Bengt Holmström, an influential MIT economist and long-time faculty member, has been named a winner of the 2016 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, for his work on contract theory.
Holmström was named co-winner of the prize along with Oliver Hart of Harvard University.
Holmström said he was “surprised and honored” to be a recipient, in a conversation with MIT News after he was notified about the award.
“I am very lucky,” Holmström stated, adding that significant credit for his honor should go to his own mentors and colleagues. Holmström also said it was “wonderful to share the award” with Hart and credited MIT for providing a professional and intellectual home for over two decades.
“MIT is a wonderful place,” Holmström said, noting that he was “very glad” to represent the Institute as a Nobel winner. Holmström holds a joint appointment between the Department of Economics and the MIT Sloan School of Management.
“MIT’s latest Nobel laureate is not only an extraordinary economic thinker,” said MIT President L. Rafael Reif while introducing Holmström at an on-campus press conference on Monday morning. “Bengt Holmström is also an outstanding citizen of MIT and a delightful human being.”
Reif added that Holmström is “disarmingly honest, decent, forthcoming, objective, collaborative, [and] open-minded,” and equipped with a “world-class sense of humor.”
“Invaluable” work on “essential” subject
The Royal Swedish Academy of Sciences, in granting the award, notes that contracts “are essential to the functioning of modern societies,” and states that the work of the two economists had been “invaluable in helping us understand real-life contracts and institutions, as well as the potential pitfalls when designing new contracts.”
The Academy’s award cites multiple aspects of Holmström’s work on contracts that have contributed significantly to our understanding of the issue, dating to the 1970s.
One of these, the “informativeness principle,” was developed and published by Holmström in 1979, addressing the “principal-agent problem” (the structure of contracts between employers and employees). This principle suggests that optimal contracts should structure compensation based on “all outcomes that can potentially provide information about actions that have been taken,” as the Academy observes.
In the case of setting an executive’s compensation, for instance, that means a firm would reward the executive based on not just its own performance but also the performance of other firms in that sector — as way of evaluating not just the actions the executive took but those that he or she could have taken. Holmström’s 1979 paper on the subject, “Moral Hazard and Observability,” has been widely cited in the years since.
The Academy also cites a pair of insights about contract structures that Holmström developed in the early 1980s. In the 1982 paper “Moral Hazard in Teams,” he concluded that dividing a firm’s income among its workers could lead to a free-rider problem, in which some employees contribute less than others, relative to their compensation. In this case, Holmström suggested, outside ownership of firms can produce more flexible compensation and boost individual incentives.
Holmström co-authored another 1982 paper, “Managerial Incentive Problems: A Dynamic Perspective,” whose model of career trajectories was highlighted in the Academy’s announcement. As Holmström noted in the paper, current salaries do not necessarily neatly match employee performance; instead, firms may reward current performance with higher salaries to prevent employees from switching firms in a competitive labor market. However, these dynamics may not apply as effectively to later-career employees.
The prize announcement also cited an influential Holmström paper from 1991, “Multi-Task Principal-Agent Problems: Incentive Contracts, Asset Ownership and Job Design," co-authored with Paul Milgrom, as having “changed how economists think about optimal compensation schemes and job design.” This line of research observes that employees often have many tasks, not all of which are equally simple to measure, and that compensation can be structured to incentivize performance in all tasks, not just the most easily quantifiable.
For example, as the Academy notes, a teacher rewarded only on the basis of student test scores might spend more time than is optimal on test preparation and “too little time teaching equally important (but harder to measure) skills such as creativity and independent thinking. A fixed salary, independent of any performance measures, would lead to a more balanced allocation of effort across tasks.”
Speaking to reporters after his press conference, Holmström said he was gratified by the way that contract theory had become integrated into mainstream economics in recent decades.
“Contract analysis is now everywhere,” Holmström said.
At the press conference, Holmström was asked multiple questions about the ways his theoretical analysis could be applied to contemporary business practices and business contracts, from executive compensation to the level of pay for workers overall.
While specific corporate cases vary, Holmström observed that a famously failed company such as Enron had misaligned incentives allowing executives to cash out, which he regarded as misguided — and said he hoped the academic research could further inform the corporate world.
