Monday, October 10, 2016

Oliver Hart and Bengt Holmstrom win the Nobel Prize

A vast body of research has focused on identifying the costs, be they material, social or psychological, which would deter would-be tax evaders, and counter the lure of the benefits of evasion ... The regulation literature can be read as a battleground between those who believe in deterrence versus other compliance approbetas between punishment and persuasion. In some areas the evidence is that deterrence works, at least to some degree (for example, occupational health and safety. In other domains, such as nuclear safety, there is evidence that a shift away from a rule enforcement approach toward a more communitarian style of self-regulation has improved compliance. In other domains still, it is not even clear whether the effect of increased deterrence is positive or negative Evolution of Compliance Strategies  

The development of information technology and information sharing via the Internet has resulted in a tendency by organisations to seek cost savings by outsourcing services previously performed within the organisation. The aim of this paper includes establishing to what extent outsourcing is occurring within accounting firms and to identity issues arising from outsourcing accounting services, including the outsourcing of income tax returns and client confidentiality OUTSOURCING INCOME TAX RETURNS: CONVENIENT AND/OR CONTROVERSIAL 

These are theory choices in Industrial Organization, two very famous, well-deserving economists at the top of the field.  They focused on “theory of the firm,” internal organization, incentives,, and principal-agent problems.  The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016 was awarded jointly to Oliver Hart and Bengt Holmström "for their contributions to contract theory"

STOCKHOLM—Two U.S-based economists won the Nobel Prize in Economic Sciences on Monday for their contributions to the understanding of contract design, including an analysis of issues such as the use of performance-based pay for top executives.
The Royal Swedish Academy of Sciences recognized U.K.-born Oliver Hart  and Finland-born Bengt Holmstrom for work on what is called contract theory, a comprehensive framework for analyzing many diverse issues in contractual design.
“Modern economies are held together by innumerable contracts,” the academy said. “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,” it said.

The winners will split an 8 million Swedish kronor ($924,000) award funded by the Swedish central bank. 

