10/12/2016 - Economist and professor Bengt Holmström, who spent four years (1979-1983) on the faculty of the Kellogg School of Management at Northwestern University, is one of two U.S.-based economists to be awarded the 2016 Nobel Prize in Economic Sciences by the Royal Swedish Academy of Sciences (the Academy). Holmström joined Kellogg at a time when economic theory scholars were rarely found among business school faculty, and went on to complete a significant amount of his Nobel Prize-winning work during his time here.
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.” Kellogg's early investment in research that developed and applied these theoretical tools, which was manifested in the hiring of researchers such as Holmström and 2007 Nobel Laureate Roger Myerson, helped catalyze the creation of a field that has had a major impact on how markets and organizations structure incentives.
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 and explores the role of management in structuring incentives within organizations. Another paper cited by the Academy entitled “Managerial Incentive Problems: A Dynamic Perspective” was first published in 1982 and 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 Wall Street Journal called it “telling” that much of Holmström’s early work began when he was a professor at Kellogg.
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. Mark Satterthwaite, A.C. Buehler Professor in Hospital and Heath Services Management, a Professor of Strategy, and a Professor of Managerial Economics at Kellogg, recounted his first memory of meeting Holmström in the winter of 1979. Holmström was interviewing for a junior faculty position in the Managerial Economics and Decision Sciences (MEDS) Department: “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,” Satterthwaite said. Kellogg hired Holmström on the basis of this work, which ultimately became Holmström’s most highly-cited research.
Kellogg faculty also recalled how Holmström’s work has been foundational to coursework at the school and its influence is felt in ongoing research at MEDS and elsewhere at Kellogg.
“Bengt’s contributions are wide-ranging, deep and highly relevant,” said Thomas Hubbard, Elinor and H. Wendell Hobbs Professor of Management Professor of Strategy at Kellogg. “His research provides a framework for understanding not only how incentives in contracts work both in isolation and in the broader context of an organization. For example, it underpins my empirical research on when firms outsource, and is the foundation for what I teach MBA students on this topic. Among Bengt’s many contributions is that he has helped us all understand when and why outsourcing creates economic value and when and why it doesn’t.”
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.