Why did this management theory just win the Nobel Prize?


What makes for an award-winning management theory? It’s all about balancing conflicting needs and finding what motivates people. 

It might not come as a surprise that some of the driving principles behind modern day people management theory are praiseworthy. After all, workplaces run every day thanks to them.

What you might not know is this year’s Nobel Prize in Economic Science was awarded for contributions to modern contract theory. In a nutshell, this work delves into how organisations can better understand and design contracts that easily adapt to modern work patterns.

So why is contract theory so important? Contracts have governed the workings of economies since ancient times. However, as technology advances and companies become more complex, the theory and practice of contract design is taking centre stage.

The theorists behind this year’s Nobel Prize, US-based economists Oliver Hart and Bengt Holmström, go beyond analysing deals on paper to agreements that help individuals, businesses and public bodies better assess whether the deals they strike are actually in their best interests.

“In its essence, it’s about giving each party the right incentives or motivations to work effectively together,” write Charles Duxbury and Mike Bird in the Wall Street Journal.

Their theories look at a range of issues, from use of performance-based pay for top executives to whether a public entity should be privatised.

Hongyi Li and Anton Kolotilin, both lecturers at UNSW, elegantly articulate how management theory applies to the real world in an essay published at The Conversation.

Holmstrom, they explain, brought to light the conflict inherent in teamwork and individual reward. In a paper titled Moral Hazards in Teams, the economist looked at situations in which a team of employees contributes individual efforts towards a collective output – for example, inventors working to develop a new product. The problems with a partnership scheme that shares profits equally among the team, he recognised, is that it creates a ‘free rider’ problem. This is when individuals are insufficiently motivated by an equal sharing of profits, and therefore exert less effort.

His fix? Introducing a ‘budget-breaker’ in the form of a venture capitalist, for example, who “assigns rewards and penalties to individual team members,” then keeps what’s left for themselves.

Another aspect of the theory helps companies design compensation contracts for employees where performance can only partly be measured. For example, the ‘informativeness principle’ argues that CEO pay shouldn’t depend entirely on company share price, and should instead be weighted against share prices for competitor companies. This “helps to avoid rewarding people for ‘good luck’ and punishing them for ‘bad luck’.”

Most interesting are the ways that their work (and subsequent recognition) brings into focus the crossover between organisational structure and human psychology. And it’s HR’s role in making the two work together that reveals the best expression of how contract theory manifests in the real world.

As Sylvia Vorhauser-Smith writes in Forbes, “Having the right engagement practices powered by understanding the drivers most meaningful to employees can work towards creating a more motivated and high-performing workforce.”

Structures that operate fairly and beneficially for individual employees, this management theory teaches us, go a long way towards creating a workforce geared towards success for your organisation.

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Anne Barclay
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Anne Barclay

Very interested in this summary and in particular the idea of looking at CEO performance (such as Co. share price) compared with share prices for competitor companies and developing a weighting when considered as part of a performance metric. I wonder how many companies are doing this in practice?

Dr Ronald Forbes, Leaderskill
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Dr Ronald Forbes, Leaderskill

I’m surprised at this theory winning a Nobel Prize. It’s based on an underlying assumption: that money, or material gain, is the underlying motivator of humans. I don’t believe it. You could call it a kind of ‘adolescent’ motivation, or say an early stage in personal development, but it is not what we should propagate for our long-term benefit. There is a stage beyond that: care and concern for the human community and for the environment in which we humans have developed. Thankfully, there are many of us who have reached this stage and are not finally swayed by rewards… Read more »

A P Tripathi
Guest
A P Tripathi

Beautifully narrated and addressed by the author that how individual aspirations can be merged with organisational goal. There has been a prblem with equity theories to make a balance between individuals shate and their effort. It would be interested to see how tbis theory can be useful for psychology specially in Humaran resourse devlopment with organization development.

A P Tripathi
Guest
A P Tripathi

Beautifully narrated and addressed by the author that how individual aspirations can be merged with organisational goal. There has been a prblem with equity theories to make a balance between individuals share and their effort. It would be interested to see how tbis theory can be useful for psychology specially in Humaran resourse devlopment with organization development.

More on HRM

Why did this management theory just win the Nobel Prize?


