Showing posts with label Nobel Prize. Show all posts
Showing posts with label Nobel Prize. Show all posts
Saturday, 21 January 2017
Saturday, 31 December 2016
Nobel Prize-winning thoughts on incentives and the importance of contracts
Monday, 12 December 2016
Nobel Prize lectures in economic sciences for 2016
From Nobelprize.org:
Oliver Hart: Incomplete Contracts and Control
Oliver Hart delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.
Bengt Holmström: Pay for Performance and Beyond
Bengt Holmström delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.
Oliver Hart: Incomplete Contracts and Control
Oliver Hart delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.
Bengt Holmström: Pay for Performance and Beyond
Bengt Holmström delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.
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,
Bryan continues by commenting on Hart's more recent work on the reference point approach to the firm,
Refs.:
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.As an aside Bryan writes,
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.
[...] 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.Byran is correct when he says we have, as yet, no "believable, logically ironclad theory". As I note in Walker (2016: 160)
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.)
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.But if we had all the answers there would be no fun (or point) in working in the area.
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.
Refs.:
- 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.
Sunday, 30 October 2016
Maija Halonen-Akatwijuka on "Oliver Hart, Nobel laureate"
Maija Halonen-Akatwijuka writes on Oliver Hart, Nobel laureate at VoxEU.org. 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,
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,
Halonen-Akatwijuka points out that,
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,
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,
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.
Refs.
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).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.
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.
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.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.
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.
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.Also,
[...] 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.This approach has yet to get much attention in economics textbooks, but see pages 113-117 of Walker (2016) for more.
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.
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.
Refs.
- 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.
Monday, 24 October 2016
Kevin Bryan on Bengt Holmstrom and the black box of the firm
Kevin Bryan writes at VoxEU.org on the key contributions of Bengt Holmstrom to the theory of contracts and its application to the theory of the firm. Bryan opens by saying,
So real people where into incentives contracts long before economists started formal investigation of them!!!
The British economist Edwin Chadwick was also thinking about about such issues in the mid-1800s. Chadwick pondered the question of incentives for the transportation of prisoners from the UK to Australia. Chadwick noted:
Bryan goes on:
Holmström’s contribution lies most centrally in the area of formal contract design. Imagine that you want someone – an employee, a child, a subordinate division, an aid contractor or, more generally, an ‘agent’ – to perform a task. How should you induce them to do this?Perhaps a real world example of such a contract may help illustrate that is happening here. Below are details of the contract for surgeons on the ships that transported colonists to the province of Canterbury in New Zealand in the 1850s.
If the task is ‘simple’ – meaning that the agent’s effort and knowledge about how to perform the task most efficiently is known and observable – you can simply pay a wage, cutting off payment if effort is not being exerted. When only the outcome of work can be observed, if there is no uncertainty in how effort is transformed into outcomes, knowing the outcome is equivalent to knowing effort, and hence optimal effort can be achieved via a bonus payment made on the basis of outcomes.
All straightforward so far. The trickier situations, which Holmström and his co-authors have analysed at great length, are when neither effort nor outcomes are directly observable.
Consider paying a surgeon. You want to reward the doctor for competent, safe work.
The British economist Edwin Chadwick was also thinking about about such issues in the mid-1800s. Chadwick pondered the question of incentives for the transportation of prisoners from the UK to Australia. Chadwick noted:
[I]n the first instance, a capitation payment was made on embarkation, and this resulted in the loss of half the convects put on board ; by degrees that loss was reduced to one-third ; but when, under the auspices of a new colonial administration, the system was altered to a capitation payment for all the convicts that were landed at their destination, the contrast was very striking indeed, and tho owners of the vessels carried surgeons, and the best means were devised for landing the largest possible number at the port for which they were bound.But as Byran notes that Holmstrom was aware that in general, in the modern case, it is very difficult to observe perfectly what the surgeon is doing at all times, and basing pay on outcomes has a number of problems:
Bryan continues,Holmström wrote the canonical paper on each of these topics. His 1979 paper shows that any information that reduces the uncertainty about what an agent actually did should feature in a contract, since by reducing uncertainty, you reduce the risk premium needed to incentivize the agent to accept the contract.
