Oliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts

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Oliver Hart and Bengt Holmstrom were awarded the Nobel Memorial Prize in Economic Science on Monday for improving the design of contracts, the deals that bind together employers and their workers, or companies and their customers.

Dr. Hart, a professor at Harvard, and Dr. Holmstrom, a professor at the Massachusetts Institute of Technology, have sought to determine how contracts can encourage mutually beneficial behavior.

Their work has helped to shape the way companies pay senior executives and when governments decide to hire private companies to provide public services.

Dr. Holmstrom’s work has focused on employment contracts. Companies would like employees to behave as if they owned the place: working hard, minding costs but also taking smart risks. Employees, on the other hand, would like to be paid as much as possible, for as long as possible, while working no harder than necessary. And performance is difficult to assess.

Dr. Hart’s work has focused on a related issue: Contracts are incomplete instruction manuals. They cannot specify what should be done in every case. Instead, they must sti[CENSORED]te how decisions should be made.

“His research provides us with theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and which institutions such as schools or prisons ought to be privately or publicly owned,” the Royal Swedish Academy of Sciences, which awarded the prize, said in a news release, referring to Dr. Hart.

Dr. Holmstrom, speaking via an audio connection to a news conference hosted by the academy, said he had been “very surprised and very happy” to get the news. Asked how his day was going, he said there was “a sense of things being surreal.”

Dr. Hart said he had hugged his wife, roused his son from sleep and spoken by phone with Dr. Holmstrom, whom he has known for years. Both scholars teach in Cambridge, Mass.

“I woke at about 4:40 and was wondering whether it was getting too late for it to be this year, but then fortunately the phone rang,” Dr. Hart said.

Dr. Holmstrom’s work, beginning in the late 1970s, presented evidence that companies should tie pay to the broadest possible evaluation of an employee’s performance.

One important implication of his work is that it makes sense to wait and see how things turn out. That can be done by setting aside a portion of compensation. If the company benefits, the value of the bonus set aside can be increased. If the company does not, it can be reduced.

Companies have turned increasingly to this kind of deferred compensation, particularly for senior executives, a trend Dr. Holmstrom noted with satisfaction Monday morning.

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He has also found that companies should tie pay to the share price of other firms in the same industry. It makes little sense to reward an executive for an increase that reflects broader economic factors, or to punish them for setbacks beyond their control.

Much of Dr. Holmstrom’s subsequent work has focused on a variety of important wrinkles. He noted, for example, that measuring results could cause problems, too, by encouraging employees to focus on those parts of their jobs. Paying teachers based on test results, for example, couldlead them to devote less time to teaching other skills. This suggests that employers should balance fixed pay with performance incentives.

One of Dr. Hart’s most important insights is that the power to make decisions is, in effect, a form of compensation. His work has shown that it makes sense to give the decision-making power to the parties whose performance is most difficult for the owners to assess and reward.

Investors in a company, for example, are well served by giving money and control to the executives in exchange for the promise of a fixed return and the right to seize control if things go badly. This illuminates the underlying logic of most lending.

“Incomplete-contract theory predicts that entrepreneurs should have the right to make most decisions in their firms as long as performance is good, but investors should have more decision rights when performance deteriorates,” the academy said in an explanation of Mr. Hart’s work.

Who Are the Winners?

Dr. Hart, 68, was born in London. He studied at University College London, Cambridge University and Warwick University, all in England, before receiving his Ph.D. in 1974 from Princeton. He has been a professor of economics at Harvard since 1993.

Dr. Holmstrom, 67, was born in Helsinki, Finland. He received his Ph.D. in 1978 from Stanford and has been a professor of economics and management at M.I.T. since 1994. He previously taught at Northwestern and Yale.

Who else has won a Nobel this year?

■ Yoshinori Ohsumi, a Japanese cell biologist, was awarded the Nobel Prize in Physiology or Medicine on Monday for his discoveries on how cells recycle their content, a process known as autophagy, a Greek term for “self-eating.”

■ David J. Thouless, F. Duncan M. Haldane and J. Michael Kosterlitz shared the Nobel Prize in Physics on Tuesday for their research into the bizarre properties of matter in extreme states.

■ Jean-Pierre Sauvage, J. Fraser Stoddart and Bernard L. Feringa shared the Nobel Prize in Chemistry on Wednesday for development of molecular machines, the world’s smallest mechanical devices.

■ President Juan Manuel Santos of Colombia was awarded the Nobel Peace Prize on Friday for pursuing a deal to end 52 years of conflict with the Revolutionary Armed Forces of Colombia, or FARC, the longest-running war in the Americas.

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COMMENTS
Who won the 2015 Nobel Memorial Prize in Economic Science?

Angus Deaton was awarded last year’s prize for improving the data that shape public policy, including measures of wealth and poverty, savings and consumption, health and happiness.

When will other prizes be announced?

The Nobel Prize in Literature will be announced on Thursday in Sweden. Read about last year’s winner, Svetlana Alexievich.

Correction: October 10, 2016 
Because of an editing error, an earlier version of this article misidentified the professor who said he was “very surprised and very happy” to get the news of the Nobel award. It was Dr. Holmstrom, not “Dr. Holt.” (There is no Dr. Holt among the winners.) Also because of an editing error, the article misidentified the developer of rules for executive pay. It was Dr. Holmstrom, not the other winner, Dr. Hart.