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Hart, Holmstrom win Nobel in Economics

Online Desk:
Oliver Hart and Bengt Holmstrom were awarded the Nobel Memorial Prize in Economic Science on Monday
for improving the design of contracts, the deals that bind together employers and their workers, or
companies and their customers.Dr. Hart, a professor at Harvard, and Dr. Holmstrom, a professor at the
Massachusetts Institute of Technology, have sought to determine how contracts can encourage mutually
beneficial behavior.Their work has helped to shape the way companies pay senior executives and when
governments decide to hire private companies to provide public services.
Dr. Holmstrom’s work has focused on employment contracts. Companies would like employees to behave
as if they owned the place: working hard, minding costs but also taking smart risks. Employees, on the
other hand, would like to be paid as much as possible, for as long as possible, while working no harder
than necessary. And performance is difficult to assess.
Dr. Hart’s work has focused on a related issue: Contracts are incomplete instruction manuals. They
cannot specify what should be done in every case. Instead, they must stipulate how decisions should be
made.”His research provides us with theoretical tools for studying questions such as which kinds of
companies should merge, the proper mix of debt and equity financing, and which institutions such as
schools or prisons ought to be privately or publicly owned,” the Royal Swedish Academy of Sciences,
which awarded the prize, said in a news release, referring to Dr. Hart.
Dr. Holmstrom, speaking via an audio connection to a news conference hosted by the academy, said he
had been “very surprised and very happy” to get the news. Asked how his day was going, he said there
was “a sense of things being surreal.”Dr. Hart said he had hugged his wife, roused his son from sleep and
spoken by phone with Dr. Holmstrom, whom he has known for years. Both scholars teach in Cambridge,
Mass.”I woke at about 4:40 and was wondering whether it was getting too late for it to be this year, but
then fortunately the phone rang,” Dr. Hart said.
Dr. Holmstrom’s work, beginning in the late 1970s, presented evidence that companies should tie pay to
the broadest possible evaluation of an employee’s performance.One important implication of his work is
that it makes sense to wait and see how things turn out. That can be done by setting aside a portion of
compensation. If the company benefits, the value of the bonus set aside can be increased. If the company
does not, it can be reduced.Companies have turned increasingly to this kind of deferred compensation,
particularly for senior executives, a trend Dr. Holmstrom noted with satisfaction Monday morning.
He has also found that companies should tie pay to the share price of other firms in the same industry. It
makes little sense to reward an executive for an increase that reflects broader economic factors, or to
punish them for setbacks beyond their control.Much of Dr. Holmstrom’s subsequent work has focused on a
variety of important wrinkles. He noted, for example, that measuring results could cause problems, too, by
encouraging employees to focus on those parts of their jobs. Paying teachers based on test results, for
example, couldlead them to devote less time to teaching other skills. This suggests that employers should
balance fixed pay with performance incentives.
One of Dr. Hart’s most important insights is that the power to make decisions is, in effect, a form of
compensation. His work has shown that it makes sense to give the decision-making power to the parties
whose performance is most difficult for the owners to assess and reward.Investors in a company, for
example, are well served by giving money and control to the executives in exchange for the promise of a
fixed return and the right to seize control if things go badly. This illuminates the underlying logic of most
lending.
“Incomplete-contract theory predicts that entrepreneurs should have the right to make most decisions in
their firms as long as performance is good, but investors should have more decision rights when
performance deteriorates,” the academy said in an explanation of Mr. Hart’s work.

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