- First, the patient outcome depends on the effort of not just one surgeon, but on others in the operating room and prep table. Team incentives must be provided.
- Second, the doctor has many ways to shift the balance of effort between reducing costs to the hospital, increasing patient comfort, increasing the quality of the medical outcome, and mentoring young assistant surgeons. So paying on the basis of one or two tasks may distort effort away from other harder-to-measure tasks. There is a multitasking problem.
- Third, the number of medical mistakes, or the cost of surgery, that a hospital ought to expect from a competent surgeon depends on changes in training and technology that are hard to know, and hence a contract may want to adjust payments for its surgeons on the performance of surgeons elsewhere. Contracts ought to take advantage of relevant information when it is informative about the task being incentivised.
- Fourth, since surgeons will dislike risk in their salary, the fact that some negative patient outcomes are just bad luck means that you will need to pay the surgeon very high bonuses to overcome their risk aversion. When outcome measures involve uncertainty, optimal contracts will weigh ‘high-powered’ bonuses against ‘low-powered’ insurance against risk.
- Fifth, the surgeon can be incentivised either by payments today or by keeping their job tomorrow, and worse, these career concerns may cause the surgeon to waste the hospital’s money on tasks that matter to the surgeon’s career beyond the hospital.
It might seem strange that contracts in many cases do not satisfy this ‘informativeness principle’. For example, CEO bonuses are often not indexed to the performance of firms in the same industry. If oil prices rise, essentially all oil firms will be very profitable, and this is true whether or not a particular CEO is a good one. Bertrand and Mullainathan (2001) argue that this is because many firms with diverse shareholders are poorly governed.
Much of Holmström’s work in the 1980s and 1990s tried to square the gap between theory and empirics by finding justifications for the simplicity of many real world contracts that can be rationally justified.A brief discussion of a simple version of Holmstrom's 1982 paper, due to Kim C. Border, and its relationship to Alchian and Demsetz's work is given in chapter 4 of The Theory of the Firm: An overview of the economic mainstream.
Written jointly with Paul Milgrom, the famous ‘multitasking’ paper published in 1991 notes that contracts shift incentives across different tasks in addition to serving as risk-sharing mechanisms and as methods for inducing effort. Since bonuses on task A will cause agents to shift effort away from hard-to-measure task B, it may be optimal to avoid strong incentives at all (just pay teachers a salary rather than a bonus based only on test performance) or to split job tasks (pay bonuses to teacher A who is told to focus only on mathematics test scores, and pay salary to teacher B who is meant to serve as a mentor).
That outcomes are generated by teams also motivates simpler contracts. Holmström’s 1982 article on incentives in teams points out that if both my effort and yours is required to produce a good outcome, then the marginal product of our efforts are both equal to the entire value of what is produced, hence there is not enough output to pay each of us our marginal product. What can be done?
Alchian and Demsetz had noticed this problem in 1972, arguing that firms exist to monitor the effort of individuals working in teams. With perfect knowledge of who does what, you can simply pay the workers a wage sufficient to make the optimal effort, then collect the residual as profit.
Holmström notes that the monitoring isn’t the important bit; rather, even shareholder-controlled firms where shareholders do no monitoring at all are useful. The reason is that shareholders can be residual claimants for profit, and hence there is no need to distribute profit fully to members of the team.