We get what we pay for indeed ... Being a tax dodger doesn’t mean you’re smart Newsweek ...
Neil H. Buchanan is an economist and legal scholar, a professor of law at George Washington University and a senior fellow at theTaxation Law and Policy Research Institute at Monash University in Melbourne, Australia. He teaches tax law, tax policy, contracts and law and economics. His research addresses the long-term tax and spending patterns of the federal government, focusing on budget deficits, the national debt, health care costs and Social Security. 
You get what you pay for via Marginal Revolution: Here is Bengt Holmström’s home page, which includes a CV, short biography, and links to research papers.  He has taught for a long time at MIT, was born in Finland, and is one of the most famous and influential economists in the field of contracts and industrial organization.  Here is the Swedish summary.
One key question he has considered is when incentives should be high-powered or when they should be more blunt.  It is now well known that you get what you pay for.
His most famous paper is his 1979 “Moral Hazard and Observability.”  What are the optimal sharing rules when the principal can observe outcomes but not efforts or inputs?  And how might those sharing rules lead to a less than optimal result?  This is probably the most elegant and most influential statement of how direct incentives and insurance value in a contract can conflict and hinder efficiency.  A simple example — what about deductibles in a health insurance contract?  Yes, they do encourage the customer to internalize the value of staying in better health.  But they also limit the insurance value of a contract.  That a first best will not be created in this situation was part of what Holmstrom showed, and he showed it in a very tractable way.
If you are thinking about CEO compensation, you might turn to the work of Holmström, specifically with Steve Shavell.  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.
“Moral Hazard in Teas,”1982, is a very famous and influential paper, here is the working paper version.  Holmström showed that the optimal incentive scheme has to consider time consistency.  Sometimes good incentive schemes impose penalties on the workers/agents to get them to work harder.  But let’s say you had a worker-owned and worker-run firm.  If the workers fail, will the workers/owner impose punishments on themselves?  Maybe not.  Thus in a fairly general class of situations you need an outside residual claimant to impose and receive the penalty.  This is Holmström trying to justify one feature of the capitalist system against socialists and Marxists.
Managerial Incentive Problems: A Dynamic Perspective” is another goodie, this one from 1999.  The key point is that repeated interactions, for instance with a manager, can make incentive problems worse rather than better.  The more the shareholders monitor a manager, for instance, and the more that is over a longer period of time, perhaps the manager has a greater incentive to manipulate signals of value.  When are career incentives beneficial or harmful?  This paper is the starting point in thinking through this problem.  Here is one of the possible traps: if a worker fully reveals his or her quality to the boss, the boss will use that information to capture more surplus from the worker.  So many workers don’t let on just how talented they are, so they can slack more, rather than being caught up in the dragnet of a ‘super-efficient” incentives scheme.  I have long found this to be a very important paper, it is probably my favorite by Holmström. Holmström and Hart together have a very nice piece surveying the theory of contracts and theories of the firm
Here is Hart’s most famous piece, with Sandy Grossman, 1986, “The Costs and Benefits of Ownership.”  Think of it as an extension of Ronald Coase and Oliver Williamson, also two Nobel Laureates (hey, that’s a lot of prizes for one topic area…)
Why does one party ever purchase residual rights in the assets of another party?  Say for instance there is a factory firm and a coal mining firm.  The coal can be treated in a particular way to be more suitable for use in the factory.  If the factory firm buys out the coal mining company, the incentives for coal treatment differ, that is the key insight behind this model.  You can think of this as a very important modification of the Coase Theorem.  It does matter who owns the asset.  Why?  If the coal mining company owns the coal, it has one set of incentives to make ex ante improvements in the values of those assets; if the factory firm owns the coal mine, it has another set of incentives.  Part of the work in this paper is done by a bargaining axiom — if you own an asset outright, you keep a greater share of the proceeds from improving the value of that asset.
This is a very tricky paper to master.  It has all kinds of assumptions built in about ownership, control, and residual claimancy, which do not move together in simple ways.  Eventually Hart (working with others, and work from Holmstrom as well) cleaned up the assumptions and produced a more transparent model of this process.  This paper is a — I should say the —  starting point for thinking about mergers, vertical integration, and other questions of corporate ownership and contract and control.  Bengt Holmstrom of all people wrote a very nice appreciation of the paper.
What about Grossman, I hear you wondering?  I would have guessed he would have shared in the Prize, as he has other seminal papers about information.  On the bright side for him, he has made hundreds of millions of dollars running a hedge fund.
Hart is a true gentleman and he has a very nice British accent.  He is very highly respected by his peers.  Here is his Wikipedia page.  Here ishis home page, he is now at Harvard but spent part of his career at MIT.  Here is his vita.  Here is Hart on Google Scholar.  Here is the Nobel survey essay from Sweden.
His second best known piece is “Property Rights and the Nature of the Firm,” with John Moore, 1990.  This is again a model and series of parables about ownership and the allocation of rights, but with some twists on the earlier Grossman and Hart piece.  The key point is to not allow inessential agents to achieve blocking power of value creation.  The authors tell a story about a venture with a tycoon, a boat owner, and a chef, all of whom might organize a voyage together.  The tycoon and the boat owner are essential, so one of them should own the boat, and then they can split most of the surplus from the voyage and pay the chef his or her marginal product.  Value creation then proceeds.  Alternatively, if the chef owns the boat, the surplus has to be split three ways and that results in some loss of value, due to a tougher bargaining problem, higher transactions costs, and a chance there won’t be enough surplus to cover the most significant investments.  Parties who create a lot of value should own things is the central message here, and this is another key paper for thinking about contracts, ownership, and what kind of business arrangements induce investment in idiosyncratic assets, yet another follow-up on the work of previous Laureates Coase and also Oliver Williamson.
In case you hadn’t figured it out by now, Oliver Hart is basically a theorist in his major lines of research.
Another famous paper by Grossman and Hart is “Takeover Bids, the Free Rider Problem, and the Theory of the Corporation.”  One of Alex’s most interesting papers is an extension of this work, so I suspect he’ll be covering it in detail (wake up, Alex, the Swedes were early this year!).  In a nutshell, this model helps explain why a lot of value-maximizing takeover don’t happen, or why it is hard to buy up a whole city block and renovate it.  Let’s for instance a corporation currently is valued at $80 a share, and a raider has a good plan to make the company worth $100 a share.  The raider then  comes along and offers you, a shareholder, $90 for each of your shares.  Will you sell?  Well, it depends what you think the other shareholders will do.  But you might not sell, instead seeking to hold on for the ride.  If others sell, you can get $100 in value instead of $90.  But if everyone feels this way, then no one sells and the bid fails.  Then you might sell at $90 after all, but then no one will sell after all…and so on.  A tough problem, but this is a very important piece in understanding the limitations of various kinds of takeovers.  Right now my security device won’t let me link to the paper but try googling the title.
Hart’s 1983 paper with Sandy Grossman was at the time a breakthrough and highly rigorous means of modeling the principal-agent problem.  It is in Econometrica and quite hard for many people to read.  Economists had been modeling principal-agent problems through the notion of a participation constraint.  Have the contract give incentives, subject to the proviso that it is still worthwhile for the agents to be involved in the trades.  But Mirrlees had pointed out this can give misleading results when there is not automatically a unique solution to the problem at hand..  Grossman and Hart reconceptualized the math, and the conceptual apparatus, into a convex programming problem.  Theorists love the paper, and it was highly influential when it came out.
Here is Hart and Moore on incomplete contracts and renegotiation.  This paper is connected to the Nobel Prize for Jean Tirole two years ago.  How can you write a contract so a) parties will make the appropriate relationship-specific investments, and b) it doesn’t have to be renegotiated all of the time?  Again, Hart’s work is obssessed with this idea of value maximization within corporate endeavors and possible obstacles to such value maximization.
By the way, here is Hart, with Shleifer and Vishny, on why the private sector probably should not be allowed to own and run prisons.  The incentive to cut costs is too strong!  Government ownership will instead, in their view, create more value maximization because the government won’t have the same profit incentive to skimp on quality along various margins.  This paper has been highly influential in recent debates over private ownership of prisons, which recently was countermanded at the federal level at least.  You also probably wouldn’t want Air Force One owned by the private sector, though you do want it to be designed and produced by the private sector.  This paper helped produce a framework for understanding the reasons why.

A message to blockchainers from the Nobel committee

It seems appropriate that in the current hysterical blockchain climate — a climate epitomized by the notion that everyone from bankers and lawyers will soon be dis-intermediated because of smart-contracts on blockchains — the Royal Swedish Academy of Sciences has awarded its latest prize to Oliver Hart from Harvard University and Bengt Holmström from MIT for their work on contracting Read more