Oliver Hart Prize Lecture: Incomplete Contracts and Control

392 

The Nobel Prizes

can agree that the terms of the contract should be roughly the same as before. 

However, if outside conditions change then notions of fairness and good faith 

emanating from earlier contracts may make it difficult for the parties to adjust 

to the new environment, and they may fail to trade even though this is efficient. 

For details, see Halonen-Akatwijuka and Hart (2016).

7. LOOKING AHEAD

When Sanford Grossman and I sat in his office in the summer of 1983, our goal 

was to develop a formal model of the limits of contracts and the boundaries of 

the firm. I can report only partial success in this endeavor. There is as yet no 

tractable, widely agreed upon, theory of incomplete contracts. Indeed, to the 

extent that, as I have argued, one must depart from rationality to make progress, 

there may never be.

At the same time I believe that the incomplete contracts approach yields 

some valuable insights. I have tried to describe some of them here, but there 

are many other applications, including in the areas of law and political science.

Economists are drawn to areas with simple, elegant, and uncontroversial 

models. The area of incomplete contracts is not like that; it is messy. But contracts 

are incomplete in reality and contractual incompleteness underlies numerous 

significant phenomena, some of which have great policy relevance. I hope that 

economists, particularly young ones, will, in spite of the messiness, continue to 

work on this challenging topic.

REFERENCES

Aghion, P. and P. Bolton (1992), An Incomplete Contracts Approach to Financial 

Contracting, Review of Economic Studies 59: 473–494.

Aghion, P., D. Fudenberg. R. Holden, T. Kunimoto, and O. Tercieux (2012), Subgame-

Perfect Implementation under Information Perturbations, Quarterly Journal of 

Economics 127: 1843–1881.

Alchian, A.A. and H. Demsetz (1972), Production, Information Costs, and Economic 

Organization, American Economic Review 62: 777–795.

Andersen, S., U. Gneezy, M. Hoffman, S. Ertac, and J.A. List (2011), Stakes Matter in 

Ultimatum Games, American Economic Review 101: 3427–3439.

Antras, P. (2003), Firms, Contacts, and Trade Structure, Quarterly Journal of Economics

118: 1375–1418.

Antras, P. and E. Helpman (2004), Global Sourcing, Journal of Political Economy

112: 552–580.

Baker, G. and T.N. Hubbard (2003), Make versus Buy in Trucking: Asset Ownership, Job 

Design, and Information, American Economic Review 93: 551–572.

---

Incomplete Contracts and Control 

393

Baker, G. and T.N. Hubbard (2004), Contractibility and Asset Ownership: On-Board 

Computers and Governance in U.S. Trucking, Quarterly Journal of Economics 119: 

1443–1479.

Baliga, S. and T. Sjöström (2016), A Theory of the Firm Based on Haggling, Coordination 

and Rent Seeking, Northwestern University working paper.

Bartling, B. and K. Schmidt (2015), Reference Points, Social Norms, and Fairness in 

Contract Renegotiations, Journal of the European Economic Association 13: 98–129

Benmelech, E. (2009), Asset Salability and Debt Maturity: Evidence from Nineteenth-

Century Railroads, Review of Financial Studies 22: 1545–1584.

Benmelech, E. and N. Bergman (2008), Liquidation Values and the Credibility of Financial 

Contract Renegotiation: Evidence from U.S. Airlines, Quarterly Journal of Economics

123: 1635–1677.

Bernstein, S., A. Korteweg, and K. Laws (2017), Attracting Early Stage Investors: Evidence 

from a Randomized Field Experiment, forthcoming in Journal of Finance.

Bolton, P. and D. Scharfstein (1990), A Theory of Predation Based on Agency Problems 

in Financial Contracting, American Economic Review 80: 93–106.

Bolton, P. and D. Scharfstein (1996), Optimal Debt Structure and the Number of Creditors, 

Journal of Political Economy 104: 1–25.

Borek, C.T., A. Frattarelli, and O. Hart (2014), Tax Shelters or Efficient Tax Planning? A 

Theory of the Firm Perspective on the Economic Substance Doctrine, Journal of Law 

and Economics 57: 975–1000.

Brandts, J., G. Charness, and M. Ellman (2016), Let’s Talk: How Communication Affects 

Contract Design, Journal of the European Economic Association 14: 943–974.

Camerer, C. (2003), Behavioral Game Theory: Experiments in Strategic Interaction, 

Princeton University Press.

