Just for fun: the theory of the firm 3

In a previous post on the 'reference point' approach to the theory of the firm, Just for fun: the theory of the firm 2, it was noted that

The behavioural assumptions on which the analysis is based are undoubtedly strong, and although they are broadly consistent with a number of ideas in the behavioural economics literature, there is no single model or experiment that appeal can be made to that supports precisely what is done.

It turns out there is some experimental evidence to support 'what is done'. In particular there are two papers which look at aspects of the 'reference point' approach to incomplete contracts which underlies the approach taken to the theory of the firm.

The first of these paper is Contracts as Reference Points – Experimental Evidence by Ernst Fehr, Oliver Hart, and Christian Zehnder, Working Paper, November 2008. The abstract reads,

In a recent paper, Hart and Moore (2008) introduce new behavioral assumptions that can explain long term contracts and important aspects of the employment relation. However, so far there exists no direct evidence that supports these assumptions and, in particular, Hart and Moore’s notion that contracts provide reference points. In this paper, we examine experimentally the behavioral forces stipulated in their theory. The evidence confirms the model’s prediction that there is a tradeoff between rigidity and flexibility in a trading environment with incomplete contracts and ex ante uncertainty about the state of nature. Flexible contracts – which would dominate rigid contracts under standard assumptions – cause a significant amount of shading on ex post performance while under rigid contracts much less shading occurs. Thus, although rigid contracts rule out trading in some states of the world, parties frequently implement them. While our results are broadly consistent with established behavioral concepts, they cannot easily be explained by existing theories. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.

The second paper is Contracts, Reference Points, and Competition—Behavioral Effects of the Fundamental Transformation by Ernst Fehr, Christian Zehnder and Oliver Hart, Journal of the European Economic Association, April–May 2009 7(2–3): 561–572. The abstract reads

In this paper we study the role of incomplete ex ante contracts for ex post trade. Previous experimental evidence indicates that a contract provides a reference point for entitlements when the terms are negotiated in a competitive market. We show that this finding no longer holds when the terms are determined in a non-competitive way. Our results imply that the presence of a “fundamental transformation” (i.e., the transition from a competitive market to a bilateral relationship) is important for a contract to become a reference point. To the best of our knowledge this behavioral aspect of the fundamental transformation has not been shown before.