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The Nobel Prize in Economics recognizes research into how bonuses for CEOs affect corporate finance both short term and long term. (Illustration: Royal Swedish Academy of Sciences)

Nobel economics theory supports KTH research into small business financing

Published Oct 12, 2016

Research in contract theory, which was recognized by the Nobel Prize in Economics, is being used at KTH Royal Instiute of Technology to examine the impact of the financial crisis on small businesses.

Oliver Hart, a British economist at Harvard University, and Bengt Holmstrom, a Finnish economist at MIT, were awarded the Nobel Prize in Economics for their work expanding our understanding of contracts and how they work.

Contract theory provides a general conceptual framework that can be used to analyze all the possible contracts – be they bonus program for CEOs, deductibles in insurance or privatization of public enterprises.

Pontus Braunerhjelm

Contracts help us to manage conflicts of interest. They are necessary for society to function, writes the Royal Swedish Academy of Sciences in its citation. They should create confidence and get us to work together, through employment contracts or loan contracts. Contracts are also needed to build the institutions of society, such as schools, hospitals and prisons.

“Their (Hart and Holmström ) theories have had a tremendous impact, not least because they could be applied in so many areas,” says , a professor in the Department of Industrial Economics and Management at KTH. “They created a new approach for socio-economic research, and they have contributed to a better understanding of how to design different types of contracts.”

Researchers at KTH use contract theory to investigate the growth potential for smaller companies. The theories may explain why in the wake of the financial crisis some firms had greater difficulty obtaining financing, mainly bank loans, according to Christian Thomann , who does research on entrepreneurship and risk analysis at KTH.

Since the financial crisis, corporate loans have been considered riskier than before, which hits smaller companies hardest. Unlike more established companies, many small enterprises and startups are no longer considered reliable as a contract partner for lenders.

“What we see in our data is that lending to small businesses has declined and that the banks only provide loans with short maturities,” Thomann says. “This has significant implications for economic development. Hazardous industries in particular have seen a decrease in productivity as a result of the decline in confidence of financiers' side.”

Christian Thomann

Along with research colleagues Gustav Martinsson and James R. Brown, Thomann hopes to move forward proposals for new financing opportunities that can help small, unestablished companies to make the necessary investments.

“Our research in this area would not have been possible without the Nobel laureates’ work. Their theories help us to explain what we observe in reality through our investigations,” he said.

Thomann has also applied the economics laureates’ theory in a different area - the design of employment contracts.

The result showed, among other things, that insurance companies base decisions about whether to reward employees with occasional bonuses or high fixed salaries on how long they are expected to stay with the company.

Christer Gummeson