Hard bargains

ECONOMICS can seem a rather bloodless science. In its simplest models, prices elegantly balance supply and demand, magically directing individuals’ pursuit of their own self-interest towards the greater good. In the real world, humans often undermine the greater good by grabbing whatever goodies their position allows them. The best economic theorising grapples with this reality, and brings us closer to understanding the role of power relationships in human interactions. This year’s Nobel prize for economic sciences—awarded to Oliver Hart and Bengt Holmström—celebrates their study of economic power, and the tricky business of harnessing it to useful economic ends.

Behind the dull-sounding “contract theory” for which the two were recognised lies an important truth: that when people want to work together, individual self-interest must be kept under control. For a chef and a restaurant-owner to work together productively, for example, the owner must promise not to use the power he has to change the locks in order to deny the chef his share of future profit. Mr Hart, a British economist working at Harvard University, tackled power dynamics while seeking to explain the existence of firms—a question which has troubled economists since the work of the late Ronald Coase, another Nobelist, starting in the 1930s. Firms provide some advantage over dealing with others through exchanges of cash for services in the open market, but economists have struggled to pinpoint what that advantage is.

The difficulty in writing contracts that cover all future situations seems to be crucial. Agreeing beforehand how any hypothetical future windfall or loss ought to be shared can be impossible. Yet the uncertainty of working without such a complete contract could be big enough to prevent potentially profitable partnerships from forming. In work with Sanford Grossman, (an economist who might plausibly have shared the prize), Mr Hart reasoned that firms solve this problem by clever use of the bargaining power bestowed by the ownership and control of key assets, such as machines or intellectual property. Instead of fussing over how to divide up the spoils in every possible future, in other words, workers agree to sell their labour to a firm that owns the machinery or technology they use, in the knowledge that ownership gives the firm the power to hoover up a disproportionate share of the profits.

This power comes with costs as well as benefits, which help shape how big companies become and exactly what they do. In other work, Mr Hart noted that workers and managers who look after equipment can make decisions to improve its productivity (like maintaining the machinery and investing in training). But just how much time and energy they spend on such efforts depends on what share of future profits they can expect. A publisher might buy a printing company in order to have more control over its assets, and ensure its presses are used to print its own books first. Yet if the takeover means that the workers tending the presses see smaller rewards for their efforts, and their managers cannot keep tabs on them, they might shirk the extra sorts of work that keep the presses running as productively as possible. So the theory has real-world relevance; Mr Hart used it to explain precisely why inmates may fare worse at privately run prisons than at public ones. Managers of both care about the bottom line, but the incentive to cut costs is sharper in private prisons, because the profits flow into the pockets of owners who benefit directly.

The work of Mr Holmström, a Finnish economist at the Massachusetts Institute of Technology, centres on the behaviour of individuals rather than organisations. Many of the basic power dynamics in society boil down to the relationship between one person—a principal—who needs another—an agent—to do something for him. The principal can use contracts to shape the incentives facing the agent, the better to get him to direct his activities. Yet getting the incentives just right is no easy feat.

A firm owner setting pay for a senior manager wants to get his employee to deliver the best possible results. Linking a bonus to performance—to profits, for example—would seem to be the order of the day. Yet profits rise and fall for reasons which have nothing to do with managerial effort, such as the health of the economy. Bonus payments that mostly reward this sort of noise actually dull the incentives facing the manager. Better to base contracts only on information (like profits relative to the industry average) which sheds light on the manager’s true performance.

The small print

Yet surprisingly often, firms opt not to structure pay in this way. Mr Holmström’s work describes why that might be so. Most jobs are made up of many different tasks, for instance, some of which are easier to assess than others. Bonuses linked to the easily measured stuff, like profits, encourage agents to spend more time boosting those measures, at the expense of other, harder-to-measure things that are nonetheless important, like brand reputation or product quality. In some cases, firms might therefore opt to pay fixed salaries, or to separate roles into those specialising in the easy-to-assess tasks, who can be offered high-powered incentive pay, and others paid fixed rates for woollier sorts of work. Throughout his career, Mr Holmström has worked out how the ways contracts can and cannot be made to manipulate others determine the structure of jobs, firms and even industries.

Like many of the most deserving laureates, Mr Hart and Mr Holmström opened whole new lines of inquiry to later economists (indeed, the winner of the prize in 2014, Jean Tirole, did important work in response to their contributions). The Nobel committee should be applauded for rewarding economists who place power dynamics front and centre. Economic life is messy, but it is also, occasionally, comprehensible.

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