The Theory of the Firm: An Overview of the Economic Mainstream, Revised Edition

This is a revised edition of Walker (2017). New sections or subsections have been added on the X-inefficiency model, the division of labour and the firm - both pre and post-1970, ownership of the firm and the human capital based firm. Additions have been made to sections on entrepreneurship, the incomplete contracts approach to the firm, the discussion of Coase’s paper on the ‘The Nature of the Firm’, the discussion of industry-level analysis versus intra-firm analysis, reasons for ignoring firm, a small addition has been made to the Sreni material in section 2.1 and material on Commenda, Waqf and the Clan Corporation has also been added to section 2.1. Appendix 4 has been deleted.

Walker, Paul (2017). The Theory of the Firm: An overview of the economic mainstream, London: Routledge.

The Theory of the Firm: An ... by Paul Walker

Partial versus general equilibrium: the theory of the firm example

A point worth making about the modern models of the theory of the firm is that they illustrate a general issue to do with post-1970 microeconomics, namely, the retreat from the use of general equilibrium (GE) models.

Historian of economic thought Roger Backhouse writes that

 “[i]n the 1940s and 1950s general equilibrium theory [ ...] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254)

and that by the

“[ ...] early 1960s, confidence in general equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s Theory of Value being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), 

but

“[ ...] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over” (Backhouse 2002: 262).

As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in Walras’s famous Elements of Pure Economics, Friedman argued,

“[e]conomics not only requires a framework for organizing our ideas [which Walras provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall” (Friedman 1955: 908).

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

All the models considered in this book are partial equilibrium models, but in this regard, the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well defined institutional settings”.

The Foss, Lando and Thomsen classification scheme for the theory of the firm clearly illustrates the movement of the current theory of the firm literature away from GE towards partial equilibrium analysis. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of GE theory is violated when modelling issues to do with the firm. The theories are divided into either a principal-agent group, based on violating the ‘symmetric information’ assumption, or an incomplete contracts group, based on the violation of the ‘complete contracts’ assumption. The reference point approach extends the incomplete contracts grouping to situations where ex-post trade is only partially contractible.

The introduction of the entrepreneur, as in the models proposed by Silver, Spulber and by Foss and Klein, also challenges, albeit in a different way, the standard GE model since, as William Baumol noted more than 40 years ago, the entrepreneur has no place in formal neoclassical theory.

“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).

The reasons for this are not hard to find. Within the formal model, the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms or other important economic institutions. Bernard Salanie has noted that,

“[ ...] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models” (Salanie 2005: 1).

This would suggest that to make GE models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with non-market organisations such as the firm - developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as essential. One catalyst for the development of such a new approach to GE is that partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a GE framework.

Zingales on Hart

At the 2018 ASSA meeting Luigi Zingales delivered a lecture honouring Oliver Hart, co-winner of the 2016 Nobel Prize for economics.

In part Zingales said,

In the 1970s, this question [the make-or-buy decision] started to receive attention in the so-called transaction-cost literature. The key contributions during that period were Alchian and Demsetz (1972), Williamson (1971 and 1975) and Klein, Crawford, and Alchian (1978). Alchian and Demsetz identified the unique nature of the firm in the team production and the associated cost of metering individual contributions to the collective output. This is the line of research the other Nobelist we are celebrating today, Bengt Holmstrhom, pursued. By contrast, Williamson and Klein, Crawford, and Alchian focused on the role of the firm in mitigating the cost of opportunism. Imagine a printing press owned and operated by someone different from the publisher. If alternative users have much lower valuations for the services of the printing press than the current user, there exists an appropriable quasi rent. Klein, Crawford, and Alchian conclude that “if an asset has a substantial portion of quasi rent which is strongly dependent upon some other particular asset, both assets will tend to be owned by one party.” They are quick to add that “this advantage of joint specialized assets … must of course be weighed against the cost of administering a broader range of assets within the firm.”

