The world of business and finance is strung together by innumerable contracts – formal agreements drawn up between two or more parties to ensure everyone knows what is expected, and benefits to some degree from a deal without being treated unfairly. This is not just the case in obvious business transactions but whenever there is a matter of supply and demand – between employer and employee, for example, or company manager and shareholder.
Understanding the nuances of contract theory has far-reaching consequences at all levels of working life, and it is for their work in this field that Bengt Holmström and Oliver Hart were awarded the 2016 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
In all business dealings there is an element of trust, but is that enough? A handshake or a verbal agreement, as the saying goes, isn’t worth the paper it’s written on, so formal contracts are drawn up, stipulating for example a delivery date, the materials used in a manufacturing process and the fee. Employers issue contracts to employees outlining terms and conditions so the employee knows what is expected of them, but also the limits of what is expected to avoid them being exploited. It is important with all contracts that both parties are encouraged to work for their mutual benefit.
In the late 1970s, Bengt Holmström examined a broad spectrum of cases to identify the incentives at play in order to work out the optimum contractual arrangements. Concentrating on contracts where some of the work is unsupervised or relies on an element of luck, Holmström devised the ‘informativeness principle’ which explained how the contract should link the agent’s pay to performance-relevant information, weighing risks against incentives. He later translated these findings to more general settings, covering performance-related pay, bonuses and potential promotion; covering situations in which agents juggled several tasks or in which some members of a team might be tempted to shirk their responsibilities. His research provides a basis for understanding how incentives in contracts work and helps explain why and when companies outsource work and whether this creates economic value or not.
Oliver Hart later expanded on Holmström’s theories. Between them, they raised contract theory to a field of basic research and have continued their work, exploring many of its applications. Their analysis of optimal contractual arrangements forms the foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions. Holmström’s work in particular has been of benefit in the areas of performance-related pay and for drawing up contracts and policies in the field of insurance.
Bengt Robert Holmström was born in April 1949 in Helsinki, Finland, to a family that was part of a Swedish-speaking minority in the country. He received his BSc in mathematics and science from the University of Helsinki before moving to the US, where he gained his MSc in Operations Research at Stanford University, California, in 1975 and stayed on to receive his PhD at Stanford’s Graduate School of Business in 1978.
From 1979-82 he served as associate professor at the Kellogg Graduate School of Management at Northwestern University, Illinois, before being named Edwin J Beinecke Professor of Management at Yale University’s School of Management (1983-94). In 1994 he joined the faculty at Massachusetts Institute of Technology, where he was head of the Economics Department from 2003-06 and is now the Paul A Samuelson Professor of Economics. He is a fellow of the American Academy of Arts and Sciences, the Econometric Society (serving as its president in 2011) and the American Finance Association, and a 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.
He holds several honorary degrees and was awarded the Banque de France-TSE Senior Prize in Monetary Economics and Finance in 2012, the Stephen A. Ross Prize in Financial Economics and the Chicago Mercantile Exchange – MSRI Prize for Innovative Quantitative Applications in 2013 and the Distinguished CES Fellow award from CESifo, Munich in 2016. He is also a board member of the Aalto University in Finland and a former board member of the Nokia Corporation (1999-2012).
Picture: © Peter Badge/Lindau Nobel Laureate Meetings