Bryan goes on:
Free-riding can therefore be eliminated by simply paying team members a wage of X if the team outcome is optimal, and zero otherwise. Even a slight bit of shirking by a single agent drops their payment precipitously (which is impossible if all profits generated by the team are shared by the team), so the agents will not shirk. Of course, when there is uncertainty about how team effort transforms into outcomes, this harsh penalty will not work, and hence incentive problems may require team sizes to be smaller than that which is first-best efficient.And when thinking about agency costs and innovation Bryan writes,
A third justification for simple contracts is career concerns: agents work hard today to try to signal to the market that they are high-quality, and do so even if they are paid a fixed wage. This argument had been made less formally by 2013 Nobel laureate Eugene Fama, but Holmström in a 1982 working paper (finally published in 1999) showed that this concern about the market only completely mitigates moral hazard if outcomes within a firm are fully observable to the market, or the future is not discounted at all, or there is no uncertainty about agent’s abilities. Indeed, career concerns can make effort provision worse; for example, agents may take actions to signal quality to the market that are negative for their current firm.
A final explanation for simple contracts comes from Holmström’s 1987 paper with Milgrom. They argue that simple ‘linear’ contracts, with a wage and a bonus based linearly on output, are more ‘robust’ methods of solving moral hazard because they are less susceptible to manipulation by agents when the environment is not perfectly known. [...]
These ideas are reasonably intuitive, but the way Holmström answered them is not. Think about how an economist before the 1970s, like Adam Smith in his famous discussion of the inefficiency of sharecropping, might have dealt with these problems. These economists had few tools to deal with asymmetric information, so although economists like George Stigler (1961) analysed the economic value of information, the question of how to elicit information useful to a contract could not be discussed in any systematic way.
These economists would also have been burdened by the fact that the number of contracts one could write are infinite. So beyond saying that under a contract of type X does not equate marginal cost to marginal revenue, the question of which ‘second-best’ contract is optimal is extraordinarily difficult to answer in the absence of beautiful tricks like the revelation principle, partially developed by Holmström himself.
Holmström’s work is brilliant in how it clarifies many puzzles that are tricky to understand without thinking about incentives within a firm. For example, why would a risk-neutral firm not work enough on high-variance moonshot-type R&D projects? This is a question Holmström asks in his 1989 paper. Four reasons:
- First, in Holmström and Milgrom’s 1987 linear contracts paper, optimal risk-sharing leads to more distortion by agents the riskier the project being incentivised, so firms may choose lower expected value projects even if they themselves are risk-neutral.
- Second, firms build reputation in capital markets just as workers do with career concerns, and high-variance output projects are more costly in terms of the future value of that reputation when the interest rate on capital is lower (for example, when firms are large and old).
- Third, when R&D workers can potentially pursue many different projects, multitasking suggests that workers should be given small and very specific tasks so as to lessen the potential for bonus payments to shift worker effort across projects. Smaller firms with fewer resources may naturally have limits on the types of research a worker could pursue, which surprisingly makes it easier to provide strong incentives for research effort on the remaining possible projects.
- Fourth, multitasking suggests that agent’s tasks should be limited, and that high-variance tasks should be assigned to the same agent, which provides a role for decentralising research into large firms providing incremental, safe research, and small firms performing high-variance research. A deep understanding of how these types of internal incentives aggregate into explanations for why firms appear the way they do can best be achieved by a thorough reading of Holmström and Milgrom’s beautiful 1987 paper, “The Firm as an Incentive System”.
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,
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).
Refs.:
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).
Refs.:
- 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
Views on the 2016 Nobel Prize in economics
Just a few links giving different views on the prize.
The Conversable Economist: Oliver Hart and Bengt Holmström: The 2016 Nobel Prize in Economics
A Fine Theorem: NOBEL PRIZE 2016 PART I: BENGT HOLMSTROM
A Fine Theorem: NOBEL PRIZE 2016 PART II: OLIVER HART
Coordination Problem: And the Nobel Goes To ... Oliver Hart and Bengt Holmstrom
Mises Wire: The 2016 Nobel Prize: Incentives, Property Rights, and Ownership
Marginal Revolution: Private Prisons and Incentive Design: Critiquing Oliver Hart
Marginal Revolution: The Performance Pay Nobel
Marginal Revolution: Bengt Holmström, Nobel Laureate
Marginal Revolution: Oliver Hart, Nobel Laureate
Free exchange: Oliver Hart and Bengt Holmstrom win the Nobel prize for economic sciences
Money Watch: Why this Nobel prize for economics is so well deserved
Monday, 10 October 2016
2016 Nobel Prize in economics
Press Release: The long and the short of contractsPopular Science Background
Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design.
