371
Incomplete Contracts and Control
Prize Lecture, December 8, 2016
by Oliver Hart
Department of Economics, Harvard University, USA
1. INTRODUCTION
The work on incomplete contracts cited by the prize committee began in the
summer of 1983, but it may be useful to say a bit about how I reached that point.
As a graduate student, first at the University of Warwick and then at Princeton
University, with a degree in mathematics behind me, I was drawn to general
equilibrium theory, and my Ph.D. thesis was on general equilibrium theory with
incomplete markets.
1
Although I ended up focusing on optimality and existence
problems that could arise even in exchange economies, one of my primary inter-
ests was the theory of production. In a complete market Arrow-Debreu economy
with perfect competition, it makes sense for a firm to maximize profit or net
market value. But with incomplete markets, what is the generalization of this
goal? More fundamentally, what happens if shareholders disagree about what
the firm should do?
2
I started to work on this topic after my thesis and as a result of a serendipitous
assignment continued the work with Sanford Grossman in the summer of 1976.
3
At some point we decided that, interesting though the disagreement between
shareholders was, an empirically more important conflict was that between
managers and shareholders.
4
This led first to work on corporate takeovers as
a mechanism for disciplining management and then to a paper on debt as a
bonding device.
5
At some stage we realized that since we were studying ways to
incentivize management, maybe we should analyze directly the optimal incentive
scheme between an owner and a manager. This led to Grossman and Hart (1983),
a paper squarely in the principal-agent tradition.
372
The Nobel Prizes
This rather circuitous path helps to explain how my thinking evolved from
markets to contracts as the unit of analysis, and provides the backdrop to the
summer of 1983. Sitting in Grossman’s University of Chicago office, the two of us
were considering what to work on next. After some discussion we decided that
a question that was ripe for analysis was: Why would one firm ever buy another
firm rather than conduct business with that firm through a contract? In other
words, what are the limits of contracts and why do we have firms?
Of course, this was hardly a new question: there is a literature on the bound-
aries of the firm that goes back to Coase (1937) and includes Oliver Williamson’s
many works (see, e.g., Williamson (1975)), and Klein et al. (1978). I think that
it is fair to say that we were aware of this literature without being intimate with
it. (Intimacy came later.) One thing that we knew for sure is that the literature
was informal (or in the prize committee’s felicitous language, “not formalized”).
As economic theorists with a formal training we thought that we might be able
to add something.
We worked on the difference between firms and contracts for ten very intense
days. With apologies to John Reed these were ten days that shook my world.
6
I
recall that initially we thought that the difference had to do with authority. An
employer can choose the task of an employee.
7
But what is the conceptual dif-
ference between this and a requirements contract between two firms where one,
the buyer say, can choose how many widgets q to buy from the other, the seller,
with payment determined by a pre-agreed schedule: p = p(q)? One could say
that the buyer has authority over q in this case. Perhaps more seriously, once we
are in a world where a buyer obtains private information about a demand shock
and a seller obtains private information about a supply shock, then, according to
mechanism design theory, the quantity q should depend on both parties’ reports
about their shocks: neither party should have authority over q.
At some point it dawned on us that we were thinking about the issue the
wrong way. We were viewing the problem in complete contracting terms. But
what if the contract between the buyer and seller is incomplete?
2. INCOMPLETE CONTRACTS
The formal literature to that point was all about complete contracts. These are
contracts where everything that can ever happen is written into the contract.
There may be some incentive constraints arising from moral hazard or asym-
metric information but there are no unanticipated contingencies.
Actual contracts are not like this, as lawyers have realized for a long time.
They are poorly worded, ambiguous, and leave out important things. They are
Incomplete Contracts and Control
373
incomplete. At some stage Grossman and I realized that a critical question that
arises with an incomplete contract is, who has the right to decide about the
missing things? We called this right the residual control or decision right. The
question is, who has it?
Further thought led us to the idea that this is what ownership is. The owner
of an asset has the right to decide on how the asset is used to the extent that its
use is not contractually specified. This naturally leads to a theory of the difference
between contracts and firms. Think of a firm as consisting of assets. If firm A
and firm B sign an arms-length (incomplete) contract, then the owner of firm A
has residual control rights over the A assets and the owner of firm B has residual
control rights over the B assets. In contrast if, say, firm A buys firm B, then the
owner of firm A has residual control rights over the A and B assets.
Why should it matter who has residual control rights? Residual control
rights are like any other good: there is an optimal allocation of them. Sometimes
it is more efficient for one owner to hold all the residual control rights, and
sometimes it is more efficient for these control rights to be split between several
owners. Which is the case will determine whether firms A and B should merge
or stay as separate entities.
Grossman and I constructed a formal model along these lines (see Grossman
and Hart (1986)), and I developed the ideas and model further in work with John
Moore (see Hart and Moore (1990)). Collectively these papers are often referred
to as “property rights theory” (PRT).
It is useful to illustrate the model with a real-world example. Consider a
power plant that locates next to a coal mine with the purpose of burning coal
to make electricity.
8
One way to regulate the transaction is for the power plant
to sign an arms-length long-term contract with the coal mine. Such a contract
would specify the quantity, quality, and price of coal for many years to come. But
any such contract will be incomplete. Events will occur that the parties could not
foresee when they started out.
For example, suppose that the power plant needs the coal to be pure but that
it is hard to specify in advance what purity means, given that there are many
potential impurities. Imagine that ten years into the relationship, ash content is
the relevant impurity and that high-ash-content coal is more expensive for the
power plant to burn than low-ash-content coal but cheaper for the coal mine to
produce. Given that the contract is incomplete, the coal mine may be within its
rights under the contract to supply high-ash-content coal.
The power plant and coal mine can, of course, renegotiate the contract. How-
ever, the coal mine is in a strong bargaining position. It can demand a high price
for switching to low-ash-content coal. The reason is that the power plant does not
Dostları ilə paylaş: |