By Satyam Kumar
The Nobel Prize in economics is a controversy in itself. Economics is, possibly, the only field where two people could share the same prize for saying exactly the opposite things. Nobel Prize in the field of economics is not a part of the original family of Nobel prizes. In 1968, Sveriges Riksbank (Sweden’s central bank) established this Prize in memory of Alfred Nobel, founder of The Nobel Prize. Many eminent personalities have raised their voices against the validity of the Nobel Prize in economics and also questioned the merit of economics to deserve a Nobel as a science. The debate certainly is a valid as it is a contentious one, but for the purposes of this entry, we focus on the prize alone: First, the prize undoubtedly remains the highest award in the field of economics; Second, it requires immense talent, effort and patience to get this prize. The average age of all Laureates in Economic Sciences between 1969 and 2014 is 67 years. It means that your work has to stand the test of time before you are considered worthy of the prize; Third, The prize money is huge- 8 million Swedish krona!
The much awaited Nobel Prize in field of economic sciences was announced last week on 10th October. This year the prize has been shared by two economists- Oliver Hart and Bengt Holmstrom for their contributions to ‘Contract theory’.
We live in a comlex world today. People have different interests. Contractual agreements are the ‘tools’ which are used to mitigate these conflicts of interest. A contract helps the two sides of the deal work together over a long period of time. The contract creates rules that allow agents with different interests to cooperate to achieve some goal. Well designed contracts provide incentives for the contracting parties to exploit the prospective gains from cooperation. For example, labor contracts include pay and promotion conditions that are designed to retain and motivate employees; insurance contracts combine the sharing of risk with deductibles and co-payments to encourage clients to exercise Caution; credit contracts specify payments and decision rights aimed at protecting the lender, while encouraging sound decisions by borrowers.
Incentives, lying at the heart of Contract Theory, are important. Ask Steven Levitt, and he would tell you that incentives are everything. From Adam Smith to Chester Bernard, most of the prominent economists have realized the power of proper incentives. Contract Theory has, therefore, had a major impact on Organizational Economics and Corporate Finance, and it has deeply influenced other fields such as Industrial Organization, Labor Economics, Public Economics, Political Science, and Law. It helps us find mutually beneficial solutions to the famous principal-agent problem involving moral hazard. The Royal Swedish Academy of Sciences has said on the official Nobel website: “The contributions by the laureates have helped us understand many of the contracts we observe in real life. They have also given us new ways of thinking about how contracts should be designed, both in private markets and in the realm of public policy.”
BENGT R. HOLMSTROM
Bengt Robert Holmström is a Finnish economist who is currently Paul A. Samuelson Professor of Economics at the Massachusetts Institute of Technology.
He received his B.S. in Mathematics and Science from the University of Helsinki, a Master of Science degree in Operations Research from Stanford University in 1975, and his Ph.D. from the Graduate School of Business at Stanford.
Holmström is particularly well known for his work on principal-agent theory. More generally, he has worked on the theory of contracting and incentives especially as applied to the theory of the firm, to corporate governance and to liquidity problems in financial crises.
In the 1970s Holmstrom showed how a principal, for example a company’s shareholders, should design an optimal contract for an agent, like the CEO. His “informativeness principle” showed how the contract should link the agent’s pay to information relevant to his or her performance, carefully weighing risks against incentives, the academy said. One of his famous works has been in the field of salary of the CEOs. He tackles a very pertinent question, should the CEO be rewarded when a company’s stock prices go up? He says that even a bad CEO may end up getting a huge salary if he is heading a company in a booming industry. In his famous paper, Moral hazard and observability (1979), he said 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 absurd, but according to Holmstrom, most of the CEOs are rewarded for luck. It is better to link the CEO’s pay to his company’s share price relative to those of similar firms from the same industry.
Holmstrom’s work on the compensation of CEOs has reignited the heated debate on the handsome salaries of CEOs. It could not have come at a better time. The rhetoric of ‘We are the 99%’ has once again acquired center stage with the US elections around the corner and a manifestation of this inequality debate can be seen in the rise of Donald Trump.
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.
In recent years, he has studied issues relating to financial market liquidity and its relevance to financial regulation. Holmström and Tirole use a model of managerial wealth constraints to investigate a number of important issues in corporate finance, including the impact of wealth shocks on the banking system, banking regulation, the role of public liquidity provision for firms, and how liquidity affects asset prices and expected returns.
When he briefed the media after the announcement of the prize, he said that he was not expecting the prize this time. We’re not sure if this is a sample of his sense of humour or humility in the face of his enormous contribution to Economics.
The announcement of the Nobel Prize on 10th of October extended the joy for Oliver Hart who celebrated his birthday just the previous day. Surely this was the best birthday present one could hope for.
Oliver Hart is a British-born American economist and the Andrew E.Furer Professor of Economics at Harvard University. He earned his M.A. in economics at the University of Warwick in 1972, and his Ph.D. in economics at Princeton University in 1974.
In the mid-1980s, Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances. His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.
His work showed that cost reduction and improvements to quality are the conflicting forces at work when a government decides whether it should privatize a service or run it on its own. Private operators may have very little incentive to improve the quality and their main aim would be to reduce costs. Hart famously cited the U.S prison systems as an example in a paper written in 1990s. Federal authorities in the United States are in fact ending the use of private prisons, partly because – according to a recently released U.S. Department of Justice report – conditions in privately-run prisons are worse than those in publicly-run prisons. This also partly explains the pathetic condition of catering in Indian Railways; which is mostly run by private operators, use of poor quality of material in roads and bridges built by private contractors etc. Probably, we now have a considerable theoretical backing to persuade the university administration to do away with privately run canteens in college campuses!
Venture capital is an important field where Contract Theory can be seen in action. When an entrepreneur finds a venture capitalist to fund her idea, then along with decisions around the division of cash flows and equities, the allocation of control rights are also to be dealt with. There are cases when founders retain control over cash flows but give much of the control right to venture capitalists, but once business picks up, the founders could be thrown out by the venture capitalists. At other times, the venture capitalists may have a larger share in profits but little control rights. Division of control rights is very important in such contracts.
The incomplete contracts model also has important applications to political institutions. For example, the division of responsibilities among different decision-making bodies such as executive and legislative branches of government can be productively viewed as an allocation of control rights along the same lines as in the theory of incomplete contracts.
The Nobel Prize this year has been well received. Various scholars and media houses have applauded the Nobel committee for their Selection. Paul Krugman tweeted -“Hart and Holmstrom so obviously deserving that my first thought was- ‘didn’t they have it already?’” The prize this year also shows the shift of attention of the academy away from macroeconomics to economists whose research, has focused on specific matters and institutions. In the past, Nobel went almost exclusively to macro research. In the decade after the prize was created, nine out of 10 prizes went to ideas with “macro” roots. However in the last two decades, the number of prizes in fields like Game Theory is on the rise. Since 1991, more than 20 economists have been awarded Nobel Prizes for their work in the overlapping fields of New Institutional Economics, Game Theory, Industrial Organization, Contract Theory and Information Asymmetry. At least in the field of Nobel Prizes, macroeconomics seems to be ‘going backward’.