Society’s many contractual relationships include those between shareholders and top executive management, an insurance company and car owners, or a public authority and its suppliers. As such relationships typically entail conflicts of interest, contracts must be properly designed to ensure that the parties take mutually beneficial decisions. This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities.
In the late 1970s, Bengt Holmström demonstrated how a principal (e.g., a company’s shareholders) should design an optimal contract for an agent (the company’s CEO), whose action is partly unobserved by the principal. Holmström’s informativeness principle stated precisely how this contract should link the agent’s pay to performance-relevant information. Using the basic principal-agent model, he showed how the optimal contract carefully weighs risks against incentives. In later work, Holmström generalised these results to more realistic settings, namely: when employees are not only rewarded with pay, but also with potential promotion; when agents expend effort on many tasks, while principals observe only some dimensions of performance; and when individual members of a team can free-ride on the efforts of others.
In the mid-1980s, Oliver Hart made fundamental contributions to a new branch of contract theory that deals with the important case of incomplete contracts. Because it is impossible for a contract to specify every eventuality, this branch of the theory spells out optimal allocations of control rights: which party to the contract should be entitled to make decisions in which circumstances? Hart’s findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law. His research provides us with new theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and when institutions such as schools or prisons ought to be privately or publicly owned.
Through their initial contributions, Hart and Holmström launched contract theory as a fertile field of basic research. Over the last few decades, they have also explored many of its applications. Their analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions.
Scientific Background.
A great award, contract theory is important in so many areas of economics now. For me, of course, its importance is in the theory of the firm. Both the work of Hart and Holmstrom has played a major role in the modern theory of the firm. In addition to the Ronald Coase (Nobel 1991) and Oliver Williamson (Nobel 2009) these guys are two of the biggest players in the field. Holmstrom's work has been in the area of the moral hazard in teams approach to the firm while Hart was one of the major developers of the incomplete contracts (or property rights) and reference point approaches to the firm.
Monday, 3 October 2016
The economics Nobel Prize
At The Enlightened Economist blog Diane Coyle writes,
There must be others.
A comment on my post reviewing The Nobel Factor by Avner Offer and Gabriel Soderberg asked if the book covers the reasons Joan Robinson was never awarded the prize. There is a passing mention: “In the list of those who were denied the prize, it is difficult not to conclude that Robinson and Galbraith were kept out for ideological reasons.” Other non-winners in contention include, among others, Will Baumol, Zvi Griliches, Albert Hirschman, Moses Abramovitz, Harold Hotelling, Anthony Atkinson, Dale Jorgensen, Partha Dasgupta, Nicholas Kaldor and – the other woman – Anna Schwartz. A mixed bunch, some still alive of course.My comment on this was,
Hotelling died only 4 years after the prize started so its not surprising he didn’t get it. Robinson, Griliches and Schwartz could be considered a bit unlucky. Was Kaldor ever really in the running? If so for what? Baumol, Atkinson, Jorgenson are still in the running. Galbraith? What planet are these guys on?! The rest I’m not sure were/are genuine contenders.But as we are only a week away from the announcement of 2016 prize we do face the question of who is likely to get it this time round? Baumol/Kirzner for entrepreneurship is always picked by many. I'm going for Oliver Hart/Bengt Holmstrom for contract theory/theory of the firm, Posner for law and economics is always possible. Paul Romer for growth theory (and causing trouble in macro!).
There must be others.
Tuesday, 13 October 2015
2015 Nobel Prize in economics
The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2015 to
Angus Deaton
Princeton University, NJ, USA
"for his analysis of consumption, poverty, and welfare".
