Brush up on contract theory: Nobel brings Harvard, MIT economists’ work into the public sphere
Bengt Holmström of MIT and Oliver Hart of Harvard University were awarded the Nobel Prize in economics Monday for their pioneering work on how to design better contracts, the basic underpinning of most financial transactions.
The two Cambridge professors had toiled in a crucial but esoteric corner of economics until being thrust into the spotlight as shared winners of the prestigious prize.
Their work has touched on everything from executive pay to health insurance deductibles to the use of tax shelters and how to divide up control of a firm when it’s not explicitly written into an agreement.
“Bengt and Oliver’s research has not only helped us to better understand incentives and institutions, it has helped us design better ones,” said James Poterba, president of the National Bureau of Economic Research, a Cambridge nonprofit.
The men will split the $924,000 prize.
While they teach at rival universities, Holmström, 67, and Hart, 68, are friends and past collaborators. Perhaps most important, they are among a small band of economists who have devoted their work to contract theory, which has just begun to gain the same cachet in academic circles as game theory and the study of stock market fluctuations.
“Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions,” the Royal Swedish Academy of Sciences wrote in its Nobel announcement.
The prize validated years of work, Hart said Monday.
“I’m happy to have won it with [Holmström],” he said. “We see ourselves as together kind of trying to advance this field and make it something that economists want to learn about.”
The win marks the 10th economics Nobel prize for Harvard and the fifth for the Massachusetts Institute of Technology.
The British-born Hart, who has taught at Harvard since 1993, focuses on the unanswered questions surrounding contracts: What happens when contracts are incomplete and who makes the decisions and controls a company when duties aren’t laid out in black and white?
“It’s transformational work,” said David Laibson, chairman of the economics department at Harvard. “How we should set up these relationships so they’re socially beneficial — those are subtle and complicated questions, and Oliver has been our guide on these issues for 30 years.”
Holmström, who was born in Helsinki, has devoted much of his work to the study of executive pay and other contracts between employers and employees. His economic models can help companies develop the right incentives to optimize employees’ performance.
“The Nobel Prize typically tries to recognize economic papers that really change the way other economists think about the world,” said Glenn Ellison, head of MIT’s economics department. “I think Bengt’s work really meets that model.”
But their work was little known to those outside of the economics orbit.
Hart said he rarely gets inquiries from the news media or the public to explain his work. In fact, he woke up at 4:40 a.m. Monday wondering whether his window to win the Nobel prize was quickly closing. Minutes later, the phone rang with the Nobel announcement, Hart said.
Soon after, Hart received a text message from Holmström, asking him to call. The messages from colleagues, friends and strangers have kept rolling in since.
“I’m quite an obscure academic,” said Hart, who lives in Lexington with his wife, Rita Goldberg, a lecturer in literature at Harvard. “I’ll be a little less obscure now. Not that the quality of my work is any different. This prize makes a difference.”
Through his work with blurry contracts, Hart has testified in cases against Black & Decker and Wells Fargo, two companies that tried to claim tax deductions after spinning off business lines and claiming those as independent entities. But Hart testified the parent companies still retained decision-making control and couldn’t qualify for the millions in deductions they were seeking.
Angelo Frattarelli, the assistant chief in the Justice Department’s tax division who worked on the cases with Hart, said he remembered showing up at Harvard to assess whether the professor would be tough enough to withstand cross-examination.
At first he was unsure. For starters, Hart’s office was not what he expected.
“I was expecting a dean’s office, but it only had a small window, and he had stacks of articles on his desk, and I had to talk to him between stacks,” Frattarelli said. “He was so nice. He spoke matter-of-factly. But his personality belies his underlying intensity.”
Under intense questioning from the other side, Hart never buckled, Frattarelli said.
Holmström’s work has focused on how to design compensation systems that motivate workers while reducing the impact of luck and chance.
For instance, the use of stock options can unfairly compensate an underperforming executive who happens to cash in during a general rise in the entire stock market. Such plans should instead reward executives who outperform others in their particular industry sector.
Holmström has also studied the problem of multitasking workers who are responsible for several business activities. The way a company pays such workers can distort their performance. If a worker gets extra bonuses for doing well on one of several jobs, he or she could be tempted to neglect the other jobs, thereby lowering overall performance and costing the company money.
Holmström said he has always been drawn to study topics that other researchers have neglected or overlooked. That was the case when he started exploring contract theory.
“Basically, it is always about asking the right questions. If I look at my own strengths, I think it is in asking the questions,” Holmström said. “If the question is stated correctly, there are a hundred people who can solve it. It’s like an exam. But making the exam, or figuring out what questions should go on the exam, is hard.”
On Monday, it wasn’t just Holmström’s quest to expand contract theory that drew praise from his colleagues.
Holmström has “a world-class sense of humor,” MIT President L. Rafael Reif said.
As Holmström stepped to the podium, the new Nobel laureate unfolded a sheet of paper. “I don’t really have any notes,” Holmström said. “This is my shopping list.”