By Zulfiqar Sheth
The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 to Oliver Hart, Harvard University, Cambridge, MA, USA and Bengt Holmström of Massachusetts Institute of Technology, Cambridge, MA, USA for their contributions to contract theory.
Brief Biography of Oliver Simon D’Arcy Hart
68 years old Oliver Simon D’Arcy Hart is a British-born American economist and the Andrew E. Furer Professor of Economics at Harvard University, where he has taught since 1993. Hart works mainly on contract theory, the theory of the firm, corporate finance, and law and economics. He obtained his PhD degree from Princeton University in 1974 , MA(Economics) from Warwick University in 1972 and B.A. in Mathematics from Cambridge University (King’s College) in 1969. His research centers on the roles that ownership structure and contractual arrangements play in the governance and boundaries of corporations. He has published a book (Firms, Contracts, and Financial Structure, Oxford University Press, 1995) and numerous journal articles. He has used his theoretical work on firms in two legal cases as a government expert (Black and Decker v. U.S.A. and WFC Holdings Corp. (Wells Fargo) v. U.S.A.). He is a Fellow of the Econometric Society, the American Academy of Arts and Sciences, the British Academy, and the American Finance Association, a member of the National Academy of Sciences, and has several honorary degrees. He has been president of the American Law and Economics Association and a vice president of the American Economic Association.
Brief Biography of Bengt Robert Holmström
Bengt Robert Holmström is the Paul A. Samuelson Professor of Economics at Massachusetts Institute of Technology, where he also was head of the Economics Department from 2003-2006. He holds a joint appointment with MIT’s Sloan School of Management. He is an elected fellow of the American Academy of Arts and Sciences, the Econometric Society and the American Finance Association, and an elected foreign member of the Royal Swedish Academy of Sciences and the Finnish Academy of Sciences and Letters. He is a research associate of the National Bureau of Economic Research and a member of the executive committee for the Center of Economic Policy Research. In 2011, he served as President of the Econometric Society. He received his doctoral degree from Stanford University in 1978. He has served as an associate professor at the Kellogg Graduate School of Management at Northwestern University (1979-82) and as the Edwin J. Beinecke Professor of Management at Yale University’s School of Management (1983-94). Holmström is a microeconomic theorist, best known for his research 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.
Contracts and contribution of Hart and Holmström
Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.
Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.
In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.
In the mid-1980s, Oliver Hart made fundamental contri-butions 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? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. 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.
Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.
(Zulfiqar Sheth is a doctoral fellow at the Department of Economics, Aligarh Muslim University, India. Can be reached at email@example.com)