Bengt Holmstrom, an influential MIT economist and long-time faculty member, has been named a winner of the 2016 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, for his work on contract theory.
Holmstrom was named co-winner of the prize along with Oliver Hart of Harvard University.
The Royal Swedish Academy of Sciences, in granting the award, notes that contracts “are essential to the functioning of modern societies,” and states that the work of the two economists had been “invaluable in helping us understand real-life contracts and institutions, as well as the potential pitfalls when designing new contracts.”
The Academy’s award cites multiple aspects of Holmstrom’s work on contracts that have contributed significantly to our understanding of the issue, dating to the 1970s.
One of these, the “informativeness principle,” was developed and published by Holmstrom in 1979, addressing the “principal-agent problem” (the structure of contracts between employers and employees). This principle suggests that optimal contracts should structure compensation based on “all outcomes that can potentially provide information about actions that have been taken,” as the Academy observes.
In the case of setting an executive’s compensation, for instance, that means a firm would reward the executive based on not just its own performance but also the performance of other firms in that sector — as way of evaluating not just the actions the executive took but those that he or she could have taken. Holmstrom’s 1979 paper on the subject, “Moral Hazard and Observability,” has been widely cited in the years since.
The Academy also cites a pair of insights about contract structures that Holmstrom developed in the early 1980s. In the 1982 paper “Moral Hazard in Teams,” he concluded that dividing a firm’s income among its workers could lead to a free-rider problem, in which some employees contribute less than others, relative to their compensation. In this case, Holmstrom suggested, outside ownership of firms can produce more flexible compensation and boost individual incentives.
Holmstrom co-authored another 1982 paper, “Managerial Incentive Problems: A Dynamic Perspective,” whose model of career trajectories was highlighted in the Academy’s announcement. As Holmstrom noted in the paper, current salaries do not necessarily neatly match employee performance; instead, firms may reward current performance with higher salaries to prevent employees from switching firms in a competitive labor market. However, these dynamics may not apply as effectively to later-career employees.
The prize announcement also cited an influential Holmstrom paper from 1991, “Multi-Task Principal-Agent Problems: Incentive Contracts, Asset Ownership and Job Design," co-authored with Paul Milgrom, as having “changed how economists think about optimal compensation schemes and job design.” This line of research observes that employees often have many tasks, not all of which are equally simple to measure, and that compensation can be structured to incentivize performance in all tasks, not just the most easily quantifiable.
For example, as the Academy notes, a teacher rewarded only on the basis of student test scores might spend more time than is optimal on test preparation and “too little time teaching equally important (but harder to measure) skills such as creativity and independent thinking. A fixed salary, independent of any performance measures, would lead to a more balanced allocation of effort across tasks.”
Holmstrom, 67, joined the MIT faculty in 1994 and currently serves as the Paul A. Samuelson Professor of Economics.
A native of Finland, Holmstrom received a B.S. in from the University of Helsinki in 1972, in mathematics, physics, theoretical physics, and statistics. He received a master’s of science from Stanford in 1975, in operations research, and earned his PhD in 1978, from Stanford’s Graduate School of Business.
Holmstrom first served as an assistant professor at the Swedish School of Economics and Business Administration, in 1978-79, and then became an assistant professor at Northwestern University. He served on the faculty at Yale University from 1983 until 1994, when he joined MIT, with a joint appointment between the Department of Economics and the MIT Sloan School of Management.
Holmstrom was named the Paul A. Samuelson Professor of Economics in 1997 and served as chair of the Department of Economics from 2003 through 2006.
Oliver Hart served as a professor of economics at MIT from 1985 through 1993.
MIT News will continue to update this story with more information throughout the day.
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