Angus Deaton, UK and US citizen. Born 1945 in Edinburgh, UK. Ph.D. 1974 from University of Cambridge, UK. Professor of Economics and International Affairs, Princeton University, NJ, USA, since 1983.
The work for which Deaton is now being honoured revolves around three central questions:
How do consumers distribute their spending among different goods? Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation.
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics.
How do we best measure and analyse welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data.
Press Release
Advanced Information
Princeton University, NJ, USA
"for his analysis of consumption, poverty, and welfare".
Angus Deaton, UK and US citizen. Born 1945 in Edinburgh, UK. Ph.D. 1974 from University of Cambridge, UK. Professor of Economics and International Affairs, Princeton University, NJ, USA, since 1983.
The work for which Deaton is now being honoured revolves around three central questions:
How do consumers distribute their spending among different goods? Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation.
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics.
How do we best measure and analyse welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data.
Press Release
Advanced Information
Tuesday, 14 October 2014
2014 Nobel Prize in economics: Jean Tirole
A number of people seem more excited by this award than me, see for example, A Fine Theorem, Joshua Gans at Digitopoly and Tyler Cowen at Marginal Revolution. (Peter Klein at Organizations and Markets and Joseph Salerno at the Mises Economics Blog are less excited.)
Cowen does mention Tirole's survey article with Holmstrom on the theory of the firm which is well worth reading even if a few years old now. In a survey paper of mine on the theory of privatisation I say this about a paper by Laffont and Tirole (Jean-Jacques Laffont and Jean Tirole (1991). ‘Privatization and Incentives’, Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.):
Cowen does mention Tirole's survey article with Holmstrom on the theory of the firm which is well worth reading even if a few years old now. In a survey paper of mine on the theory of privatisation I say this about a paper by Laffont and Tirole (Jean-Jacques Laffont and Jean Tirole (1991). ‘Privatization and Incentives’, Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.):
In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm’s manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm’s investment. A rational expectation of such an expropriation would reduce the incentives of a public firm’s manager to make the required investment. For a private firm, the manager’s incentives to invest are better given that both the firm’s owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm’s cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm’s management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm’s managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.Cowen goes on to say,
It’s an excellent and well-deserved pick. One point is that some other economists, such as Oliver Hart and Bengt Holmstrom, may be disappointed they were not joint picks, this would have been the time to give them the prize too, so it seems their chances have gone down.Hart and Holmstrom's chances may have gone up since they can now be given for their, separate and joint, work on different aspects of the theory of the firm.
Tuesday, 8 January 2013
Aumann on Shapley and Roth
In the February 2013 Notices of the American Mathematical Society Robert Aumann writes on Shapley and Roth Awarded Nobel Prize in Economics (pdf).
(HT: Market Design)
(HT: Market Design)
Monday, 7 January 2013
Roberto Serrano on Lloyd Shapley
When Lloyd Shapley was named co-winner of last year's Nobel Prize in economics many people went, Who? Well here is a link to a paper by Roberto Serrano which explains Shapley's contribution to game theory.
(HT: Market Design)
(HT: Market Design)
Tuesday, 16 October 2012
2012 Nobel Prize in Economics 2
From the Nobel website,
In this paper Alvin Roth himself asks: What have we learned from market design? Update to Roth (2008). The abstract reads:
The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2012 toAdditional information is available here. Joshua Gans notes A Nobel Prize for Market Design.
Alvin E. Roth
Harvard University, Cambridge, MA, USA, and Harvard Business School, Boston, MA, USA
and
Lloyd S. Shapley
University of California, Los Angeles, CA, USA
"for the theory of stable allocations and the practice of market design".
Stable allocations – from theory to pratice
This year's Prize concerns a central economic problem: how to match different agents as well as possible. For example, students have to be matched with schools, and donors of human organs with patients in need of a transplant. How can such matching be accomplished as efficiently as possible? What methods are beneficial to what groups? The prize rewards two scholars who have answered these questions on a journey from abstract theory on stable allocations to practical design of market institutions.