What makes for an award-winning management theory? It’s all about balancing conflicting needs and finding what motivates people. 

It might not come as a surprise that some of the driving principles behind modern day people management theory are praiseworthy. After all, workplaces run every day thanks to them.

What you might not know is this year’s Nobel Prize in Economic Science was awarded for contributions to modern contract theory. In a nutshell, this work delves into how organisations can better understand and design contracts that easily adapt to modern work patterns.

So why is contract theory so important? Contracts have governed the workings of economies since ancient times. However, as technology advances and companies become more complex, the theory and practice of contract design is taking centre stage.

The theorists behind this year’s Nobel Prize, US-based economists Oliver Hart and Bengt Holmström, go beyond analysing deals on paper to agreements that help individuals, businesses and public bodies better assess whether the deals they strike are actually in their best interests.

“In its essence, it’s about giving each party the right incentives or motivations to work effectively together,” write Charles Duxbury and Mike Bird in the Wall Street Journal.

Their theories look at a range of issues, from use of performance-based pay for top executives to whether a public entity should be privatised.

Hongyi Li and Anton Kolotilin, both lecturers at UNSW, elegantly articulate how management theory applies to the real world in an essay published at The Conversation.

Holmstrom, they explain, brought to light the conflict inherent in teamwork and individual reward. In a paper titled Moral Hazards in Teams, the economist looked at situations in which a team of employees contributes individual efforts towards a collective output – for example, inventors working to develop a new product. The problems with a partnership scheme that shares profits equally among the team, he recognised, is that it creates a ‘free rider’ problem. This is when individuals are insufficiently motivated by an equal sharing of profits, and therefore exert less effort.

His fix? Introducing a ‘budget-breaker’ in the form of a venture capitalist, for example, who “assigns rewards and penalties to individual team members,” then keeps what’s left for themselves.

Another aspect of the theory helps companies design compensation contracts for employees where performance can only partly be measured. For example, the ‘informativeness principle’ argues that CEO pay shouldn’t depend entirely on company share price, and should instead be weighted against share prices for competitor companies. This “helps to avoid rewarding people for ‘good luck’ and punishing them for ‘bad luck’.”

Most interesting are the ways that their work (and subsequent recognition) brings into focus the crossover between organisational structure and human psychology. And it’s HR’s role in making the two work together that reveals the best expression of how contract theory manifests in the real world.

As Sylvia Vorhauser-Smith writes in Forbes, “Having the right engagement practices powered by understanding the drivers most meaningful to employees can work towards creating a more motivated and high-performing workforce.”

Structures that operate fairly and beneficially for individual employees, this management theory teaches us, go a long way towards creating a workforce geared towards success for your organisation.

5
Leave a reply

avatar
500
  Subscribe to receive comments  
Notify me of
Anne Barclay
Guest
Anne Barclay

Very interested in this summary and in particular the idea of looking at CEO performance (such as Co. share price) compared with share prices for competitor companies and developing a weighting when considered as part of a performance metric. I wonder how many companies are doing this in practice?

Dr Ronald Forbes, Leaderskill
Guest
Dr Ronald Forbes, Leaderskill

I’m surprised at this theory winning a Nobel Prize. It’s based on an underlying assumption: that money, or material gain, is the underlying motivator of humans. I don’t believe it. You could call it a kind of ‘adolescent’ motivation, or say an early stage in personal development, but it is not what we should propagate for our long-term benefit. There is a stage beyond that: care and concern for the human community and for the environment in which we humans have developed. Thankfully, there are many of us who have reached this stage and are not finally swayed by rewards… Read more »

A P Tripathi
Guest
A P Tripathi

Beautifully narrated and addressed by the author that how individual aspirations can be merged with organisational goal. There has been a prblem with equity theories to make a balance between individuals shate and their effort. It would be interested to see how tbis theory can be useful for psychology specially in Humaran resourse devlopment with organization development.

A P Tripathi
Guest
A P Tripathi

Beautifully narrated and addressed by the author that how individual aspirations can be merged with organisational goal. There has been a prblem with equity theories to make a balance between individuals share and their effort. It would be interested to see how tbis theory can be useful for psychology specially in Humaran resourse devlopment with organization development.

More on HRM