Friday, October 14, 2016

Some Information About This Year's Winners Of The Nobel Prize In Economics

They are Oliver Hart and Bengt Holmström.

For more information about them see  Economics Nobel Rewards Theories Worth Building On by Tyler Cowen writing for Bloomberg New. Here is an excerpt from his article:

"Hart, in a series of papers with co-authors, tried to figure out when one company should buy out the assets of another company. Mergers and acquisitions are common, but when do they maximize business value? Hart was able to figure out how ownership transfers influence earlier decisions to invest in the value of company assets. For instance, if Bayer buys out Monsanto, the incentives for the former managers to add value may go up, and for the latter managers the incentives may go down. The success of the merger may depend on whether the gain here outweighs the loss. In a related paper, Hart helped devise a technical language for analyzing when too many potential veto points in a business deal can block progress.

Hart, again with co-authors, also wrote a seminal paper on when we should prefer government over private-sector ownership. Most of us prefer to eat in private rather than government-owned restaurants because we believe we’ll get lower costs, tastier food, and more innovation. At the same time, private prisons may not be such a great idea. Prison companies will try to cut costs, but the result may be facilities that are insufficiently humane. Sometimes the apparently inefficient bureaucracy does a better job helping to meet social goals.

It's a longstanding question why corporate takeovers don’t do a better job in disciplining bad managers. Hart, with Sanford Grossman, wrote the most influential paper on that question. Say a share is selling for $80 but a corporate raider can make the company worth $100 a share.

Shareholders might resist a bid for $90, hoping to hang on for the ride and get the full $100 in value. Maybe not enough people will sell, and so a value-enhancing takeover doesn’t always happen; a similar logic explains why urban renewal, through “buying out a block,” sometimes fails as well.
Holmström has worked on closely parallel issues of contracts and corporations. Let’s say you are designing a contract for a worker or for that matter a chief executive officer. How much should you reward for perceptions of effort and how much should you reward for some measure of successful outcomes, such as measured profit or the success of that worker’s division? Holmström created the technical language that made systematic progress on these questions possible, and he also showed why you might wish to reward on both bases.

A related question is how much risk you should place on the party you are contracting with. Insurance companies face this problem when they try to calculate an optimal deductible. A higher medical-insurance deductible will reduce the number of unnecessary doctor visits, but also lower the value of the insurance by putting more financial risk on the patient. Holmström showed that there isn’t a rigorous way to get this trade-off just right.

Both economists showed us how hard it is to write truly well-functioning contracts, because solving one incentive problem often creates another. Perhaps most importantly, they created the systematic formal language for demonstrating why this has to be the case.

For another specific example, Holmström analyzed why “career concerns” can induce employees to send off false signals of value rather than doing their jobs properly. In other cases, a worker may shirk so that the boss doesn’t discover how talented she is. Revealing one’s full level of talent sometimes just allows the boss to extract more effort."

See also  Oliver Hart and Bengt Holmstrom Win Nobel in Economics for Work on Contracts by BINYAMIN APPELBAUM of the NY Times. Excerpts:
"Economists since Adam Smith have grappled with the conflicts inherent in the relationship between owners and employees. Dr. Holmstrom’s work, beginning in the late 1970s, presented evidence that companies should tie pay to the broadest possible evaluation of an employee’s performance. In later work, he focused on the benefits of simple contracts that mixed base pay with limited incentives.

Dr. Hart’s work begins from the observation that contracts are incomplete instruction manuals. They cannot specify what to do in every case. Instead, they must stipulate how decisions should be made.
“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 said in a summary of his work."

"One implication of Dr. Holmstrom’s work is that it makes sense to withhold some compensation for a time, to evaluate the results of a manager’s work.

Companies have turned increasingly to this kind of deferred compensation, particularly for senior executives.

But his influence on compensation practices is limited. 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. 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 such advice has not become common practice."

And here is something Tyler Cown wrote on his blog:

"If you are thinking about CEO compensation, you might turn to the work of Holmström,  the Swedes have a good summary of this paper and point:
…an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This informativeness principle does not merely say that payments should depend on outcomes that can be affected by agents. For example, suppose the agent is a manager whose actions influence her own firm’s share price, but not share prices of other firms. Does that mean that the manager’s pay should depend only on her firm’s share price? The answer is no. Since share prices reflect other factors in the economy – outside the manager’s control – simply linking compensation to the firm’s share price will reward the manager for good luck and punish her for bad luck. It is better to link the manager’s pay to her firm’s share price relative to those of other, similar firms (such as those in the same industry).
That is again a result about how incentives and insurance interact.  When do you pay based on perceived effort, and when on the basis of observed outcomes, such as profits or share price?  Holmström has been the number one theorist in helping to address issues of this kind."

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