“I wish they would listen a little bit more to what we know and understand,” Holmström said.
On worker compensation generally, Holmström noted that it was hard to judge whether incomes were always at appropriate levels given the many factors involved, but said that he found stagnant incomes generally to be “a worrisome development as far as I’m concerned.”
In good company
Holmström, 67, joined the MIT faculty in 1994 and currently serves as the Paul A. Samuelson Professor of Economics. He is the fifth person to win the Nobel Prize in economic sciences while serving as a member of the MIT faculty, following Paul A. Samuelson (1970), Franco Modigliani (1985), Robert M. Solow (1987), and Peter Diamond (2010). Additionally, 10 MIT alumni and seven former MIT faculty have won the Nobel Prize in economic sciences.
Holmström’s MIT colleagues praised his accomplishments and contributions to the Institute.
“It's been tremendous to have been Bengt's friend and colleague for the past 22 years,” said Glenn Ellison, the Gregory K. Palm (1970) Professor of Economics at MIT and current head of MIT’s Department of Economics. “He is a remarkable economist. And he has also been a remarkable contributor to the department in so many other ways: He was a dedicated department head; he taught innovative graduate and undergraduate classes; he worked with a number of our top Ph.D. students; he cared greatly about his undergraduate advisees. The prize could not be more deserved and our department could not be happier for Bengt.”
Melissa Nobles, the Kenan Sahin Dean of MIT's School of Humanities, Arts, and Social Sciences, said that MIT was "very proud to celebrate Bengt Holmström’s pioneering economics research today. Bengt’s foundational research in contract theory, which has provided practical tools for many areas of modern society, represents MIT’s profound commitment to basic research that can generate new and deep understandings of the human complexities — the political, cultural, and economic realities that shape our existence. Bengt has been a much-admired member of MIT’s School of Humanities, Arts, and Social Sciences since 1994, and on behalf of the entire school community, I want to wish him — and his co-winner, Oliver Hart, of Harvard — our warmest congratulations."
David C. Schmittlein, the John C Head III Dean of MIT Sloan, added that Holmström’s research "holds real insights for business leaders everywhere, in every industry. He continues a long tradition of inventive economic thinking at MIT, and his ideas remain central to how we think about contracts and employee incentives. I know the faculty at MIT Sloan joins me in congratulating Professor Holmström and Professor Hart on this signature achievement.”
Beyond his work on contract theory, Holmström has published extensive research on corporate governance, and on liquidity in markets. On the latter topic, he has collaborated extensively with Jean Tirole, a former MIT faculty member and long-time visiting MIT faculty member, who was the 2014 Nobel laureate in economics. In addition to several papers on the subject, Holmström and Tirole co-authored a book, “Inside and Outside Liquidity,” published by the MIT Press in 2011.
A native of Finland, Holmström received a B.S. in from the University of Helsinki in 1972, in mathematics, physics, theoretical physics, and statistics. He received a master’s of science from Stanford in 1975, in operations research, and earned his PhD in 1978, from Stanford’s Graduate School of Business.
Holmström first served as an assistant professor at the Swedish School of Economics and Business Administration, in 1978-79, and then became an assistant professor at Northwestern University. He served on the faculty at Yale University from 1983 until 1994, when he joined MIT.
Holmström was named the Paul A. Samuelson Professor of Economics in 1997 and served as chair of the Department of Economics from 2003 through 2006.
“I think there is something really exciting cooking in economics at MIT,” Holmström said at his press conference.
Prior to his Nobel award, Holmström had already received a long series of academic honors. He was elected a fellow of the American Academy of Arts and Sciences in 1993. He is a member of the Econometric Society and the American Finance Association. Holmström is also an elected foreign member of the Royal Swedish Academy of Sciences and a member of the Finnish Academy of Sciences and Letters. He is a research associate of the National Bureau of Economic Research, based in Cambridge, Massachusetts, and has given invited lectures in several countries.
Oliver Hart served as a professor of economics at MIT from 1985 through 1993.
Holmström and Hart spoke to each other briefly after winning the Nobel on Monday morning. At his press conference, Holmström was asked what he had said to Hart, and produced a one-word answer: “Congratulations.”
All told, there have been 87 MIT-connected winners of the Nobel Prize.