In these few lines there are all the key insights of the pre-Hart literature, but also all its limitations, among them:

1. If integration has to do with joint specialized physical assets, to what extent does an employee “belong” to a firm? What makes an employee different from an independent contractor? Are Alchian and Demsetz right in claiming that “I can fire my grocer by stopping purchases from him”? (Not just a theoretical discussion, think about Uber.)
2. What aspect of integration produces all these benefits? Why can’t they be achieved through long-term contracting?
3. Can you have too much integration? Are the limits of the firm determined only by “administrative or bureaucratic costs” or can integration also be detrimental? Does communism not work only because of bureaucracy?

It is these limitations that Hart along with Sandy Grossman and John Moore sort to deal with.

The main source of these limitations is the lack of a formal model, the lack of a language to express clearly the driving forces. The work by Grossman and Hart and Hart and Moore answers all these questions.

1. First of all, the emphasis moves from the specialization of physical assets to that of human capital. In this way, they are able to explain how a firm has “power” over its employees. When my colleague “fires” United Airlines, he does not deprive United employees of any asset they have specialized to. When the CEO of United fires a pilot, he does deprive her of assets (physical and organizational) she specialized to. A pilot (especially an older pilot) is more valuable inside United than outside of it. Thus, a specialized pilot will continue being employed by United. Nevertheless, United’s ability to control the pilot’s quasi-rent is the source of the power an employer has over its employee.

One of the many merits of Oliver’s contribution is to have brought back the concept of power inside economics. This is a concept pervasive in political science and sociology, and pervasive in Marxian economics, but completely absent from neoclassical economics. In fact, Oliver’s view of the firm is very reminiscent of the Marxian view, but where Marx sees exploitation, Oliver sees an efficient allocation.

1. Having identified the source of power, Grossman and Hart help us understand why this can only stem from integration.

To cut this Gordian knot, Oliver and Sandy introduce a new concept: the “residual right of control,” i.e. the right to dispose of an asset in all the situations that have not been explicitly contracted out. They identify this residual right of control with ownership.

With regard to ownership being identified with residual rights of control it is interesting to note a footnote in the Grossman and Hart paper,

Richard Posner, whose opinion on the legal definition of ownership we solicited, has referred us to the following statement by Oliver Wendell Holmes (1881/1946, p. 246): "But what are the rights of ownership? They are substantially the same as those incident to possession. Within the limits prescribed by policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one but him."

Zingales continues,

Of course, this opens the question of why some contingencies cannot be written in a contract, a question Oliver has spent a great deal of time on and a question I will return to momentarily, if time allows.

But if we accept that contracts are incomplete, then it is easy to see how the residual right of control can be used opportunistically to reduce the share of the surplus of other parties in a relationship.

This insight applies in all walks of life. For example, I just launched an economic podcast. In preparation for this event, I have spent a lot of time and effort. Much of this effort is specific to this particular podcast. So how does ownership of this podcast, which currently is in the hands of the University of Chicago, affect my incentives? Not only I, but most of the economics profession would not have a framework to think about this important question without the work of Oliver.

This is an inconsequential example, but it illustrates how rich the Grossman-Hart-Moore framework is in addressing a fundamental problem of entrepreneurs: how to allocate cash flow and control rights to maximize the commitment of all the key players to a new venture. I regularly teach this in my entrepreneurship class and I would not know how to frame this problem if it wasn’t for Grossman-Hart-Moore.

Note that—unlike Williamson—their results do not rely on friction in the renegotiation process. Grossman-Hart-Moore assume costless renegotiation ex post. Still, ownership (and the residual right of control it confers) matters because of the way it affects the out-of-equilibrium outside option and, through it, the share of ex post surplus each party appropriates. This share impacts not only the distribution of the quasi-rents, but also the ex ante incentives to make firm-specific investments, and thus efficiency itself.

