Wednesday, 12 October 2016

Hart and/or Holmstrom and the theory of the firm.

One part of the contribution of Hart and Holmstrom that has not been emphasised in other coverage of the Nobel award is their huge contribution to the theory of the firm, both separately and together. I wish to briefly cover this area. In doing so I draw on material from The Theory of the Firm: An Overview of the Economic Mainstream. See also Walker (2015).

One grouping in the literature on the firm is referred to as the ‘firm as a solution to moral hazard in teams approach’. This is an area where Holmstrom has been active. In a paper, Holmstrom (1982), he looks looks at the incentive problems of teams and identifies possible solutions. Holmstrom assumes that the members of the team each take actions which are unobservable to the monitor but the overall result of the combined actions is observable. What Holmstrom shows is that it is only under very restrictive assumptions that the monitor can ensure that efficient effort levels will be provided by each team member. The monitor can do this by designing a sophisticated incentive scheme. But Holmstrom shows that given unobservable effort levels, the requirements for the incentive scheme to be a Nash equilibrium, to balance the budget and to be Pareto optimal, cannot be met together. More specifically, a budget-balancing incentive scheme cannot reconcile the Nash equilibrium requirement and Pareto optimality because each team member will equalise the costs and benefits of extra effort; that is, if the team revenue is increased by the efforts of a single member, then that member should receive that revenue to ensure that they are properly motivated. But as the monitor only knows that team revenue has increased and not the effort levels of each individual member, then all members of the team would have to each receive the extra revenue to ensure that the hardworking member is rewarded for his or her efforts. But this will, obviously,violate the balanced budget condition. This suggests that there is an advantage, in terms of incentives, in the team not having to balance their budget.

Another group in the literature is the ‘firms as an incentive system view’. This approach to the theory of the firm was developed by Holmstrom and Milgrom (1991, 1994), Holmstrom and Tirole (1991) and Holmstrom (1999). In their view the firm is characterised by a number of factors: (1) the employees do not own the non-human assets of the firm; (2) the employees are subject to a ‘low-powered incentive scheme’; and (3) the employer has authority over the employee.

Holmstrom and Milgrom (1991) make two observations. First, they note that there are a number of ways that an employee can spend their time, many of which can be of value to an employer. But if these multiple activities compete for the worker’s attention, then the incentives offered for each of the activities must be comparable. Otherwise, the employee will put most effort into those things that are most well compensated and put less effort into the others activities. The second observation relates to the provision of strong incentives to a risk-averse employee. Providing strong financial incentives is costly because it loads extra risk into the worker’s pay. In addition, the cost is greater the more difficult it is to measure performance. This means that, other things being equal, tasks where performance is hard to measure should not be given as intense incentives as ones that are more accurately observed. But having low-powered incentives means that the employer needs to be able to exercise authority over the use of the employee’s time, since the employee will not have the proper incentives to be productive.

This logic suggests that, conversely, an independent contractor should face the opposite combination of instruments. The choice between having an employee or using an independent contractor depends on the ability of the principal to measure each dimension of the agent’s contribution. Thus, in the Holmstrom and Milgrom approach, measurability of performance is one important determinant of the boundaries of the firm. In addition their approach incorporates the importance of the allocation of property rights to the physical assets in determining incentives via determination of bargaining positions as is the case with the Williamson and Grossman-Hart-Moore approaches.

Hart enters our story with the  'firm as an ownership unit' approach to the firm. This approach is more commonly called the property rights theory or incomplete contracts theory of the firm. Early contributions to this approach include Grossman and Hart (1986,1987), Hart and Moore (1990) and Hart (1995).

The central idea in the property rights approach is that as contracts are incomplete the allocation of control rights affects the incentives that people face, and thus their behaviour and the allocation of resources.This theory defines ownership of an asset as the possession of the residual control rights
over that asset. A firm is defined as a collection of jointly-owned (non-human) assets. This means, for example, that the distinction between an independent contractor and an employee turns on who owns the non-human assets with which the agent works. An independent contractor owns his own 'tools' while an employee does not.

