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Bengt Holmstrom, Oliver Hart win Nobel Economics Prize for contract theory

The new theoretical tools created by Hart and Holmstrom are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design, says the academy
Oliver Hart, Bengt Holmstrom

UK-born Oliver Hart and Finland-bon Bengt Holmstrom have won 2016 Nobel Economics prize for their contributions to contract theory, shedding light on how contracts help people deal with conflicting interests, the Royal Swedish Academy of Sciences announced on Monday.

“(Their work) lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions,” the award-giving body said on announcing the 8 million Swedish crown ($928,000) prize.

The Royal Swedish Academy of Sciences said such contractual relationships can deal with anything from CEO bonuses to the deductibles and co-pays for insurance.

“The new theoretical tools created by Hart and Holmstrom are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design,” the academy said.

Both Nobel laureates are economics professors at universities in Cambridge, Massachusetts. The London-born Hart, 68, who is an American citizen, works at Harvard University, while Holmstrom, a 67-year-old Finnish citizen, works at Massachusetts Institute of Technology.

According to reports, Holmstrom has also served on the board of Finnish mobile phone company Nokia.

Speaking to reporters in Stockholm by telephone, Holmstrom said he felt “very lucky” and “grateful.”

In the 1970s, Holmstrom showed how a principal, for example a company’s shareholders, should design an optimal contract for an agent, like the CEO. His “informativeness principle” showed how the contract should link the agent’s pay to information relevant to his or her performance, carefully weighing risks against incentives, the academy said.

Hart made fundamental contributions to a new branch of contract theory in the mid-1980s. The academy said his findings on “incomplete contracts” shed new light on the ownership and control of businesses.

“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 academy added.

“Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions,” read the academy’s press statement.

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