Coase, R.H. (1937), The Nature of the Firm, Economica 4: 386–405.

Coase, R.H. (1960), The Problem of Social Cost, Journal of Law and Economics 3: 1–44.

d’Aspremont, C. and L.A. Gérard-Varet (1979), Incentives and incomplete information, 

Journal of Public Economics 11: 25–45.

Drèze, J. (1974), Investment Under Private Ownership: Optimality, Equilibrium and 

Stability, In J. Drèze ed. Allocation Under Uncertainty: Equilibrium and Optimality, 

Chp. 9, 129–166, Macmillan, London.

Fehr, E. and K.M. Schmidt (2003), Theories of Fairness and Reciprocity: Evidence and 

Economic Applications. In Mathias Dewatripont, Lars Peter Hansen and Stephen 

J Turnovsky eds. Advances in Economics and Econometrics, Econometric Society 

Monographs, Eighth World Congress, Volume 1, 208–257.

Fehr, E., O. Hart, and C. Zehnder (2009), Contracts, Reference Points, and Competition—

Behavioral Effects of the Fundamental Transformation, Journal of the European 

Economic Association 7: 561–572.

Fehr, E., O. Hart, and C. Zehnder (2011), Contracts as Reference Points—Experimental 

Evidence, American Economic Review 101: 493–525.

Fehr, E., O. Hart, and C. Zehnder (2015), How do Informal Agreements and Revision 

Shape Contractual Reference Points?, Journal of the European Economic 

Association 13: 1–28.

Gale, D., and M. Hellwig (1985), Incentive-Compatible Debt Contracts: The One-Period 

Problem, Review of Economic Studies 52: 647–663.

---

394 

The Nobel Prizes

Grossman, S. and O. Hart (1979), A Theory of Competitive Equilibrium in Stock Market 

Economies, Econometrica 47: 293–330.

Grossman, S. and O. Hart (1980) Takeover Bids, the Free-Rider Problem, and the Theory 

of the Corporation, Bell Journal of Economics 11: 42–64.

Grossman, S. and O. Hart (1982), Corporate Financial Structure and Managerial 

Incentives. In J. McCall ed. The Economics of Information and Uncertainty, University 

of Chicago Press: Chicago IL.

Grossman, S. and O. Hart (1983), An Analysis of the Principal-Agent Problem, 

Econometrica 51: 7–45.

Grossman, S. and O. Hart (1986), The Costs and Benefits of Ownership: A Theory of 

Vertical and Lateral Integration, Journal of Political Economy 94: 691–719.

Güth, W., R. Schmittberger, and B. Schwarze (1982), An Experimental Analysis of 

Ultimatum Bargaining, Journal of Economic Behavior and Organization 3: 367–388.

Hadfield, G.K. and I. Bozovic (2016), Scaffolding: Using Formal Contracts to Support 

Informal Relations in Support of Innovation, Wisconsin Law Review 5: 981–1032.

Halonen-Akatwijuka, M. and O. Hart (2016), Continuing Contracts, Harvard University 

working paper.

Hart, O. (1975), On the Optimality of Equilibrium when the Market Structure is 

Incomplete, Journal of Economic Theory 11: 418–443.

Hart, O. (1979), On Shareholder Unanimity in Large Stock Market Economies, 

Econometrica 47: 1057–1083.

Hart, O. (1995), Firms, Contracts, and Financial Structure, Clarendon Press: Oxford UK.

Hart, O. (2009), Hold-Up, Asset Ownership, and Reference Points, Quarterly Journal of 

Economics 124: 267–300.

Hart, O. and B. Holmström (2010), A Theory of Firm Scope, Quarterly Journal of 

Economics 125: 483–513.

Hart, O. and J. Moore (1988), Incomplete Contracts and Renegotiation, Econometrica

56: 755–785.

Hart, O. and J. Moore (1990), Property Rights and the Nature of the Firm, Journal of 

Political Economy 98: 1119–1158.

Hart, O. and J. Moore (1994), A Theory of Debt Based on the Inalienability of Human 

Capital, Quarterly Journal of Economics 109: 841–879.

Hart, O. and J. Moore (1998), Default and Renegotiation: A Dynamic Model of Debt, 

Quarterly Journal of Economics 113: 1–41.

Hart, O. and J. Moore (1999), Foundations of Incomplete Contracts, Review of Economics 

Studies 66: 115–138.