But, how and why does ownership matter? The answer is that in a world of incomplete contracts, ownership (i.e. having residual control rights) can serve as a source of power. Given that incomplete contracts contain gaps (or ambiguities) the question arises of who gets to make decisions in these non-contracted for situations? For the property rights theory, it is the owner. This matters since if there are two separate firms, A and B say, then the management of each firm can make decisions for their firm in the uncontracted for situations. If, on the other hand, A was to take over B then A’s management could make decisions for both A and B in the uncontracted for cases. To see the implications of this imagine that B supplies A with an input for A’s production process. If A and B are separate firms then B’s management could threaten to withdraw both its assets and its own labour if the firms cannot, say, agree on the terms for an increase in the supply of the input. If A owns B then B can only threaten to withhold its labour. The latter threat is normally weaker than the former. Such differences in power will effect the distribution of surplus generated by the relationship between A and B. If the firms are separate, then A may have to pay a lot to induce B to supply the increased level of inputs whereas if A owns B, then it can enforce the supply at a much lower cost since B’s management has a reduced threat, and thus, bargaining power.

Determining the boundaries of the firm requires us to balance the advantages of integration against its disadvantages. The benefit of integration is that the acquiring firm’s, A above, incentives to make relationship-specific investments is stronger because it now has greater residual control rights and thus can command a larger share of the ex post surplus created by such investments.The disadvantage of integration is that the incentives of the acquired firm, B, to make relationship-specific investments is reduced since they now have fewer residual controls rights and thus are able to capture less of the ex post surplus that their investments creates. To put this in employee/independent contractor terms, the optimal size of a firm trades off the fact that hiring an employee means hiring someone who lacks optimal incentives since they risk being held up by the firm because they can be fired, and thereby separated from the assets they need to be productive, versus using an independent contractor who could hold-up the firm by threatening to quit the relationship and taking his assets with him.

An implication of this is that if a non-contractible, specific to a particular set of assets, investment is undertaken then a non-owner risks being held-up by the owner. Thus,the property rights theory would say that whoever makes the most important, non-contractible,asset-specific investment should be the owner of the asset.and a larger share of the ex post surplus created by such investments.

Another approach in which Hart is a major contributor is the 'the reference point approach' to the firm.

Hart (2008) presents a simple reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below. Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.

At this stage Hart ignores the fact that B could engage other economists or that S could give lectures elsewhere. While trade could proceed smoothly, it is also possible that it will not. We will assume that B and S each have some discretion over the ‘quality’ of performance. For example, S could give a witty, lively, entertaining lecture or a very boring one. B on the other hand could treat S well, give her a nice dinner and pay quickly, or treat her badly.

In the language of Hart and Moore (2008) each party is able to provide basic (perfunctory) or exemplary (consummate) performance. It is further assumed that only the basic (perfunctory) level of performance can be legally enforced: exemplary (consummate) performance is entirely discretionary. It is assumed that each party is more or less indifferent between providing each level of performance − exemplary performance costs only a little more than basic or may even be slightly more pleasurable − and will provide exemplary performance if they feel they are being 'well treated' but not if they feel they are being 'badly treated'. Cutting back on exemplary performance is called ‘shading’. Such behaviour cannot be observed or punished by an outsider. Shading hurts the other party.

Hart emphasises that each party will feel 'well treated' if they receive what they think they are entitled to; that a contract between the parties is a reference point for perceived entitlements; and that should there be no reference point, then entitlements can diverge, wildly in some cases.

To return to the example above. First, we will add a time line. The time line tells us that B and S will write a contract some months before the lecture is given, at date 0, rather than at the last minute, date 1. One reason for this is that each party has more options earlier on. In fact it is assumed that there is a competitive market for sellers, at date 0.

Assume, further, that although B and S sign a contract at date 0, they leave the question of how much B will pay S open until the night before the lecture, date 1. This may seem a bad idea, and later it will be shown that it is. If no price is specified, then any p between 10 and 20 is possible. What might each party feel entitled to?