1. Having identified how integration works, Grossman-Hart-Moore can also explain the costs of integration. Since control is zero-sum, control given to party A takes control away from party B, reducing B’s incentives to make firm-specific investments. Thus, integrating a supplier reduces the incentive of the supplier to invest in his human capital. As a result, who should own what, the famous question of the boundaries of the firm, finds a very simple answer: it depends upon the relative importance of the contribution to the various parties.

Hart's work has affected many areas of economics.

Before Oliver finance scholars had focused on the allocation of cash flow rights. Yet, it was difficult to explain why capital structure mattered purely on the basis of cash flow right allocation, since all the effects produced by financing decisions could be undone by contracts. It is thanks to Oliver’s model that researchers could start thinking in terms of control allocation: capital structure mattered because it provides a contingent way to allocate control. In other words, Grossman-Hart-Moore changed the way corporate finance theory was done and did so in an irreversible way.

Unlike poets who only allow people to express their feelings, economic theorists also provide a framework for empirical researchers to study new phenomena. The work of Kaplan and Stromberg (2003) on the allocation of control rights in venture capital contracts or the work of Michael Roberts and Amir Sufi on debt covenants would be inconceivable without Oliver’s work.

Similarly, it is very difficult to understand corporate governance without Oliver’s contribution. The famous survey by Shleifer and Vishny (1997) that incorporates Oliver’s work on control rights, changed the literature on corporate governance. Without Oliver’s seminal contribution that change would not have taken place.

While finance has been the main area of application of ICT, there is hardly a field in economics that has not been impacted. One of the first applications, pioneered by Oliver himself with Tirole, is to industrial organization. ICT provides a way to rationalize the famous market foreclosure argument. Another natural area of application is to the costs and benefits of public ownership. This also was pioneered by Oliver with Shleifer and Vishny in the famous prison paper. It is also not surprising that ICT has been applied to internal organization (Aghion) and to international trade (Antras). Finally, issues of power and contract incompleteness are essential to political economy, and in fact in recent years we have seen a proliferation of applications in this direction.

There are a lot of other areas where Oliver’s theory of incomplete contracts can be profitably applied, as family economics. There is hardly a contract that is more incomplete than marriage and one where relationship specific investments (like the children) are more important.

Oliver is a role model not only for his intellectual achievements, but also for the integrity with which he has achieved them. For more than a decade he argues back and forth with two other Nobelist Erik Maskin and Jean Tirole abut the foundations of his theory of incomplete contract. In spite of the enormous amount of reputation he had a stake, he had the courage to recognize that Maskin and Tirole’s critiques were valid and he went back to the drawing board and produced with John Moore a new foundation of incomplete contracts [this work is the 'reference point' approach to incomplete contracts].

The incomplete contracts theory has been one of the major theoretical advances in economics in the last 30 years and Hart's role in it fully justifies the award of the Nobel Prize.

Fun in the sun

Organizational Economics Workshop
Barcelona Graduate School of Economics
14-15 June 2018.

A non-exhaustive list of topics is:

• Relational contracts
• Theory of the Firm
• Incomplete Contracts
• Internal Organization and Incentive Systems
• Management practices
• Business Law and Economics

Keynote speaker
Robert Gibbons (MIT)

What is an incomplete contract?

A two minute answer to the question from Oliver Hart.

Oliver Hart, incomplete contracts and control

From the 2017 Royal Economic Society Conference comes this video of the talk by Oliver Hart, the Winner of the 2016 Nobel Prize in Economics, which is an extended version of his Prize Lecture.


Watch it and actually learn something worth learning!! An usual thing in economics these days. And no, not a regression anywhere.

Contracts are important and old ..... really old

From the Presentation Speech by Professor Per Strömberg, Member of the Royal Swedish Academy of Sciences, Chairman of the Nobel Committee for the Prize in Economic Sciences in Memory of Alfred Nobel, 10 december 2016.

