Sunday, 30 October 2016

Maija Halonen-Akatwijuka on "Oliver Hart, Nobel laureate"

Maija Halonen-Akatwijuka writes on Oliver Hart, Nobel laureate at As is well known by now Oliver Hart has been jointly awarded the 2016 Nobel Prize in Economic Sciences with Bengt Holmstrom "for their contributions to contract theory". Halonen-Akatwijuka looks at Hart's contribution to contract theory. In particular incomplete contracts.

Halonen-Akatwijuka opens her discussion by noting,
The cornerstone of Hart’s contribution to incomplete contracts theory is his 1986 paper with Sandy Grossman on the costs and benefits of ownership. In this paper, they develop the formal theory of incomplete contracts and with it introduce the notions of control and power that have had great impact in many fields beyond the theory of the firm (see Aghion et al 2016).

Even in market economies, a significant proportion of transactions do not take place in the market but within firms. Grossman and Hart (1986) build on the foundations laid by previous Nobel laureates Ronald Coase and Oliver Williamson in asking what determines whether a transaction occurs inside the firm or in the market – that is, whether there is vertical integration or non-integration.

Coase’s (1937) answer was that both market and internal transactions have their costs and they are organised so that the transaction costs are minimised. Williamson (1975, 1985) emphasised a particular cost of transacting in the market: the hold-up problem. When a productive relationship requires an investment that has much lower value in other uses, the investor may only make the investment if the relationship is within the firm, since in the market, such relationship-specific investment is vulnerable to expropriation in bargaining when contracts are incomplete. Williamson was less clear about the costs of integration, which, in his view, related to bureaucratic decision-making.

Grossman and Hart (1986) formalised the analysis of the boundaries of the firm and provided a rationale not just for the benefits but also for the costs of vertical integration. When contracts are incomplete, a trading relationship can be governed by allocating the control rights – or power – to a party. Ownership of an asset brings with it control rights as the owner has the right to refuse to trade with a supplier/buyer (unless a prior contract is in place). The question then arises of not just whether the assets should be integrated or not, but also who should be the owner.

Ownership gives power to an agent in the sense that his default payoff is increased. If buyer B owns the asset that supplier S works with — and therefore S becomes B’s employee — B can get a higher share of the surplus in bargaining. The benefit of integration is that B’s incentives in relationship-specific investments are stronger. But the hold-up problem does not disappear inside the firm as he still needs to bargain with his employee to complete the production.

The cost of integration is the other side of the coin: S as an employee has weaker incentives than as an independent supplier. Given this trade-off, if one of the parties is a key investor, then it is optimal for him to become the owner of the integrated firm. That guarantees the best incentives for the key investment while the cost of weaker incentives for the party with less important investment is not significant.

Hart’s 1990 paper with John Moore developed the theory for a multi-asset and multi-party setting. Ownership – or power – is distributed among the parties to maximise their investment incentives. Hart and Moore show that complementarities between the assets and the parties have important implications. If the assets are so complementary that they are productive only when used together, they should have a single owner. Separating such complementary assets does not give power to anybody, while when the assets have a single owner, the owner has power and improved incentives.
A point to note here is that this ideas of having a single owner for complementary assets helps explain by we most often see control rights and income right being bundled together. Income rights give people an incentive to use assets efficiently while control rights give them the ability to do so. Income and control rights are complementary.
Furthermore, if there are such strong complementarities between an asset and a party that the asset is productive only with that party, then this indispensable party should own the asset. Ownership of the asset would not give power to anybody else and the incentive effect would be wasted.

This theory of the firm is now known as Grossman-Hart-Moore (GHM) property rights theory. It has been applied in various fields, including corporate finance, public economics, political economy and international trade.
I would, of course, recommend reading pages 98-107 of Walker (2016) for a brief introduction to the Grossman-Hart-Moore approach to the theory of the firm.

