Nobel prize

What this year’s winners of the Nobel Prize in economics have taught us about contracts and executive pay

By Tina Irgang

On October 10, The Royal Swedish Academy of Sciences announced it was awarding this year’s Nobel Prize in economics to two academics with a long record in researching how to write better contracts and how to reward executives’ performance.

The prize went to Finnish-born Bengt Holmström of MIT and British-born Oliver Hart of Harvard University. “This year’s laureates have developed contract theory, a comprehensive framework for analyzing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatization of public-sector activities,” according to the academy’s announcement.

“Holmström’s work, beginning in the late 1970s, presented evidence that companies should tie pay to the broadest possible evaluation of an employee’s performance,” The New York Times explains. Basically, he pursued the question of what kind of information was relevant in evaluating executive performance and therefore should influence incentive pay.

“He has argued, for example, that companies should tie such evaluations to the stock market performance of their industry rather than focusing solely on the company’s own stock price,” The New York Times notes. “It makes little sense to reward an executive for gains that reflect a broader change in the industry’s fortunes, or to punish executives for setbacks beyond their control.” But, the paper adds, while Holmström’s work has been influential, this particular piece of advice “has not become common practice.”

Another conclusion Holmström has drawn: “In high-risk industries, pay should lean toward a fixed salary, while in more stable sectors, pay should be more biased toward performance rewards.”

How to write a better contract

Hart “has focused his research on the division of power in economic relationships, including in contracts,” according to Bloomberg News. “Hart’s idea is that the very basic contract, since the future is uncertain, must spell out who has the right to decide what to do when the parties can’t agree.”

Hart argues that “contracts are incomplete instruction manuals,” says The New York Times. “They cannot specify what to do in every case. Instead, they must stipulate how decisions should be made.”

Bloomberg notes that Hart’s work is particularly relevant to government contractors: “In the area of defense, for example, there are frequently questions about who will own the intellectual property and technology in the development of a fighter jet or other complex systems.” Those questions often don’t have a clear-cut, upfront answer. Instead, the answer “depends on the specifics of the deal and the investments you need to protect. You have to think about who has property rights over the innovation,” Columbia Business School professor Patrick Bolton told Bloomberg.

So the next time you negotiate pay, think of Holmström and Hart, and remember: Tie incentives only to those things executives (and other employees) can actually control. And when negotiating a contract, don’t get bogged down in accounting for every possible outcome — instead, focus on how future disputes will be settled.

Tina Irgang is the managing editor of SmartCEO magazine and SmartCEO.com. Contact her at tina@smartceo.com.