The magic of incentives

Espen Rasmus Moen

How should managers be rewarded? And who shall own the company? This year's Nobel Prize in Economics provides answers.

FEATURE ARTICLE: Espen R. Moen on economics

The Nobel Prize in Economics for 2016 goes to Oliver Hart and Bengt Holmstrøm.

Prior to 1970, microeconomics was primarily about markets. About supply curves, demand curves, perfect competition, monopoly and oligopoly.

Interesting enough in itself, but with limited relevance for understanding phenomena outside the market - like internal organization of businesses, incentive structures and the importance of ownership. This changed in the early 1970s.

Younger economists became interested in information structures, distribution of information and incentives. A new field within microeconomics emerged, contract theory, with significant catchment within financial economics, strategy and other business economics.

Pioneers in contract theory

This year's Nobel Prize winners are two of the pioneers in contract theory.

Contracts shall ensure that the parties to a transaction keep their promises. In addition, incentives can be built into contracts. Hence contracts can be used to govern behaviour.

In the late 1970s Holmstrøm constructed a framework for analysing how a principal, let's say a business owner, can design a contract with an agent, as the business manager, to safeguard the owner's interests.

Reward is key

The degree of performance-based rewards becomes central. A high degree of performance-based reward, gives strong incentives for the manager to perform, but could lead to an unfortunate distribution of risk between the parties.

Holmstrøm further discussed principles for selecting variables that the agent's salary should depend on, like ensuring that remuneration did not depend on factors beyond the manager's control.

An example is the development of the company's stock price, which is affected by numerous factors outside the manager's control. It is less true for the development of the stock price relative to competitors' price level, and the reward should thus depend on the relative stock price.

Another example is the remuneration of workers. Holmstrøm showed that if an employer must perform many tasks, so-called multitasking, then tasks that are difficult to measure often would be neglected.

Easier to measure quantity than quality

It is often easier to measure quantity than quality, and easier to measure individual performance than cooperation. Furthermore, it is likely to be easier to measure the short-term effects than long-term effects of the work. If quantity, individual performance and short-term results are rewarded, the employees are likely to neglect quality and cooperation.

It can also be shown that if an employee is driven by intrinsic motivation and this is partially displaced by economic incentives, this will weaken the benefits of performance-based pay.

Oliver Hart is best known for his work on incomplete contracts and the importance of ownership. It is often difficult to sign contracts for important aspects of a delivery, for example in relation to quality, because it is difficult to verify the result to a court.

Ownership gives stronger negotiation power

Hart and his co-authors show that property rights are of significance in the vacuum created by incomplete contracts, since ownership is crucial in determining who has control over the critical resources in situations where contracts have no bite. Ownership thus gives an actor a stronger bargaining position in future negotiations.

The example often used is a manufacturer and a subcontractor who must work together to produce a product, and where the value of the product depends on both parties' investments.

In the absence of contracts, both parties are vulnerable, since the other party may seize all or part of the rewards of their investment. Hart shows that the greatest overall value creation is achieved if the party that has the greatest influence on the total investment, also owns the rights to the project, because this party then gets the most return for their investment.

Wide range of application

Harts theories on incomplete contracts and ownership have a wide range of applications. The theory provides an analytical apparatus that can be used to analyse the optimal ownership structures, also when it comes to drawing the line between private and public ownership.

Signatory has also used this theory to analyse whether it may be desirable with private, publicly funded employment services. Harts theories are central to corporate finance and for theories about the financing of entrepreneurs.

I got to know Oliver Hart during my time at the London School of Economics (LSE) and has met Bengt Holmstrøm on several occasions.

Both are exceptionally good mathematical economists, highly innovative and influential and are generous personalities.

The article is published as a feature article in Dagens Næringsliv on 11 October, 2016.

Published 24. October 2016

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