Nobel Prize in Economics 2016: Know how the winners helped design insurance policies, executive pay

Zee Media Bureau

Two US-based academics won the Nobel Economics Prize on Monday for groundbreaking research on contract theory that has helped design insurance policies, executive pay and even prison management.

Oliver Hart, a British-American economist, and Bengt Holmstrom of Finland "have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities," the Nobel jury said.

Their pioneering work has laid "an intellectual foundation" for designing policies and institutions in many areas, "from bankruptcy legislation to political constitutions," it added.

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?`"

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.

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. 

Hart, born in 1948, 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.

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.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.

The literature prize will be announced Thursday, with Philip Roth of the US, Haruki Murakami of Japan, Norwegian playwright Jon Fosse and Syrian poet Adonis mentioned as possible winners.

Know more about the winners

1) Oliver Hart

Oliver Hart, born in 1948, is an economics professor at Harvard University in the United States. He was born in Britain.

Born in Britain, Hart earned his BA in mathematics at King's Callege Cambridge in 1969, hi MA in economics at University of Warwick in 1972, and his PdD in economics at Princeton University in 1974.

Afterwards, he joined Churchill College, Cambridge as fellow and London School of Economics as professor.

He also taught at Massacchusetts Institute of Technology. He serving at Harvard University since 1993.

2) Bengt Holmstrom

Bengt Holmstrom is a professor of economics and management at Massachusetts Institute of Technology.

Born on 18 April 1949, Holmstrom is a Finnish economist who is currently the Paul A. Samuelson Professor of Economics at the Massachusetts Institute of TechnologyHolmström received his B S in mathematics and science from the University of Helsinki, a Master of Science degree in Operations Research from Stanford University in 1975, and his PhD. from the Graduate School of Business at Stanford. He has been on the faculty of M.I.T. since 1994.

Holmström is particularly well known for his work on principal-agent theory.

List of previous winners

2016: Oliver Hart (Britain-US) and Bengt Holmstrom (Finland)

2015: Angus Deaton (Britain-US)

2014: Jean Tirole (France)

2013: Eugene Fama, Lars Peter Hansen and Robert Shiller (US)

2012: Alvin Roth and Lloyd Shapley (US)

2011: Thomas Sargent and Christopher Sims (US)

2010: Peter Diamond and Dale Mortensen (US) and Christopher Pissarides (Cyprus-Britain)

2009: Elinor Ostrom and Oliver Williamson (US)

2008: Paul Krugman (US)

2007: Leonid Hurwicz, Eric Maskin and Roger Myerson (US)

2006: Edmund Phelps (US)

2005: Thomas Schelling (US), Robert J. Aumann (US-Israel)

2004: Finn Kydland (Norway), Edward Prescott (US)

2003: Robert Engle (US), Clive Granger (Britain)

2002: Daniel Kahneman (Israel-US) and Vernon Smith (US)

2001: George Akerlof (US), A. Michael Spence (US), Joseph Stiglitz (US)

2000: James Heckman (US), Daniel McFadden (US)

1999: Robert Mundell (Canada)

1998: Amartya Sen (India)

1997: Robert Merton (US), Myron Scholes (US)

1996: James Mirrlees (Britain), William Vickrey (US)

1995: Robert Lucas Jr (US)

1994: John Harsanyi (US), John Nash (US), Reinhard Selten (Germany)

1993: Robert Fogel (US), Douglass North (US)

1992: Gary Becker (US)

1991: Ronald Coase (Britain)

1990: Harry Markowitz (US), Merton Miller (US), William Sharpe (US)

1989: Trygve Haavelmo (Norway)

1988: Maurice Allais (France)

1987: Robert Solow (US)

1986: James Buchanan (US)

1985: Franco Modigliani (US)

1984: Richard Stone (Britain)

1983: Gerard Debreu (US)

1982: George Stigler (US)

1981: James Tobin (US)

1980: Lawrence Klein (US)

1979: Theodore Schultz (US), Arthur Lewis (Britain)

1978: Herbert Simon (US)

1977: Bertil Ohlin (Sweden), James Meade (Britain)

1976: Milton Friedman (US)

1975: Leonid Kantorovich (Soviet Union), Tjalling Koopmans (US)

1974: Gunnar Myrdal (Sweden), Friedrich von Hayek (Britain)

1973: Vassily Leontief (US)

1972: John Hicks (Britain), Kenneth Arrow (US)

1971: Simon Kuznets (US)

1970: Paul Samuelson (US)

1969: Ragnar Frisch (Norway), Jan Tinbergen (Netherlands)

(With Agency inputs)