Hart and Moore (2008) take the view that entitlements can diverge. S may feel that the whole success of the talk will be due to her giving it and thus she feels entitled to p = 20. On the other hand B may have a somewhat different view of S’s abilities and likely contribution and thus feel that S is worth much less, say, p = 10.

Even though they disagree as to what p should be, they are rational enough to arrive at a compromise, say p = 15. According to Hart and Moore (2008) each party will feel short-changed and therefore aggrieved. Since B is aggrieved by 5, (15-10), B shades to the point where S’s payoff falls by 5θ, where θ is the constant of proportionality. And since S is also aggrieved by 5, (20-15), S shades to the point where the payoff for B falls by 5θ.

The end result of this is that if S and B leave the determination of the price until the night before the lecture, there will be a deadweight loss of 10θ due to the shading activities of each party. This reduces the value of the relationship between S and B from 10 to 10−10θ = 10(1−θ).

Next Hart asks the question: Can anything be done to avoid this deadweight loss? His answer is yes. But first note an answer that doesn’t do the job. Ex post Coasian bargaining at date 1 doesn’t work. The reason is that shading is not contractible and thus an agreement not to shade is not enforceable. Or to put this another way, if B offers to pay S more to reduce her shading, say B offers to pay p = 16 to S rather than 15, then this will indeed reduce S’s shading, from 5θ to 4θ, since S will now feel less aggrieved, but it will also increase B’s shading from 5θ to 6θ, since he now feels more aggrieved. Total deadweight loss does not change, it remains at 10θ. However there is a simple solution; the parties just put the price in the contract at date 0. Since it has been assumed that the market for lectures is competitive at date 0, B will be able to hire S for a price p = 10. With this price specified in the contract, there is nothing for B and S to disagree about at date 1. The fact that B and S may disagree about the contribution that S makes to the success of the lecture no longer matters. B and S have agreed that B will pay S 10, and neither B nor S will be disappointed or aggrieved when that happens. Importantly, agreeing in advance, at date 0, to a payment of 10 eliminates ex post argument and aggrievement, and thus both parties will be willing to provide exemplary performance. Here we have the first best being achieved and zero deadweight losses as a result. This does raise an obvious question: What changes between dates 0 and 1? Why does a date 0 contract that fixes p avoid aggrievement, whereas a date 1 contract that fixes p does not? The crucial point here is the role of the ex ante market at date 0. This market gives an objective measure of what B and S bring to the relationship. Given the assumption of a competitive date 0 market, there are many sellers willing to supply at p = 10 and thus S accepts that she cannot expect to receive more than 10, while B understands that he can’t expect to pay less, as no one would be willing to give the lecture for less. Thus, neither party is aggrieved by p = 10. This gives us a model of the contractual relationship between B and S, but, as Hart explains, we need one further ingredient to create a theory of the firm.

Now let us add a little more realism by assuming that not all of the details of the lecture can be anticipated at date 0. To keep things simple we will assume that two different lectures can be given.

Lecture 1 - say, a theory of the firm lecture - is the same as above, with a value of 20 and costs of 10. Lecture 2 - say, a microeconometrics lecture - yields value of 14 and costs of 8. Note that lecture 1 is more efficient in that it generates a greater surplus - 10 v's 6. Assume that the lectures can not be specified in the date 0 contract, since thinking about econometrics is sooooo boring that no one can stay awake long enough to write the contract! At date 1, however, the choice between them becomes clear.

Now we have to compare two organisational forms: an employment contract and an independent contractor. First, let B and S fix the price of the good at date 0, at say 10, and let B and S agree at date 0 that S will be an independent contractor. This is, in other words, a market exchange between two separate economics agents. Independent contractor means here that S gets to pick which lecture to give.

Hart then asks, What will S do? Given that the price has been fixed by the date 0 contract, S will pick lecture 2, since it is cheaper for her. But note this is inefficient. B will be aggrieved because S didn’t choose lecture 1, which B feels entitled to; B is short-changed by 6 (20-14), and he will therefore shade enough to reduce S’s payoff by 6θ. Total surplus in this case will be 6 − 6θ.