One of the applications of the Grossman-Hart-Moore theory that Hart has written on is to privatisation. The reason for this application is that there is a close relationship between the theory of the firm and the theory of privatisation. As Hart himself has written,
Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms,A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals).Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B.
[...] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership.
Thus, we can think about the nationalisation/privatisation decision of the government in a similar way to the integration/spin-off decision of the private firm, conceptually both decisions are about determining the boundaries of an organisation.

Halonen-Akatwijuka points out that,
Hart’s 1997 paper with Andrei Shleifer and Robert Vishny applies the property rights theory to privatisation of tax-funded welfare services, such as schools, prisons and refuse collection. Government contracts with a service provider but the contract is incomplete, particularly regarding the quality of the service. The provider can invest in cost reduction but the owner has the control rights to decide whether the cost innovation will be implemented.

Under privatisation, the provider has the control rights and will implement cost innovation even if it damages the quality of the service. Since the provider gets the full benefit from cost-cutting and ignores the quality-reducing effect, his incentives for cost reduction are too strong.

Under public ownership, the provider needs government approval for any innovations, and therefore a quality-damaging innovation would not go ahead. This means that the provider will take into account the quality-reducing effect but has generally weak incentives to reduce costs.

Privatisation is therefore not desirable for services where cost reduction can damage quality. Hart and his co-authors argue that prisons meet this condition reasonably well. Federal authorities in the US are indeed ending the use of private prisons partly because of quality issues.

In contrast, privatisation works well for services where the quality-reducing effect is likely to be trivial, such as refuse collection. Finally, for some welfare services such as schools, competition can discipline quality-damaging cost-cutting, and therefore there is a reasonably valid case for privatisation.

When she turns to Hart's more recent work Halonen-Akatwijuka writes about what is now referred to as the "reference points" approach to contracts,
In recent work, Hart has introduced the theory of contracts as reference points (Hart and Moore 2008). The basic idea is that the role of a contract is to shape the parties’ expectations and to get them ‘on the same page’ to avoid future misunderstandings. Misunderstandings cause parties to feel aggrieved and lead to shading in ex post performance, causing deadweight losses.

The benefit of a rigid contract is that it fixes expectations, avoiding arguments. But it may not perform well when there is uncertainty. A flexible contract can adjust to the state of nature, but there is also room for arguments.
This approach has yet to get much attention in  economics textbooks, but see pages 113-117 of Walker (2016) for more.

Given this lack of discussion I will take a quick look the model given in Hart (2008) which presents a simple, intuitive, 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.
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).

Halonen-Akatwijuka also notes that this reference point theory shifts the focus from ex ante investment incentives, as in the Grossman-Hart-Morre theory, to ex post inefficiencies caused by shading and, importantly, this approach is not subject to the Maskin and Tirole (1999) critique (see pages 110-113 of Walker (2016) for more on the critique and why it is a problem for the Grossman-Hart-Moore theory).

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). For more on these papers see Walker (2013).

Halonen-Akatwijuka and Hart (2016) have also applied the contracts as reference point approach continuing contracts.

  • Aghion, P, M Dewatripont, P Legros and L Zingales (eds) (2016), The Impact of Incomplete Contracts on Economics, Oxford University Press.
  • 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.
  • Halonen-Akatwijuka, M and O Hart (2016), ‘Continuing Contracts’, mimeo.
  • 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 Holmstrom (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.
  • Hart, O, A Shleifer and R Vishny (1997), ‘The Proper Scope of Government: Theory and an Application to Prisons’, Quarterly Journal of Economics 112(4): 1127-61.
  • Walker, Paul (2013). ‘The ‘Reference Point’ Approach to the Theory of the Firm: An Introduction’, Journal of Economic Surveys, 27(4) September: 670–95.
  • Williamson, Oliver (1975), Markets and Hierarchies, Free Press.
  • Williamson, Oliver (1985), The Economic Institutions of Capitalism, Free Press.

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