The Power of Convictions

Much has already been written about the winners of this year’s Nobel Prize in Economics: Oliver Hart and Bengt Holmstrom. With their contributions, not only did they create a new area of economic inquiry (the analysis of the contractual relations permeating our society),[1]  but they also had profound impact on business practices, from the way managers are remunerated to the way takeover rules are designed. The prize has been attributed not only to two outstanding scholars, but to two outstanding human beings. I will write more about Oliver, because he has been my teacher, mentor, and co-author, but what I say about Oliver could be applied to Bengt as well. 

Oliver is the most intellectually honest person I know. He is single-minded in the pursuit of the truth and he is fearless in the defense of the results of his analysis, even when these results are not politically appealing. He is not afraid to go against conventional wisdom, even when he is alone. Yet, he is also ready to revise his views based on the contributions of others.

Nothing illustrates this point better than the decade-long controversy on the foundations of incomplete contracts. After studying contracts for years, Oliver understood that you could not explain the world if we assume that economic agents can write all the possible contracts economists think they can write. For this reason, Oliver, together with Sandy Grossman, took a very alternative path: they assumed that you cannot write any contract and analyzed the implications this assumption had for the importance of control rights and ownership.

For example, the difference between an employee of General Motors (GM) and a GM supplier is given by who controls the assets to produce the GM parts. GM may dismiss an employee, excluding him from accessing the factory, but it cannot deprive an independent supplier of access to his own factory. GM can only stop buying from an independent supplier. This difference in outside options in case there is a dispute changes the incentives of the supplier and the buyer. Thanks to this idea, Hart and his co-authors have been able to explain why some companies are vertically integrated, and others are not. They were also able to explain why the financing of a company with debt is fundamentally different from financing  with equity: it is not just a matter of cash flow allocation; it is a matter of who is in control in the various possible situations.

This “Incomplete Contract Theory” became very popular not only in finance, but also in organization,  and was extremely successful in explaining not only the  way companies finance themselves, but also the role of authority in firms, and even international trade.

Most economists would rest on the laurels of such an accomplishment. Not Oliver. With John Moore he engaged in a twenty-year search for the intellectual foundations of contract incompleteness. Their initial explanation was challenged by two other Nobel Prize winners: Eric Maskin and Jean Tirole. In 2008 (at the age of 60), Oliver had the intellectual courage to admit defeat. He recognized that Maskin and Tirole’s criticisms of the intellectual foundations of his theory were correct and he had to change them. And he did. In a paper with John Moore he developed new intellectual foundations for the incomplete contract theory.

Any description of Oliver would be incomplete (no pun intended) if it did not mention Rita, his wife of more than forty years. Sometimes it may challenging to be married to such an intellectual giant, even more so if he brings–as Oliver does–the same rigor he applies to his work to everything he does in life. Rita is the perfect companion for him. She is vivacious and charming, gently nudging Oliver through the ordinary tasks of life, which sometimes takes Oliver more time than any normal human being because he puts so much thought into them. But Rita is also an intellectual companion, a literature scholar, a published author, and a phenomenal debater. I suspect it may be easier for Oliver to win an argument in academic seminars than to win one at home. It is probably this lively and lovely debating that keeps them so young.

Join me in congratulating them for their Nobel Prize.

Luigi Zingales is Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance, and Charles M. Harper Faculty Fellow at the University of Chicago Booth School of Business.

This post was originally published on premarket.org – the blog of the Stigler Center at the University of Chicago Booth School of Business. The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.