At the edge of the Mediterranean − outside today's Izmir, Turkey − the Greek city of Teos was located in ancient times. During recent excavations of that city, archaeologists discovered a 1.5 meter high white marble stele, with a fifty line long chiselled inscription. The stele turned out to be a 2,200 year old lease agreement for a property including buildings, farmland and associated slaves.

A wealthy man in Teos had donated the property to a nearby gymnasium, but the students - who were busy with their studies and sports - leased it out to the highest bidder. One clause in the detailed agreement gave the owners the right to inspect yearly whether the tenant was keeping the buildings in good repair and taking good care of the farmland. More than half of the lines of the inscription listed the extra fees and penalties that could be charged to the tenant in case of a breach of contract. The agreement also gave the owners the right to hold religious ceremonies on the property three days per year; this not only provided the students with spiritual sustenance, but also made their rental income tax-free.

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 interview

Guy Rolnik interviews this year's Nobel Prize in Economics co-winner Professor Oliver Hart about incomplete contracts and the theory of the firm.

Half an hour well spent.

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,

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

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

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

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

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

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

Hart’s 1990 paper with John Moore developed the theory for a multi-asset and multi-party setting. Ownership – or power – is distributed among the parties to maximise their investment incentives. Hart and Moore show that complementarities between the assets and the parties have important implications. If the assets are so complementary that they are productive only when used together, they should have a single owner. Separating such complementary assets does not give power to anybody, while when the assets have a single owner, the owner has power and improved incentives.

A point to note here is that this ideas of having a single owner for complementary assets helps explain by we most often see control rights and income right being bundled together. Income rights give people an incentive to use assets efficiently while control rights give them the ability to do so. Income and control rights are complementary.

Furthermore, if there are such strong complementarities between an asset and a party that the asset is productive only with that party, then this indispensable party should own the asset. Ownership of the asset would not give power to anybody else and the incentive effect would be wasted.

This theory of the firm is now known as Grossman-Hart-Moore (GHM) property rights theory. It has been applied in various fields, including corporate finance, public economics, political economy and international trade.

I would, of course, recommend reading pages 98-107 of Walker (2016) for a brief introduction to the Grossman-Hart-Moore approach to the theory of the firm.

One of the applications of the Grossman-Hart-Moore theory that Hart has written on is to privatisation. The reason for this application is that there is a close relationship between the theory of the firm and the theory of privatisation. As Hart himself has written,

Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms,A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals).Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B.

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.

The benefit of a rigid contract is that it fixes expectations, avoiding arguments. But it may not perform well when there is uncertainty. A flexible contract can adjust to the state of nature, but there is also room for arguments.

This approach has yet to get much attention in  economics textbooks, but see pages 113-117 of Walker (2016) for more.

Given this lack of discussion I will take a quick look the model given in Hart (2008) which presents a simple, intuitive, reference points model and applies it to the theory of the firm. What is presented below is a slightly modified version of Hart's model. I hope that you can tell the difference between the zero's and the theta's below.

Hart assumes that a seller, S, can provide a good, costing 10, to a buyer, B, who is willing to pay 20. Let us assume that we are talking about a public lecture on some aspect of microeconomics which B is organising and which B wants S to give. A successful lecture is worth 20 to B and it costs 10 for S to give the lecture.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.

Hart goes on to say,

[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.

Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).

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

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

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

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.

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,

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?

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.

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.

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:

​[I]n the first instance, a capitation payment was made on embarkation, and this resulted in the loss of half the conve​cts 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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.

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.

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.

Bryan continues,

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.

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.

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.

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.

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.

And when thinking about agency costs and innovation Bryan writes,

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”.

For just how long are there "behavioural" responses to contract changes?

In a recent paper in the American Economic Review (vol. 106, no. 2, February 2016, pp.316-58) Rajshri Jayaraman, Debraj Ray and Francis de Véricourt look at the Anatomy of a Contract Change.

