use these theories to understand what they’re studying.”

Holmström’s work has influenced how corporations determine CEO salaries, a process that is under renewed scrutiny as CEO pay continues to rise faster than the earnings of regular workers. Many companies compensate their CEOs according to how the stock performs, or directly in terms of stock options, but Holmström and his colleagues have argued that this practice sometimes rewards executives for getting lucky, not for doing a good job, and may cause them to harm a company's long-term potential in search of short-term gains.

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“When do you pay based on perceived effort, and when on the basis of observed outcomes, such as profits or share price? Holmström has been the number one theorist in helping to address issues of this kind,” economist Tyler Cowen wrote in an essay Monday morning.

Hart has shown that government privatization has both upsides and downsides. On one hand, competition between private contractors can lead to lower costs and higher quality. But if the government cannot adequately monitor quality, then companies will focus on cost-cutting.

These ideas were illustrated recently when the Obama administration decided to phase out the use of private prisons, citing their low quality. “They simply do not provide the same level of correctional services, programs, and resources,” Deputy Attorney General Sally Yates wrote in an August memo.

Hart's research highlights the problems with incomplete contracts, which are everywhere. It's difficult to write an arrangement that spells out every eventuality; in some cases, this problem becomes so large that it can make more economic sense for one side to buy out the other side instead of both sides committing to a tetchy agreement.

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Holmström earned his PhD at Stanford University and has taught at MIT since 1994. Hart earned his PhD at Princeton University and has taught at Harvard since 1993. The pair have mostly done their work in parallel, though they have occasionally written papers together. Both are immigrants to the United States, which is typical — the United States' Nobel laureates are disproportionately foreign-born.

Holmström first came to the country as a cultural exchange student. After graduate school, he was forced to move back to Europe as a condition of his visa. He recounted his eventual return to America at a light-hearted press conference held at MIT on Monday morning. Others, he noted, found ways of getting around the visa rules, but he didn't.

"Being from Finland, I should say we do things the way we have written them in the contract. We don’t renegotiate — those people are at Harvard,” he joked.

Last year's Nobel Prize in economics went to Princeton economist Angus Deaton for research on how people, particularly the poor, make decisions about spending money.