Hart, Holmstrom share economics Nobel for contract theory

STOCKHOLM (AP) — Two U.S.-based professors won the Nobel prize in economics on Monday for studying how to best design contracts, work that sheds light on when it makes sense to give a CEO a bonus or privatize public services like schools, hospitals and prisons.

British-born Oliver Hart of Harvard University and Finnish economist Bengt Holmstrom of the Massachusetts Institute of Technology Finland will share the 8 million kronor ($930,000) award for their contributions to contract theory.

That’s a field of research that deals with incentives and risks involved in contracts drawn up between companies and employees, banks and lenders or insurance agents and their customers.

In research in the 1970s, ‘80s and ‘90s, Hart and Holmstrom created “new theoretical tools” that shed light on how contracts help people and companies deal with conflicting interests and the “potential pitfalls” that occur when contracts are poorly designed, the Royal Swedish Academy of Sciences said.

“These kinds of insights into how we should design contracts are very important because we don’t want to give the wrong incentives to people,” said Nobel committee member Tomas Sjostrom. “We don’t want to reward them for things that they were not responsible for. We want to reward the right thing.”

Hart, 68, is a London-born U.S. citizen who has taught at Harvard since 1993. Holmstrom, 67, is an academic from Finland who used to serve on the board of the country’s mobile phone company Nokia.

Speaking to reporters in Stockholm by telephone, Holmstrom said he felt very lucky and grateful.

“I certainly did not expect it, at least at this time, so I was very surprised and very happy, of course,” he said.

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.

Pay packages, for example, should avoid holding CEOs responsible — or rewarding them — for events beyond their control.

“You don’t want to reward the CEO because the S&P 500 (stock index) has gone up 20 percent,” said Patrick Bolton of Columbia University’s School of Business, who studied under Hart and has written a textbook on the economics of contracts. “You want to reward the CEO when his company outperforms the S&P.”