…Oliver Hart and Bengt Holmström for their research on contract theory.
One of my favorite papers in all of economics is Holmstrom and Milgrom’s 1991 paper titled “Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design.” In a world where health care is increasingly moving to value-based payment, payers (i.e., insurance companies, employers, and the government) are increasingly contracting based on observed quality. However, much of the quality of care providers (i.e., physicians, hospitals, nurses) is unobservable to payers (e.g., bedside manner, unobserved clinical outcomes).
In a previous post, I summarize their argument as follows:
…it has been known that compensating individuals on one measured dimension can compel them to substitute effort away from unmeasured dimensions. For instance, if a mortgage broker is compensated only for the number of new mortgages he secures and not the credit worthiness of the borrower, it is likely that they will bring in borrowers with bad credit. In the healthcare setting, compensating doctors to do certain tests (e.g., test A1C levels) may increase the probability the doctor conducts the A1C test for diabetics, but may decrease the amount of time the physician dedicates towards counseling the patient to lose weight or stop smoking.
Alex Tabarrok of Marginal Revolution provides a concise, but a bit technical explanation of how compensation should be tied to measured output (or quality) based on the Holmstrom approach.
The Economist describes Dr. Holmstrom’s research as follows:
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.
Tyler Cowen writes in BloombergView that:
They’ve built a technical framework for other researchers to build on, which is much harder to do than to throw off useful insights. So don’t be underwhelmed if some of their work, when conveyed in sound bites, seems like something you heard last week at the water cooler.
Marketplace has a layman’s explanation of the research that won Holmstrom and Hart the award (see below).
Here’s an example: factory managers often pay workers per item produced. But if schools paid teachers in a similar way, based on student test scores, it would bring trade-offs. Teachers might focus on the wrong thing.
“We want them to raise our kids to be creative, to be mensches,” said economist Steve Tadelis of the Haas School of Business at UC Berkeley. “You will force them to just spend all their energy on that one thing, because that’s what they are getting paid for.”
Awardee number two: Oliver Hart of Harvard. Much of his work focuses on contracts and uncertainties and has been applied to governments and privatization. A local government might privatize trash pickup and find it saves money, with few trade-offs. But if it privatized a prison it might find corner-cutting, and that prisoners weren’t fed enough.
“The right answer is not privatize everything, the right answer is not have collective ownership for everything,” said economist Roger Myerson of the University of Chicago, himself a past Nobel economics winner for his work on game theory. “A good theory needs to be able to go both ways, precisely the kind of theory we need to understand the real world.”