Lloyd Shapley used so-called cooperative game theory to study and compare different matching methods. A key issue is to ensure that a matching is stable in the sense that two agents cannot be found who would prefer each other over their current counterparts. Shapley and his colleagues derived specific methods – in particular, the so-called Gale-Shapley algorithm – that always ensure a stable matching. These methods also limit agents' motives for manipulating the matching process. Shapley was able to show how the specific design of a method may systematically benefit one or the other side of the market.
Alvin Roth recognized that Shapley's theoretical results could clarify the functioning of important markets in practice. In a series of empirical studies, Roth and his colleagues demonstrated that stability is the key to understanding the success of particular market institutions. Roth was later able to substantiate this conclusion in systematic laboratory experiments. He also helped redesign existing institutions for matching new doctors with hospitals, students with schools, and organ donors with patients. These reforms are all based on the Gale-Shapley algorithm, along with modifications that take into account specific circumstances and ethical restrictions, such as the preclusion of side payments.
Even though these two researchers worked independently of one another, the combination of Shapley's basic theory and Roth's empirical investigations, experiments and practical design has generated a flourishing field of research and improved the performance of many markets. This year's prize is awarded for an outstanding example of economic engineering.
In this paper Alvin Roth himself asks: What have we learned from market design? Update to Roth (2008). The abstract reads:
"After a market has been designed, adopted, and implemented, it has a continuing life of its own. For those involved directly in the market, it is useful to continue to monitor it to make sure it is functioning well. For those of us involved in market design, it is also good to check how things are going, as a way to find out if there are unanticipated problems that still need to be addressed. Finally, the design and operation of new marketplaces also raises new theoretical questions, which sometimes lead to progress in economic theory. In this update, I’ll briefly point to developments of each of these kinds, since the publication of Roth (2008), What have we learned from market design?. I’ll discuss theoretical results only informally, to avoid having to introduce the full apparatus of notation and technical assumptions."The 2008 paper referred to is available from: Roth, Alvin E. "What have we learned from market design?" Hahn Lecture, Economic Journal, 118 (March), 2008, 285-310. Roth also writes about The Art of Designing Markets in the Harvard Business Review. Lynne Kiesling writes on the Roth/Shapley Nobel at the Knowledge Problem blog.
2012 Nobel Prize in economics
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2012 was awarded jointly to Alvin E. Roth and Lloyd S. Shapley "for the theory of stable allocations and the practice of market design"More on this later.
Tuesday, 11 October 2011
2011 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel
The 2011 Economics Nobel Prize has been awarded to: Thomas J. Sargent and Christopher A. Sims "for their empirical research on cause and effect in the macroeconomy".
The Press Release reads:
The Press Release reads:
More information is available here (pdf).Cause and effect in the macroeconomy
How are GDP and inflation affected by a temporary increase in the interest rate or a tax cut? What happens if a central bank makes a permanent change in its inflation target or a government modifies its objective for budgetary balance? This year's Laureates in economic sciences have developed methods for answering these and many of other questions regarding the causal relationship between economic policy and different macroeconomic variables such as GDP, inflation, employment and investments.
These occurrences are usually two-way relationships – policy affects the economy, but the economy also affects policy. Expectations regarding the future are primary aspects of this interplay. The expectations of the private sector regarding future economic activity and policy influence decisions about wages, saving and investments. Concurrently, economic-policy decisions are influenced by expectations about developments in the private sector. The Laureates' methods can be applied to identify these causal relationships and explain the role of expectations. This makes it possible to ascertain the effects of unexpected policy measures as well as systematic policy shifts.
