'Contract theory' earns pair Nobel Economics Prize

Oliver Hart, a British-American economist, and Bengt Holmstrom of Finland have laid "an intellectual foundation" for designing policies and institutions in many areas, "from bankruptcy legislation to political constitutions," the Nobel jury said.

Performance-based pay for top executives, insurance deductibles, and decisions on whether to privatise public-sector activities are other areas where their theories have been applied.

US economist Paul Krugman, the 2008 Nobel economics laureate, hailed their win, tweeting: "Hart and Holmstrom so obviously deserving that my first thought was 'didn't they have it already?'"

Hart, born in 1948 in London, is an economics professor at Harvard University in the United States, while Holmstrom, 67, is a professor of economics and management at Massachusetts Institute of Technology.

The pair will share the eight million kronor (826,000 euros, $924,000) prize.

"My first action was to hug my wife, wake up my younger son ... and I actually spoke to my fellow laureate," Hart told the Nobel Foundation website.

Holmstrom meanwhile told reporters via video link at the Nobel press conference in Stockholm that he was "very surprised, and very happy" to win the prestigious award.

Speaking of Hart, he said: "I'm so glad that I won it with him, he's my closest friend here."

Working both separately and together, Hart and Holmstrom created tools to help determine whether teachers, healthcare workers, and prison guards should receive fixed salaries or performance-based pay, and whether providers of public services, such as schools, hospitals, or prisons, should be publicly or privately owned.

Balancing incentives

Per Stromberg, a member of the Nobel committee, said the duo's work made it possible to balance executives' incentive pay, for example.

It "makes them maybe be more motivated, but how do you avoid bonuses and incentive pay leading to wrong decisions being made in companies?"

Contract theory "is super useful to understand that problem, not just to explain what happens but actually to help shareholders and corporate boards design better contracts as well."

In the example of car insurance, the deductible is the incentive to get carowners to lock their car, which they may otherwise not be inclined to do if they were to be fully compensated for damages.

Holmstrom is known for his research into how contracts and incentives affect corporate behaviour including governance, as well as liquidity problems in financial crises.

A board member at Finnish telecoms company Nokia from 1999 to 2012, Holmstrom was asked by reporters whether executives' bonuses were too big today.

"My theories don't take a stand on that ... My personal view is that (top executives' contracts) are too complicated today," he said, adding: "What improved in latter years is ... that they don't get everything in a very short period, they get things over time."

In the late 1970s, Holmstrom showed how the optimal contract carefully weighs risks against incentives.

In later work, he generalised those results to more realistic settings, such as when employees are not only rewarded with pay, but also with potential promotion, or when individual members of a team can coast on the efforts of others.

Privately or publicly owned?

In the mid-1980s, Hart made fundamental contributions to a new branch of contract theory that deals with so-called 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?" the jury said.

Hart's research has provided 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.

The economics award is the fifth of the six Nobel prizes to be announced this year.

Last week, the awards for medicine, physics, and chemistry were announced, as well as the peace prize, which went to Colombia's President Juan Manuel Santos for his efforts to end a half-century war with the FARC rebels.