The second organisation form to be considered is an employment contract. B and S agree at date 0 that S is an employee of B. This we take to mean that S will work for B at a fixed wage, again assume 10. B, being the employer, has the right to decide on which lecture is to be given. As the wage is fixed B will choose lecture 1, as this gives him the greater value. This is efficient. S will be aggrieved since lecture 2 wan’t chosen, but S’s aggrievement is only 2. This induces S to shade by enough to reduce B’s payoff by 2θ. Total surplus is therefore 10 − 2θ.

Under the conditions specified, the employment contract is better. This is true for two related reasons. First, the lecture matters more to B than to S. B will lose 20 − 14 = 6 if his favoured lecture is not chosen while S only loses 10 − 8 = 2 if her favoured lecture is not chosen. This means it is efficient for B to choose the lecture. Second, and related, S’s aggrievement is low since she doesn’t care very much.

Hart now changes the numbers. Keep lecture 1 as it is, but change lecture 2 so while it still yields 14, it now costs only 2. Lecture 2 is now the more efficient (12 v’s 10). Under employment, lecture 1 will be chosen, yielding a total surplus of 10−8θ. If S is an independent contractor, lecture 2 will be chosen resulting in a total surplus of 12 − 6θ.

What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.
Hart goes on to say,
“[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.” (Hart 2008: 409).
Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).

The basic ingredients of the reference point approach to contracts have been applied to the theory of the firm more fully in papers by Hart and Moore (2007), Hart (2009) and Hart and Holmstrom (2010) - yes they get together!. For more on these papers see Walker (2013).


  • Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4(16) November: 386–405.
  • Grossman, Sanford J. and Oliver D. Hart (1986). ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy, 94(4): 691–719.
  • Grossman, Sanford J. and Oliver D. Hart (1987). ‘Vertical Integration and the Distribution of Property Rights’. In Assaf Razin and Efraim Sadka (eds.), Economic Policy in Theory and Practice (504–48), London: Macmillan Press.
  • Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
  • Hart, Oliver D. (2008). ‘Economica Coase Lecture: Reference Points and the Theory of the Firm’, Economica, 75(299) August: 404–11.
  • Hart, Oliver D. (2009). ‘Hold-up, Asset Ownership, and Reference Points’, Quarterly Journal of Economics, 124(1) February: 267–300.
  • Hart, Oliver D. and Bengt Holmström (2010). ‘A Theory of Firm Scope’, Quarterly Journal of Economics, 125(2) May: 483–513.
  • Hart, Oliver D. and John Moore (1990). ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98(6): 1119–58.
  • Hart, Oliver D. and John Moore (2007). ‘Incomplete Contracts and Ownership: Some New Thoughts, American Economic Review, 97(2) May: 182–6.
  • Hart, Oliver D. and John Moore (2008). ‘Contracts as Reference Points’ Quarterly Journal of Economics, 123(1) February: 1–48.
  • Holmstrom, Bengt (1982). ‘Moral Hazard in Teams’, Bell Journal of Economics, 13(2) Autumn: 324–40.
  • Holmstom, Bengt (1999). ‘The Firm as a Subeconomy’, Journal of Law, Economics, and Organization, 15(1) April: 74-102
  • Holmstrom, Bengt and Paul Milgrom (1991). ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’, Journal of Law, Economics, & Organization, 7(Special Issue): 24–52.
  • Holmstrom, Bengt and Paul Milgrom (1994). ‘The Firm as an Incentive System’, American Economic Review, 84(4) September: 972–91.
  • Holmstrom, Bengt and Jean Tirole (1991). ‘Transfer Pricing and Organizational Form’, Journal of Law, Economics, and Organization, 7(2) Fall: 201-28.
  • Walker, Paul (2013). ‘The ‘Reference Point’ Approach to the Theory of the Firm: An Introduction’, Journal of Economic Surveys, 27(4) September: 670–95.
  • Walker, Paul (2015). 'Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective'. Journal of Economic Surveys, v29 no2, April: 317-38

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