Thomas Sargent has shown how structural macroeconometrics can be used to analyze permanent changes in economic policy. This method can be applied to study macroeconomic relationships when households and firms adjust their expectations concurrently with economic developments. Sargent has examined, for instance, the post-World War II era, when many countries initially tended to implement a high-inflation policy, but eventually introduced systematic changes in economic policy and reverted to a lower inflation rate.
Christopher Sims has developed a method based on so-called vector autoregression to analyze how the economy is affected by temporary changes in economic policy and other factors. Sims and other researchers have applied this method to examine, for instance, the effects of an increase in the interest rate set by a central bank. It usually takes one or two years for the inflation rate to decrease, whereas economic growth declines gradually already in the short run and does not revert to its normal development until after a couple of years.
Although Sargent and Sims carried out their research independently, their contributions are complementary in several ways. The laureates' seminal work during the 1970s and 1980s has been adopted by both researchers and policymakers throughout the world. Today, the methods developed by Sargent and Sims are essential tools in macroeconomic analysis.
Tuesday, 12 October 2010
2010 Nobel Prize in economics 2
Over at Marginal Revolution Tyler Cowen has written profiles on each of this year’s winners: Diamond, Mortenson, and Pissarides. Alex Tabarrok sums things up by saying,
The 2010 Nobel Prize awarded to Peter A. Diamond, Dale T. Mortensen, Christopher A. Pissarides can be thought of as a prize for unemployment theory.The Press Release from The Royal Swedish Academy of Sciences reads,
A key breakthrough was to realize that the problem was not how to explain unemployment per se but rather how to explain hiring, firing, quits, vacancies and job search and to think of unemployment as the result of all of this underlying microeconomic behavior. Notice that the underlying behavior involves not just workers looking for jobs but also employers looking for workers so explaining unemployment would require a theory of job search, worker search and matching and each aspect of the theory would have to be consistent with every other aspect; i.e. how much workers search depends on how much employers are searching (e.g. advertising) and vice-versa and also on the quality of matching and all of these considerations need to be addressed together. It was Mortensen and Pissarides in particular, building on work by Diamond, who built just such a consistent model.
A very surprising empirical fact helped to motivate this perspective: even in a recession millions of jobs are being created every month. The figures we usually hear about the number of jobs created is the net figure but in the United States in August, for example, there were 4.1 million hires (and 4.2 million separations). Thus, as noted above, understanding unemployment requires understanding these much larger flows of job creation and destruction.
Markets with search costsAdditional information is available here and here.
Why are so many people unemployed at the same time that there are a large number of job openings? How can economic policy affect unemployment? This year's Laureates have developed a theory which can be used to answer these questions. This theory is also applicable to markets other than the labor market.
On many markets, buyers and sellers do not always make contact with one another immediately. This concerns, for example, employers who are looking for employees and workers who are trying to find jobs. Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish. Simultaneously, there are both job vacancies and unemployment on the labor market.
This year's three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labor market. The Laureates' models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.
Search theory has been applied to many other areas in addition to the labor market. This includes, in particular, the housing market. The number of homes for sale varies over time, as does the time it takes for a house to find a buyer and the parties to agree on the price. Search theory has also been used to study questions related to monetary theory, public economics, financial economics, regional economics, and family economics.
2010 Nobel Prize in economics
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2010
has gone to
Peter A. Diamond
Massachusetts Institute of Technology, Cambridge, MA, USA,
Dale T. Mortensen
Northwestern University, Evanston, IL, USA
and
Christopher A. Pissarides
London School of Economics and Political Science, UK
"for their analysis of markets with search frictions".
Thursday, 10 December 2009
Nobel prize lecture by Elinor Ostrom
This 28 minute video is of the Nobel prize lecture on "Beyond Markets and States: Polycentric Governance of Complex Economic Systems" given by Elinor Ostrom who is the co-winner of the 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Ostrom delivered her Prize Lecture on 8 December 2009 at Aula Magna, Stockholm University. This video was downloaded from the Nobelprize.org. The video here is based on the "low quality" (20mb) version. There is also a "high quality" (100mb) version available.
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