Tuesday, 1 November 2016

Kevin Bryan on Oliver Hart and the nature of the firm

Kevin Bryan writes at VoxEU.org on Oliver Hart's contribution to the theory of the firm.

Bryan writes,
Grossman and Hart (1986) instead argue that the distinction that really makes a firm a firm is that it owns assets. Why does ownership matter? They retain the idea that contracts may be incomplete – at some point, I will disagree with my suppliers, or my workers, or my branch manager, about what should be done, either because a state of the world has arrived not covered by our contract, or because it is in our first-best mutual interest to renegotiate that contract.

They retain the idea that there are relationship-specific rents, so I care about maintaining this particular relationship. But rather than rely on transaction costs, they simply point out that the owner of the asset is in a much better bargaining position when this disagreement occurs. Therefore, the owner of the asset will get a bigger percentage of rents after renegotiation. Hence the person who owns an asset should be the one whose incentive to improve the value of the asset is most sensitive to that future split of rents.

Baker and Hubbard (2004) provide a nice empirical example: when on-board computers to monitor how long-haul trucks were driven began to diffuse, ownership of those trucks shifted from owner-operators to trucking firms. Before the computer, if the trucking firm owns the truck, it is hard to contract on how hard the truck will be driven or how poorly it will be treated by the driver. If the driver owns the truck, it is hard to contract on how much effort the trucking firm dispatcher will exert ensuring the truck isn’t sitting empty for days, or following a particularly efficient route.

The computer solves the first problem, meaning that only the trucking firm is taking actions relevant to the joint relationship that are highly likely to be affected by whether they own the truck or not. In Grossman and Hart’s ‘residual control rights’ theory, then, the introduction of the computer should mean the truck ought, post-computer, be owned by the trucking firm. If these residual control rights are unimportant – there is no relationship-specific rent and no incompleteness in contracting – then the ability to shop around for the best relationship is more valuable than the control rights provided by asset ownership.

Hart and Moore (1990) extend this basic model to the case where there are many assets and many firms, suggesting critically that sole ownership of assets that are highly complementary in production is optimal. Asset ownership affects outside options when the contract is incomplete by changing bargaining power, and splitting ownership of complementary assets gives multiple agents weak bargaining power and hence little incentive to invest in maintaining the quality of, or improving, the assets. Hart et al. (1997) provide a great example of residual control rights applied to the question of why governments should run prisons but not garbage collection.
As an aside Bryan writes,
[...] note the role that bargaining power plays in all of Hart’s theories. We do not have a ‘perfect’ – in a sense that can be made formal – model of bargaining, and Hart tends to use bargaining solutions from cooperative game theory like the Shapley value. After Lloyd Shapley’s Nobel prize alongside Alvin Roth in 2012, this makes multiple prizes heavily influenced by cooperative games applied to unexpected problems. Perhaps the theory of cooperative games ought still be taught with vigour in PhD programmes.
I have to agree with Bryan here, coopertive game theory should be taught to all students. The guy that taught me game theory in my honours degree covered cooperative as well as non-cooperative game theory and the cooperative stuff was interesting with more applied applications than you would think. One of my first publications was on the application of cooperative game theory to cost allocation problems. How do you allocate fixed ad joint costs of a project to those agents undertaking the project? Cooperative game theory gives some nice solution to this problem. It also comes in handy when dealing with bargaining problems like those utilised in Hart's work. The two most commonly use solutions concepts are the Nash bargaining solution and the Shapley Value.

Bryan continues by commenting on Hart's more recent work on the reference point approach to the firm,
[...] he has been primarily working on theories which depend on reference points, a behavioural idea that when disagreements occur between parties, the ex ante contracts are useful because they suggest ‘fair’ divisions of rent, and induce shading and other destructive actions when those divisions are not given. These behavioural agents may very well disagree about what the ex ante contract means for ‘fairness’ ex post.

The primary result is that flexible contracts (for example, contracts that deliberately leave lots of incompleteness) can adjust easily to changes in the world but will induce spiteful shading by at least one agent, while rigid contracts do not permit this shading but do cause parties to pursue suboptimal actions in some states of the world.

This perspective has been applied by Hart to many questions over the past decade, such as why it can be credible to delegate decision-making authority to agents: if you try to seize it back, the agent will feel aggrieved and will shade effort (Hart and Holmström 2010). These responses are hard, or perhaps impossible, to justify when agents are perfectly rational, and of course the Maskin-Tirole critique would apply if agents were purely rational.

So where does all this leave us concerning the initial problem of why firms exist in a sea of decentralised markets? We have many clever ideas, suitable for particular contexts, but still do not have a believable, logically ironclad theory.

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organised as they are, why they persist over time, and why inter-firm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational – foolishness is not a good justification for institutions employed by millions of organisations.

Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many ‘resource’ type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.)
Byran is correct when he says we have, as yet, no "believable, logically ironclad theory". As I note in Walker (2016: 160)
While the post-1970 theory of the firm literature has began the task of developing a genuine understanding of the firm, and closely related issues, it has yet to coalesce around one model or even one group of models. Even within the contemporary mainstream there are a number of competing models, to say nothing of those we could add into the mix if we were to consider the heterodox literature.

As Bylund (2016: 1–2) explains,
[...] there are several notable theories that each provide a different explanation and rationale for the business firm. [...] [T]here are several different definitions of what the firm supposedly is. [...] But each one must necessarily be incomplete, since it doesn’t capture all of what the other definitions capture.
One can be forgiven for thinking that the current situation with regard to the modelling of the firm is much like a group of blind men trying to describe an elephant, each man can tell you about the part he can feel while remaining unaware of the rest of the animal. Each of the current theories tells us something about the firm, but none can tell us everything.
But if we had all the answers there would be no fun (or point) in working in the area.

  • Baker, G, and T Hubbard (2004), ‘Contractibility and Asset Ownership: On-board Computers and Governance in US Trucking’, Quarterly Journal of Economics 119(4): 1443-79.
  • Bylund, Per L. (2016). The Problem of Production: A New Theory of the Firm, London: Routledge.
  • Grossman, S, and O Hart (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy 94(4): 691-719.
  • Hart, O, and B Holmström (2010), ‘A Theory of Firm Scope’, Quarterly Journal of Economics 125(2): 483-513.
  • Hart, O, and J Moore (1990) ‘Property Rights and the Nature of the Firm’, Journal of Political Economy 98(6): 1119-58.

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