this year<u+2019>s nobel prize in economics, the royal swedish academy of sciences announced monday, will go to oliver hart and bengt holmstrom for <u+201c>their contributions to contract theory.<u+201d> mr. hart, born in britain, is a professor at harvard. mr. holmstrom, born in finland, is a professor at mit. to understand their work, start with a pillar of economics that i teach on the first day of class: incentives matter. mr. hart and mr. holmstrom take that principle and run with it, seeking to understand incentives within both individual companies and the larger market structure. implicit in all of their work is the idea that if it<u+2019>s difficult to design optimal incentives within a single firm, it<u+2019>s well-nigh impossible for central planners to do it for the entire economy. it<u+2019>s telling that much of mr. holmstrom<u+2019>s work began when he was a professor at northwestern<u+2019>s kellogg graduate school of management. mr. holmstrom examines how corporate boards should structure managers<u+2019> pay to generate the appropriate incentives. the company<u+2019>s owners, the shareholders, want to maximize the value of the firm, but the manager could have other motives. you might think that the solution is to pay the manager according to the firm<u+2019>s profits. but the bottom line doesn<u+2019>t depend solely on the manager<u+2019>s actions. take the oil business: if a manager<u+2019>s compensation is based on the company<u+2019>s profits, then the pay is great when oil prices rise and lousy when prices fall. he is compensated, or not, for things he can<u+2019>t control. one response to this problem is to pay the manager for his effort<u+2014>if his effort can be observed and if, all else equal, it leads to better results. another way is to pay based on the company<u+2019>s performance relative to comparable firms. so if oil prices drop, the manager would receive higher pay if his company<u+2019>s profits fall by a lower percentage than the industry overall. mr. holmstrom has been an outspoken skeptic about financial regulation. in a 2003 study of corporate governance, mr. holmstrom and co-author steven n. kaplan acknowledged the scandals at enron, worldcom and other companies. but they concluded that the evidence, such as economic growth and american stock-market gains, <u+201c>suggests a system that is well above average.<u+201d> the study noted that the leveraged buyouts of the 1980s were tremendously productive and a mechanism for disciplining managers to focus on increasing value. they wrote that <u+201c>shareholders appear better off with the u.s. system of executive pay than with the systems that prevail in other countries.<u+201d> while not opposing all regulation, they said that <u+201c>the greatest risk now facing the u.s. corporate governance system is the possibility of overregulation.<u+201d> admittedly that was before the financial crisis, but it was also before congress enacted dodd-frank. mr. hart<u+2019>s work focuses on how incomplete information necessarily leads to incomplete contracts<u+2014>and how that should affect the size and scope of firms. no one can know every detail of a business relationship in advance, so it is impossible for a contract to cover every scenario. therefore, it matters who gets to make key decisions after the contract is ratified. imagine an inventor who needs to distribute a new product. success will probably ride more on the inventor<u+2019>s choices than on distribution. so it makes sense for the inventor to have the power to make the big decisions. the way to do that is for the inventor to be what economists call the <u+201c>residual claimant.<u+201d> that is, the inventor has the rights not only to the invention but also to the distribution channels. will the inventor make better decisions about distribution than a seasoned distributor would? probably not. but as mr. hart and co-author sandy grossman put it in a 1986 article , <u+201c>firm 1 [in this case, the inventor] purchases firm 2 [in this case, the distributor] when firm 1<u+2019>s control increases the productivity of its management more than the loss of control decreases the productivity of firm 2<u+2019>s management.<u+201d> or, as george mason university economist tyler cowen summed it up on his blog after the nobel announcement: <u+201c>ownership should thus migrate to those parties who have the greatest ability to improve value.<u+201d> mr. hart, along with andrei shleifer of harvard and robert w. vishny of the university of chicago, applied the thinking about incomplete contracts to prisons in a 1996 paper . many aspects of prison operation cannot be well-specified in advance<u+2014>for example, the quality of guards to hire, or when they may use force. this gives private prisons the leeway, while still meeting the terms of the contract, to cut costs by undertraining guards or treating prisoners harshly. last year, hillary clinton advocated giving companies a tax incentive to share profits with their workers. but if profit-sharing makes sense, firms are likely to come up with optimal contracts on their own. one implication of mr. hart<u+2019>s and mr. holmstrom<u+2019>s work<u+2014>and, indeed, of basic economics<u+2014>is that if employees get to share profits, their wages will fall. that there<u+2019>s no such thing as a free lunch is another important pillar of economic wisdom. mr. henderson is a research fellow with stanford university<u+2019>s hoover institution and an economics professor at the naval postgraduate school.
from corporate pay to private prisons<u+2014>lessons from the nobelists - wsj
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