The Nobel Prize for economics has been shared by two economists, each working on separate contract issues, one of them focused entirely on optimising executive pay.
British economist Oliver Hart, of Harvard University, made advances on “incomplete contracts”, but Bengt Holmström’s work in the 1970s addressed incentives for executives and how an employment contract should be designed using what is called the “informativeness principle”.
Holmström’s work was designed to specifically address the issue of agents undertaking work that cannot be observed.
The Nobel organisation said: “Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.”
Larry Elliott, in The Guardian, commented: “The best sort of contract, according to the work pioneered by Holmström, is one that provides the right balance of risk and incentives. It encourages top staff to innovate without being reckless.”
The Economist writes: “His work suggested that performance-based pay should be linked as much as possible to measures of managerial performance (such as the price of a company’s share relative to those of its peers rather than the share price in isolation).
“But the more difficult it is to find good measures of performance, the closer a pay package should get to a simple fixed salary.”
The organisation 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.”