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Nobel Prize-Winning Thoughts On Incentives And The Importance Of Contracts

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Nobel Prize-Winning Thoughts On Incentives And The Importance Of Contracts

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Nobel Prize-Winning Thoughts On Incentives And The Importance Of Contracts

Nobel Prize-Winning Thoughts On Incentives And The Importance Of Contracts

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  • <iframe src="" width="100%" height="290" frameborder="0" scrolling="no" title="NPR embedded audio player">
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Two economists who figured out the underlying patterns to make better contracts won this year's Nobel Prize in economics. Steve Inskeep talks to Bengt Holmstrom of MIT, who was one of the winners.


The Nobel Prize for Economics went to a couple of professors this week. One of them is Harvard's Oliver Hart. The other is MIT's Bengt Holmstrom. They have devoted their lives' work to what's called contract theory - how and why contracts work and how they can be made better.

This is really about incentives. Whether it's a formal written contract or a sort of informal agreement, how do you get an employee or a CEO or really anyone in life to do what you want and not do what you fear? Well, we reached out to the Nobel Laureate Bengt Holmstrom to talk about his work.

This news has caused us to go back and look at some of your academic writings. And we were looking at a dissertation of yours that I think is part of the body of work that led to this Nobel - On Incentives and Control in Organization, Part 1, from 1977. Is that right?


INSKEEP: And we even noticed it's done on a typewriter, not on a computer, it appears, and there's credit given, actually, to a typist. Did you write out in longhand this thing that led to your Nobel?

HOLMSTROM: Yes, I wrote it longhand. And I took a copy of the longhand and left it at Stanford. And that was fortunate because the longhand copy that I took with me was stolen with my car.

INSKEEP: Someone broke into the car?


INSKEEP: I wonder if the person who ended up with that manuscript realized that they had Nobel material in their hands.

HOLMSTROM: Well, I'm sure they did not. I actually did get back the car, and one of the things they had left behind was the dissertation.

INSKEEP: (Laughter). That's great. Well, how did you get interested in contracts?

HOLMSTROM: I've worked for a company in Finland from 1972 to '74, a multinational conglomerate. And I was supposed to go and do models. These were early days in computing. People thought computers can replace a lot of what the human mind is thinking. And I quickly realized that that was not the case. So that's how I got interested in incentives. And it so happened that incentives was also beginning to be of interest to economists. I had no economics training.

INSKEEP: You're reminding us that your work here is not essentially about contracts. It's about that word you're using - incentives. Do people have the incentive to do the right thing or the most profitable thing or something that maybe is a little off to the side of that?

HOLMSTROM: Yeah. How do you influence people's behavior? What do you think is your incentive? Why are you doing what you are doing?

INSKEEP: You mean being a journalist right now?

HOLMSTROM: Yeah, yeah, or how you behave as a journalist.

INSKEEP: Oh, goodness. Well, I - let's think about that. I do get paid. It's a job, but I believe in what I do. I believe in the place that I do it.

HOLMSTROM: Are you getting a fixed pay?

INSKEEP: Yes, I get a fixed pay, and that seems to be valuable because, whatever I report, my pay doesn't change. I think of myself as a citizen, and I'm participating in democracy, and that's a powerful incentive for me to do my job a certain way.

HOLMSTROM: That's an example, so it's a good design.

INSKEEP: Is there another incentive in economic life that strikes you as a little creepier, manipulative?

HOLMSTROM: Lots of things are creepy and manipulative because they are unintended consequences. Look at Wells Fargo. You know, they thought they were designing a good scheme, perhaps, initially. If you raise the number of new accounts we are getting, that's our business model. You get rewarded. And before you knew it, you know - they probably created new account initially - genuine accounts. But then, you know, they ran out of genuine accounts.

INSKEEP: You're reminding us that scandal is all about incentives. People were being paid more for opening new accounts, so they made up accounts.

HOLMSTROM: Absolutely. I have given you a lot of examples already. How am I doing?

INSKEEP: You're doing brilliantly. This has been a great dissertation. Do you feel the business world, broadly, is getting the incentives a little better over time?

HOLMSTROM: No. Part of the reason is they are all the time changing, so they are very clever at exploiting. You can think about tax schemes. It's well known that, when you change taxes, there will be loopholes. You know, Donald Trump is very proud of being able to exploit these loopholes. But for people who designed the tax system, it's frustrating. But that's never - that's the reality.

So every time you change the tax system, you will invariably discover that something happens that you didn't expect. So the tax scheme evolves all the time in response to these various loopholes. And then the world changes, and then the politicians change, and then we get another tax change, and then the cycle starts over again. So in that sense, the system tends never to become smart. You see the same thing with Obamacare.

INSKEEP: Oh, that's also all about incentives, isn't it - trying to get people to take care of themselves in a certain way?

HOLMSTROM: Absolutely.

INSKEEP: I appreciate being reminded that numbers are real, data are real, incentives are real, but you're telling me that all of them interact with human nature with unpredictable consequences.


INSKEEP: Well, there you go. Bengt Holmstrom, thanks very much. I enjoyed talking with you.

HOLMSTROM: Yes. And I, of course, was totally honest all the time, just to make clear.

INSKEEP: (Laughter).

HOLMSTROM: Because I've just gotten a Nobel Prize, and I don't have to worry about anything anymore.

INSKEEP: (Laughter). You no longer have an incentive to bend things, is what you're saying.

HOLMSTROM: Yeah, yeah. Thank you very much.

INSKEEP: The prize he won was the Nobel for Economics.

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