Former Northwestern Economics Professor Bengt Holmström Wins Nobel Prize

Seminal Work in Contract Theory Dates to His Time at Kellogg
5 minute read

Patricia Crisafulli

Economist and professor Bengt Holmström, who spent five years (1979-1983) at the Kellogg School of Management at Northwestern University, is one of two U.S.-based economists to be awarded the 2016 Sveriges Riksbank Prize in Economic Sciences by the Royal Swedish Academy of Sciences.

Holmström, who is currently a professor of economics and management at the Massachusetts Institute of Technology and the Sloan School of Management, shares the Nobel Prize in economics with Oliver Hart of Harvard University for their work on contract theory. Their work provides 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,” the academy said.

“Modern economies are held together by innumerable contracts,” the academy added in its announcement. “The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.”

In awarding the 8 million Swedish kronor ($924,000) Nobel Prize for economics, the academy cited Holmström’s “seminal paper” entitled “Moral Hazard in Teams,” which was published in the Bell Journal of Economics in autumn 1982. At this time, Holmström was an associate professor of managerial economics in the Managerial Economics and Decision Sciences (MEDS) Department at what was then known as the J.L. Kellogg Graduate School of Management. “Moral Hazard in Teams” is Holmström’s third most-cited paper, receiving more than 5,000 citations. The Wall Street Journal called it “telling” that much of Holmström’s early work began when he was a professor at Kellogg.

A second paper, also authored by Holmström during his time at Kellogg, was “Managerial Incentive Problems: A Dynamic Perspective,” which was first published in 1982. This article, which is also widely cited, examined what happens when an employee’s salary does not explicitly depend on performance, but rather is motivated due to concerns about his career and future salary.

The Economist saluted Holmström’s work, stating that it “applied a deeper analysis to the issue of performance pay, where hard work cannot always be observed properly. His work suggested that performance-based pay should be linked as much as possible to measures of managerial performance (such as the price of a company’s share relative to those of its peers rather than the share price in isolation). But the more difficult it is to find good measures of performance, the closer a pay package should get to a simple fixed salary.”

Holmström’s former Northwestern colleagues recall the economist’s early breakthrough work—as well as Northwestern’s foresight in bringing him on board at MEDS. At the time, not many business schools were hiring economists engaged in sophisticated economic theory research. Holmström, in fact, was one of two young hires into MEDS, the other being Roger Myerson, who was one of three Nobel laureates in economics in 2007. The 2010 Nobel laureate in economics Dale Mortensen was also a long-time Professor of Economics at Northwestern.

Kellogg faculty also recalled how Holmström’s and Hart’s work has been foundational to coursework at the school, for example in organizational strategy and business strategy. In addition, their influence is felt in ongoing research at MEDS, such as that conducted by Professors Tom Hubbard and Niko Matouschek. Holmström’s work, in particular, is also credited as the basis for organizational economics within Kellogg’s Strategy Department.

“Bengt’s contributions are wide-ranging, deep, and highly relevant,” said Hubbard. “For example, Bengt’s research provides a framework for understanding not only how incentives in contracts work both in isolation and in the broader context of an organization. It underpins my empirical research on when firms outsource, and is the foundation for what I teach MBA students on this topic. Bengt has helped us all understand when and why outsourcing creates economic value and when and why it doesn’t.”

Mark Satterthwaite, a Professor of Strategy and Managerial Economics at Kellogg, recalled his first memory of meeting Holmström in the winter of 1979, when Holmström was interviewing for a junior faculty position in MEDS: “In the seminar he presented, with clarity and touches of sly humor, his paper, ‘Moral Hazard and Observability,’ [published in spring 1979]. The Nobel committee cites it as establishing the foundation of principal-agent theory. I think all of us present immediately recognized the importance of his contribution, and Bengt’s truly unusual talent and insight.”

Both Holmström and Hart are known for extensive writings on banking, financial markets and liquidity. Holmström is also the co-author of Inside and Outside Liquidity with Jean Tirole, who won the Nobel Prize in economics in 2014.