The abstract reads:

We study a contract change for tea pluckers on an Indian plantation, with a higher government-stipulated baseline wage. Incentive piece rates were lowered or kept unchanged. Yet, in the following month, output increased by 20 to 80 percent. This response contradicts the standard model and several variants, is only partly explicable by greater supervision, and appears to be "behavioral." But in subsequent months, the increase is comprehensively reversed. Though not an unequivocal indictment of "behavioral" models, these findings suggest that nonstandard responses may be ephemeral, and should ideally be tracked over an extended period of time.

So we see behavioural responses in the short-run but they fade over the longer term. What does this tell us about the likely long-term effects of Walmart's much publicised "efficiency wage" experiment?

Jayaraman, Ray and de Véricourt conclude their article by saying,

Our study suggests that classical monetary incentives ultimately dominate, despite a possibly “behavioral” response in the shorter term. More generally, our findings speak to a literature in behavioral economics that highlight both the interaction between “intrinsic” and “extrinsic” motivations, as well as the dynamic evolution of those motivations following a policy change: see Gneezy and Rustichini (2000) and Gneezy, Meier, and Rey-Biel (2011). This literature emphasizes how the introduction of financial incentives might erode more social incentives (reciprocity, gratitude, or fair play).

In this paper the baseline relationship is an employment contract. The transaction is monetary to begin with, and gratitude, reciprocity and prosocial behavior are secondary considerations. Do prosocial motivations ultimately hold sway? It would appear not: they matter in the short run, but do not persist. Ultimately, in this labor market setting, monetary incentives come to dominate their nonpecuniary counterparts. This is not to argue that agents are never driven by notions of the social good, or that loyalty to an employer cannot be nurtured. But, particularly in markets where the fundamental relationship is delineated along economic lines, we need to be alert to the possibility that long- and short-term effects differ, and consequently to the hurried classification of many important economic phenomena as fundamentally “behavioral.”

At the very least these results suggest that it is important to examine responses to a policy change, not just immediately after the change but for a substantive period of time afterwards since short and long-term responses can differ substantially.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What this suggests is that employment is good if the lecture matters more to B than to S, while independent contracting is good if the lecture matters more to S than to B.
Hart goes on to say,

“[o]ne point worth emphasizing is that in neither of the above examples is the following contract optimal: to leave the choice of price and method until date 1, i.e. to rely on unconstrained Coasian bargaining. This would always yield the efficient method, but the aggrievement costs would be high. In [Table not shown] the parties would agree on method 1; however, since there are 10 dollars of surplus to argue over, shading costs equal 10θ: net surplus = 10(1 − θ), which is less than that obtained under the employment contract. In [Table 171.1] there are 12 dollars of surplus to argue over and net surplus = 12(1 − θ), which is less than that obtained under independent contracting.” (Hart 2008: 409).

Clearly the examples above are toy ones, but Hart argues they contain the basic ingredients of a theory of the firm in that they consider the choice between carrying out a transaction in the market, using an independent contractor, and 'inside the firm', via an employment contract. This was the trade-off at the heart of Coase (1937).

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

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

2016 Nobel Prize in economics

The  Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel  2016  was awarded jointly to  Oliver Hart  and  Bengt Holmström  "for their contributions to contract theory"

Press Release: The long and the short of contracts
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.

Popular Science Background

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.

Changes in economic theory

This piece by Justin Fox at BloombergView is just one example of the increasing discussion of the move towards empirical work, away from theory, in economics. This table from Hamermesh (2013: 168) shows the changing nature of research in economics: the amount of theory being published is decreasing while the amount of empirical/experimental work is increasing.

But what is missing from this discussion, however, are the changes in theory that have taken place as well. Since, roughly, 1970 the nature of the theory that is being done has changed. To quote me, Walker (2016: 155):

A final point about the models of the firm discussed in this book is that they highlight a general issue to do with post-1970 microeconomics; namely, the retreat from the use of general equilibrium (GE) models.

Much of the modern theory has developed as a reaction to perceived failures in the standard general equilibrium theory. As Salanie (2005: 2) has argued for the case of contract theory:

The theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings.

