A Scorecard to Keep Track of Players and Their Agents

Posted in Contemporary economics, History of economics Tagged with: , , ,

The Who? among those recognized by a Nobel Prize in the Economic Sciences is seldom surprising. It’s the when that usually catches auditors unaware.

Take contract theory, and the work by Oliver Hart, of Harvard University, and Bengt Holmström, of the Massachusetts Institute of Technology, that the Royal Swedish Academy of Sciences cited yesterday. As Paul Krugman, himself a Nobel laureate, tweeted yesterday, “Hart and Holmström so obviously deserving that my first thought was, ‘Didn’t they have it already?’” For a summary of the committee’s reasoning, see its popular summary, or read the full citation.

It was forty years ago that “The Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure,” burst like a high altitude flare in the Journal of Financial Economics.  The article, by Michael Jensen, fresh from the University of Chicago PhD,  and William Meckling, both then of the University of Rochester, featured an epigraph from Adam Smith.  Hard as it is to believe today, Smith was a figure seldom quoted in 1976, the bicentennial year of An Inquiry into the Nature and Causes of the Wealth of Nations.

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honor, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Smith two centuries earlier had identified the idea at the heart of what would become new-fangled “principal agent theory” – the analysis of situations in which one person, the agent, would agree to act on behalf of another, the principal. Curiosity took root in the mid-1960s at Harvard University around a famous essay by Kenneth Arrow on the intricacies of the health insurance industry. The agency problem was not just a matter of deciding to choose a doctor or an insurance company (or prefer a patient or decline an applicant), Arrow wrote, or, in a different situation, decide which subordinate to promote. Agency arrangements were ubiquitous in economic life, the very essence of the division of labor. Agency theory was quickly carried forward by Mark Pauly, Michael Spence, Richard Zeckhauser, and Stephen Ross. Then, in one broad stroke, Jensen and Meckling applied the insight, none too precisely, to the giant region of economics known as the theory of the firm.

Suddenly the entire structure of business cracked open for re-examination using the new lens:  managerial structures, production arrangements, corporate finance, labor contracts, regulatory supervision, virtually every aspect of cooperation and competition. A detailed road-map for de-regulation, re-structuring, and re-regulation began to be drawn at the intersection of law and economics where commonsense and legislative politics had sufficed before. For a reminder of the bridge-building between practice and theory that soon began, and, in due course, vice versa, see  Bloodsport: When Ruthless Dealmakers, Shrewd Ideologues, and Brawling Lawyers Toppled the Corporate Establishment , by Robert Teitelman, for many years editor-in-chief of The Deal, or, alternatively, A Giant Cow-Tipping by Savages, by John Weir Close, founder and editor of M&A Journal.

Jensen moved to Harvard Business School to teach MBAs. Meckling, dean emeritus of Rochester’s William Simon Graduate School of Business Administration, died in 1998. Meanwhile, a generation of newly-minted PhDs went to work in the late 1970s, armed with new tools for thinking about strategy derived from game theory.  Hart, trained as a general equilibrium theorist at Princeton University, quickly retooled; Holmström, a corporate planner who had begun studying operations research at Stanford University, became an economist instead.  Each joined a small corps of others who were carefully thinking through the implications of agency arrangements in the form they usually took, namely contracts.

Filip Palda, a friend, a professor at the École nationale d’administration publique (ENAP) at the Université du Québec, wrote yesterday to say, “While in graduate school at [the University of] Chicago I knew Holmström’s name was in the air quite a bit but that short piece he wrote in 1979 or so [‘Moral Hazard and Observability,’ in the Bell Journal of Economics] was totally impenetrable to me. Only years later did I understand he was about one of twenty economists who almost simultaneously realized the importance of [William] Vickrey’s 1950’s work on reverse game theory.”  Not that any of them would have put it that way, then or now.

By 1990 (cq, not 1991), the Nobel Foundation had organized the first of several symposia to think through the significance of the emerging field. Holmstrom organized it; Hart’s name, last on the program, quickly moved to the top. Both economists have been in the queue for at least fifteen years. Sanford Grossman, collaborator with Hart on a famous paper, was there in the queue for a time as well.  He left economics to start an immensely successful hedge fund; today he dabbles in brain science.

Gradually the Swedes traced various developments in a grand new theory of incentives:  Ronald Coase received a Nobel Prize in 1991; Vickrey, with James Mirrlees, in1996; Leo Hurwicz, Eric Maskin, and Roger Myerson, in 2007; Eleanor Ostrom and Oliver Williamson, in 2009; Alvin Roth and Lloyd Shapley,  in 2012; and Jean Tirole, in 2014.  Jean-Jacques Laffont and Sherwin Rosen died before they could finish their work; still others, notably Robert Wilson and Paul Milgrom, are waiting in line. Gradually the outlines of a new field have filled in.  You can read all about it in The Handbook of Organizational Economics, edited by Robert Gibbons and John Roberts, or study it in Patrick Bolton and Matthais Dewatripont’s text.

Back to ENAP’s Palda. “I am starting to tire of Nobels for this crowd. I have a rough count of about seven or eight such people in the last ten years. And the thing is, their ‘solutions’ to incentive compatibility are most often more costly than the consequences of the incompatibility. There is a sort of second law of economic thermodynamics at play, which hints that lying and cheating can’t be solved away at the blackboard.”

That’s too pessimistic by half.  There’s lying and cheating in agency arrangements, to be sure, but much of the action revolves around questions of getting the job done efficiently. Contract theory promises a better scorecard, with which to tell apart the interests of players and their agents. It has barely begun to be put to work.  The prize to Hart and Holmström demonstrates the power of patient, painstaking social science.  It’s not the first word that we honor but the last.