The Nobel Prize in Economic Sciences 2016 has been awarded to two professors of economics – Oliver Hart of Harvard University and Bengt Holmström of the Massachusetts Institute of Technology (MIT) – for their contribution to contract theory. Announcing its decision, the Nobel Prize committee stressed the practical aspects of their research: “Modern economies are held together by innumerable contracts. […] 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 committee also mentioned that the laureates’ work gives invaluable insights into “real-life contracts” and their design problems. The committee’s decision has received very positive feedback from economists. For example, Paul Krugman, the laureate of the 2008 Nobel in economics, tweeted: “Hart and Holmstrom so obviously deserving that my first thought was ‘didn’t they have it already?’” Here are some key takeaways from their work:
Pay for performance
Holmström’s research supports the view that a manager’s pay should not be linked to a company’s share price, which is still a common practice despite its limitations. Critics point out that it is not an accurate metric of their performance. In some cases, a company’s share price is increasing because financial markets are rising. Thus a manager should not be given all the credit for their company’s strong position in the stock market. As an alternative, Holmström suggests linking their pay to “the relative performance of their company compared to others in the same sector”. In his opinion, the optimal contract should be based on the informativeness principle: payments should be linked to a company’s share price, which reflects the overall performance outcomes of both parties to a contract, and set in relation to the share price of similar companies. The more difficult it is to determine an individual’s impact on business growth, the less performance-based remuneration should be provided. In such situations, a fixed salary is a better option.
Holmström’s multi-tasking model, developed in cooperation with Paul Milgrom, shows that an employee is more likely to concentrate on compensated – i.e. incentivized – tasks. For example, if a manager’s bonus is tied to short-time earnings, they might avoid long-term investments to secure their current income. They would rather earn more now than at some point in the future. Needless to say, such an attitude hinders business growth. The multi-tasking model also highlights that the relation between performance measurement and remuneration is not always straightforward. There are some tasks which are difficult to measure. If an employee’s salary is tied to performance measures, they tend to focus more on tasks which give tangible results. For instance, if a teacher’s salary is linked to student test scores, they will spend less time teaching skills which are harder to measure such as creativity or critical thinking. Holmström and Milgrom argue that in such cases the best solution is a fixed salary, unconstrained by any performance measures. It would act as a weak incentive to prioritize tasks based on their monetary value, and thus would help balance employee effort across tasks.
Hart’s research has addressed the challenge of contract incompleteness: How to write a contract which would cover all eventualities which cannot be specified in detail? In Hart’s opinion, the best solution is to write down who has decision rights in case contracting parties cannot reach an agreement on some issue. He has found out that this principle works well in financial contracts. For example, one of the best ways to boost employee innovation is to allow a manager to take control over a company as an entrepreneur. In this case, the transfer of decision rights becomes both alternative pay for performance and a work stimulus: the more control the manager has over a company, the more they are motivated to generate profit. They make most of business decisions as long as the company performs well. Once their performance worsens, the decision rights are transferred to investors.
Decision rights often depend on property rights, which give bargaining power when it is difficult to establish or enforce performance-based contract terms. In such cases, careful allocation of decision rights might result in incentives which might substitute some rewards for an outstanding performance. According to Hart’s property rights theory co-authored with Sanford Grossman, a solution creator can fully exercise their bargaining power only when they are an ‘owner-entrepreneur’. They can freely decide with whom to trade, cease unsatisfying cooperation, find new partners, etc. The researchers note that this is “a powerful driver of entrepreneurial incentives”. However, this bargaining power is lost if the solution creator has a fixed-salary employment contract. In this case, their principal holds all the property rights to whatever they create.
Hart has also discussed incomplete contracts in the context of the privatization of public services. According to him, the success of privatization depends on the choice of non-contractible investments. There are 2 main options: (1) to invest in service quality or (2) to reduce operational costs at the expense of service quality. For example, a manager hired to run a state-owned welfare facility will show little interest in improving service quality because the government cannot guarantee a financial reward for their input. In other words, a fixed salary is not a sufficient incentive. By contrast, if the same facility is run by a private contractor, they are more willing to make both types of investment. However, Hart’s joint research with Andrei Shleifer and Robert Vishny points out that in most cases incentives for cost reduction prevail. Private contractors are thus more likely to prioritize efficiency over quality.
References:  Binyamin Appelbaum, The New York Times /  The Royal Swedish Academy of Sciences, The Prize in Economic Sciences 2016: Popular Science Background /  @paulkrugman /  Chris Giles, Financial Times /  The Royal Swedish Academy of Sciences, Oliver Hart and Bengt Holmström: Contract Theory | Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016