Economics Nobel Rewards Theories Worth Building On

Both of this year’s winners have spent a lot of time interacting with the private sector and also with governments. That is what helped them build relatively abstract frameworks that would prove so useful to the further progress of research.

Often the public is not impressed by explanations of why the Nobel Prizes in economics are deserved. The work of 1985 laureate Franco Modigliani included a highly influential life-cycle savings model, and I recall hearing that Professor Modigliani won by pointing out that people need to save for old age.

This year we have two winnersOliver Hart, a British-born economist at Harvard University, and Bengt Holmström, a Finnish-born economist at the Massachusetts Institute of Technology, who are economic theorists and whose papers are difficult to read, even for many professional economists. Nonetheless their work has significantly deepened our understanding of contracts and corporations. They’ve built a technical framework for other researchers to build on, which is much harder to do than to throw off useful insights. So don’t be underwhelmed if some of their work, when conveyed in sound bites, seems like something you heard last week at the water cooler.

Hart, in a series of papers with co-authors, tried to figure out when one company should buy out the assets of another company. Mergers and acquisitions are common, but when do they maximize business value? Hart was able to figure out how ownership transfers influence earlier decisions to invest in the value of company assets. For instance, if Bayer buys out Monsanto, the incentives for the former managers to add value may go up, and for the latter managers the incentives may go down. The success of the merger may depend on whether the gain here outweighs the loss. In a related paper, Hart helped devise a technical language for analyzing when too many potential veto points in a business deal can block progress.

Hart, again with co-authors, also wrote a seminal paper on when we should prefer government over private-sector ownership. Most of us prefer to eat in private rather than government-owned restaurants because we believe we’ll get lower costs, tastier food, and more innovation. At the same time, private prisons may not be such a great idea. Prison companies will try to cut costs, but the result may be facilities that are insufficiently humane. Sometimes the apparently inefficient bureaucracy does a better job helping to meet social goals.

It's a longstanding question why corporate takeovers don’t do a better job in disciplining bad managers. Hart, with Sanford Grossman, wrote the most influential paper on that question. Say a share is selling for $80 but a corporate raider can make the company worth $100 a share. Shareholders might resist a bid for $90, hoping to hang on for the ride and get the full $100 in value. Maybe not enough people will sell, and so a value-enhancing takeover doesn’t always happen; a similar logic explains why urban renewal, through “buying out a block,” sometimes fails as well.

Holmström has worked on closely parallel issues of contracts and corporations. Let’s say you are designing a contract for a worker or for that matter a chief executive officer. How much should you reward for perceptions of effort and how much should you reward for some measure of successful outcomes, such as measured profit or the success of that worker’s division? Holmström created the technical language that made systematic progress on these questions possible, and he also showed why you might wish to reward on both bases.

A related question is how much risk you should place on the party you are contracting with. Insurance companies face this problem when they try to calculate an optimal deductible. A higher medical-insurance deductible will reduce the number of unnecessary doctor visits, but also lower the value of the insurance by putting more financial risk on the patient. Holmström showed that there isn’t a rigorous way to get this trade-off just right.

Both economists showed us how hard it is to write truly well-functioning contracts, because solving one incentive problem often creates another. Perhaps most importantly, they created the systematic formal language for demonstrating why this has to be the case.

For another specific example, Holmström analyzed why “career concerns” can induce employees to send off false signals of value rather than doing their jobs properly. In other cases, a worker may shirk so that the boss doesn’t discover how talented she is. Revealing one’s full level of talent sometimes just allows the boss to extract more effort.

Holmström also has shown why financial crises so frequently revolve around debt, when banks provide enough liquidity or might require government liquidity assistance, and exactly how and why more liquid financial assets may offer lower upfront returns. His 1990s analysis of the Nordic financial crisis of that time proved to be prophetic for later problems in the U.S. and elsewhere.

Both of this year’s winners have spent a lot of time interacting with the private sector and also with governments. That is what helped them build relatively abstract frameworks that would prove so useful to the further progress of research. If that isn’t always so obvious at first glance, well, that is in part why not everyone wins a Nobel Prize.