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Education Texas Economy: Let’s make a deal!

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Every year, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (more commonly known as the Nobel Prize in Economics) is awarded to an individual or individuals whose ideas and research have increased our understanding of important issues in economics and related areas. This year’s recipients, Oliver Hart of Harvard University and Bengt Holmstrom of Massachusetts Institute of Technology, were awarded the prize for their contributions to contract theory.

The central bank of Sweden created the Nobel Prize in Economics in 1968, and it is given by the Royal Swedish Academy of Sciences. Selection criteria include the originality of the contribution, its scientific and practical importance, and its impact on scientific progress. The effects of the work on society and public policy may also factor into the process.

Hart and Holmstrom embody these criteria through their research, which has enabled a greater understanding of why certain contracts are effective and provided guidance as to what constitutes an optimal contract. The implications of their research reach fields ranging from economics and business to political science, law, and public policy. One of the greatest freedoms we have is the fact that we can make a deal, formalized as a contract, for just about anything. Contracts govern all areas of our lives, from how much we are paid at our jobs to how insurance coverage is designed. The work performed by Hart and Holmstrom has provided new theoretical tools to better understand how agreements are made and how they can be improved.

Holmstrom’s work has mainly focused on employment contracts. Often an employer and employee face different incentives regarding optimal behavior. While an employer or company would prefer an employee to always use their time in order to maximize company profits, reduce costs, and take justified risks, an employee is essentially incentivized to work only to a level sufficient to maximize income. Any level of work in excess of this baseline provides no additional financial benefits to the employee. To compound these problems, it is sometimes difficult to directly observe the performance of an employee. Therefore, it is often useful to structure a link between performance and pay.

Much of Holmstrom’s research sought to answer questions about how to design optimal incentives for employees. One area where that topic is particularly relevant today is that of the compensation of corporate executives. He has demonstrated that bonuses linked to share price should be linked to comparable firms; otherwise, pay might be given (or withheld) for reasons beyond the control of the executive. He also observed many circumstances in which compensation should be based primarily on a fixed salary rather than on performance.

Another interesting application of Holmstrom’s research concerns teachers’ pay. Many times an employee’s job encompasses multiple tasks, only some of which may be easy to observe. Holmstrom’s research showed that in situations where pay is linked to the tasks that are easy to measure, an employee tends to spend a greater-than-optimal amount of time on these areas to the detriment of others. In particular, when teachers are rewarded based on test scores, they tend to “teach to the test,” which is not the best way to prepare students for life or to benefit society. This topic has received a lot of attention in Texas in recent years.

Hart’s work has focused on incomplete contracts, which involves designing the best basic contract that allows for unknown contingencies. Many times, parties are not able to define detailed contract terms in advance because they cannot accurately anticipate future events. The optimal contract in these instances should specify who has the power to make decisions about unknown future outcomes.

For example, it is most efficient for a manager of a firm to own the firm as well so that unilateral decisions can be made regarding the trade-off between profits and private benefits. In situations where the manager is not able to own the firm and therefore needs outside investors, it is often difficult to predict future profits. Because of this obstacle, it is typical to contract for fixed future payments along with collateral so that if payment is not made, then the investors receive ownership of the assets. This is how most bank loans are structured. Also, many contracts between entrepreneurs and venture capitalists are designed so that the entrepreneur has control when firm performance is good, but control is transferred to the investor if it deteriorates.

One fascinating application of Hart’s work has been his research into whether providers of public services such as schools, hospitals, and prisons should be publically or privately owned. Managers at such institutions are often faced with the decision of whether to make further investments in quality or to reduce costs. While it is sometimes difficult for publically owned institutions to reward any investment, Dr. Hart’s research showed that incentives for cost reductions are usually too strong at privately owned institutions. Hart and his colleagues studied prisons in particular and determined that they should be publically owned, a conclusion that has been supported by a recent U.S. Department of Justice report which demonstrated that conditions at privately owned prisons were worse than those at publically owned prisons.

Both of these researchers have contributed valuable insights into a wide range of topics within contract theory. Their work has enabled us to think more clearly about the incentives resulting from suboptimal contracts and, consequently, has provided guideposts for designing optimal contracts in the future. I would like to extend my congratulations to both Holmstrom and Hart for their contributions to our field.

Dr. M. Ray Perryman is president and CEO of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.

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