What is interesting about the these changes is that they consist of a move not towards a new general equilibrium theory but rather a movement back to partial equilibrium models.

As early as 1955 Milton Friedman was writing,

Economics not only requires a framework for organizing our ideas [which Walras provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall. (Friedman 1955: 908)

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least in so far as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

If we take as an example the theory of the firm one can clearly see this move away from general equilibrium. Foss, Lando and Thomsen (2000) offer a classification scheme to help understand the modern theory of the firm. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of general equilibrium theory is violated when modelling issues to do with the firm. The theories are divided into either a principal–agent group, based on violating the 'symmetric information' assumption, or an incomplete contracts group, based on the violation of the 'complete contracts' assumption.

The necessity of having to violate basic assumptions of general equilibrium theory so that we can model the firm, suggests, importantly, that as it stands general equilibrium cannot deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,

[...] the organization of the many institutions that govern economic relationships is entirely absent from these [general equilibrium] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models. (Salanie 2005: 1)

A benefit to these changes in the approach to theory is that these changes have helped stimulated the increase in empirical work we see. The modern theory, in areas as devise as game theory, contract theory, organisational theory, asymmetric information, incentive theory, industrial organisation etc, has lent itself to empirical/experimental testing in a way that the older theory didn't. So theoretical and empirical work has changed together in a way that is mutually reinforcing.

Of course these changes have come with costs as well as benefits.  For example, partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a general equilibrium framework.

Refs.:

• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics (vol. III, 631–58), Cheltenham, UK: Edward Elgar Publishing Ltd.
• Friedman, Milton (1955). "Leon Walras and His Economic System", American Economic Review, 45(5): 900-9.
• Hamermesh, Daniel S. (2013). "Six Decades of Top Economics Publishing: Who and How?", Journal of Economic Literature 51(1): 162-72.
• Salanie, Bernard (2005). The Economics of Contracts: A Primer, 2nd edn., Cambridge MA: The MIT Press.
• Walker, Paul (2016). The Theory of the Firm: An overview of the economic mainstream, London: Routledge.

Privatisation and information

Over at the Offsetting Behaviour blog Eric Crampton quotes from the conclusion to my recent NZEP paper on the theory of privatisation. Eric highlights the problems that the ex ante restrictions that governments often place on privatisation schemes can cause.

From Walker's conclusion

...there is an implicit assumption in the literature discussed above that economic efficiency is a major objective of privatisation but the, ex ante, conditions sometimes imposed by governments on the sale of assets often serve political rather than economic ends. Examples of such conditions are things like the New Zealand government’s restrictions on foreign ownership and the desire to sell to ‘Mums and Dads’, both of which restrict the number of possible bidders. Such conditions also result in fragmented ownership, making it difficult for owners to coordinate their efforts to effect the firm’s behaviour. In addition, given that each ‘Mum or Dad’ will own only a very small share of any of the firms, they have little incentive to become informed on the firm’s activities since they will only capture a very small amount of any improvement in performance they could bring about. These factors suggest that, in practice, little will change in terms of the behaviour of the SOEs: they will remain, for all intents and purposes, government-controlled entities. This contradicts the very reason for privatising SOEs in the first place.

While I completely agree with myself, let me add that ex ante restrictions are not the only cause of problems with privatisation programs. Badly designed ex post rules can also result in bad outcomes from privatisation:

...an important driver of several of the results presented above is the degree to which politicians can interfere, ex post, with the operations of the firm. The lower the cost of interference, the greater the likelihood of firms being induced to serve political rather than economic ends. This highlights the importance of post-privatisation regulation, and competition, to the outcome of an asset sales programme.

The easier and (politically) cheaper it is for politicians to interfere with firms after they have been privatised the more likely it is that the results of a privatisation program will be poor. A strong ex post framework which emphasises competition and raises as high as possible the costs to political interference with the privatiased firm the better the outcomes to privatisation are likely to be.