Hart, O. and J. Moore (2008), Contacts as Reference Points, Quarterly Journal of 

Economics 73: 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: 1127–1161.

Herweg, F. and K.M. Schmidt (2015), Loss Aversion and Inefficient Renegotiation, Review 

of Economic Studies 82: 297–332.

Holmström, B. (1979), Moral Hazard and Observability, Bell Journal of Economics

10: 74–91.

Holmström, B. and P. Milgrom (1991), Multi-Task Principal Agent Analyses, Journal of 

Law, Economics, and Organization 7: 24–52.

---

Incomplete Contracts and Control 

395

Holmström, B. and J. Tirole (1998), Private and Public Supply of Liquidity, Journal of 

Political Economy 106: 1–40.

Innes R. (1990), Limited Liability and Incentive Contracting with Ex Ante Action Choices, 

Journal of Economic Theory 52: 45–67.

Jensen, M. and W. Meckling (1976), Theory of the Firm: Managerial Behavior, Agency 

Costs, and Ownership Structure, Journal of Financial Economics 3: 305–360.

Joskow, P. (1987), Contract Duration and Relationship Specific Investments: Empirical 

Evidence from Coal Markets, American Economic Review 77: 168–185.

Kaplan, S. and P. Strömberg (2003), Financial Contracting Theory Meets the Real World, 

Review of Economic Studies 70: 281–315.

Kaplan, S., B, Sensoy, and P. Strömberg (2009), Should Investors Bet on the Jockey or the 

Horse? Evidence from the Evolution of Firms from Early Business Plans to Public 

Companies, Journal of Finance 64: 75–115.

Klein, B., R. Crawford, and A. Alchian (1978), Vertical Integration, Appropriable Rents 

and the Competitive Contracting Process, Journal of Law and Economics 21: 297–326.

Maskin, E. (1999), Nash Equilibrium and Welfare Optimality, Review of Economic Studies

66: 23–38.

Maskin, E. and J. Tirole (1999), Unforeseen Contingencies and Incomplete Contracts, 

Review of Economic Studies 66: 83–114.

Matouschek, N. (2004), Ex Post Inefficiencies in a Property Rights Theory of the Firm, 

The Journal of Law, Economics, and Organization 20: 125–147.

Mirrlees, J.A. (1999), The Theory of Moral Hazard and Unobservable Behavior, Review 

of Economic Studies 66: 3–21.

Modigliani, F. and M. Miller (1958), The Cost of Capital, Corporation Finance and the 

Theory of Investment, American Economic Review 68: 261–297.

Moore, J. and R. Repullo (1988), Subgame Perfect Implementation, Econometrica 56: 

1191–1220.

Rajan, R. (2012), Presidential Address: The Corporation in Finance, Journal of Finance

67: 1173–1217.

Schmidt, K. (1996), The Costs and Benefits of Privatization: An Incomplete Contracts 

Approach, Journal of Law, Economics, and Organization 12: 1–24.

Segal, I. (1999), Complexity and Renegotiation: A Foundation for Incomplete Contracts, 

Review of Economic Studies 66: 57–82.

Shleifer, A. and R. Vishny (1997), A Survey of Corporate Governance, Journal of Finance

52: 737–783.

Simon, H.A. (1951), A Formal Theory of the Employment Relationship, Econometrica

19: 293–305.

Townsend, R. (1979), Optimal Contacts and Competitive Markets with Costly State 

Verification, Journal of Economic Theory 21: 265–293.

U.S. Department of Justice (2016), Review of the Federal Bureau of Prisons’ Monitoring 

of Contract Prisons, https://oig.justice.gov/reports/2016/e1606.pdf#page=1

Williamson, O. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The 

Free Press: New York.

Woodruff, C. (2002), Non-contractible Investments and Vertical Integration in the 

Mexican Footwear Industry, International Journal of Industrial Organization 20: 

1197–1224.

---

396 

The Nobel Prizes

NOTES

1. See Hart (1975).

2. See, e.g., Dreze (1974).

3. This led to Grossman and Hart (1979); see also Hart (1979).

4. There was already active work on this question. See, e.g., Mirrlees (1999) and 

Holmström (1979) on principal-agent theory and Jensen and Meckling (1976) on 

corporate finance.

5. See Grossman and Hart (1980) and Grossman and Hart (1982).

6. I refer here to the American journalist who died in 1920, not the former CEO of 

Citigroup.

7. This is very much along the lines of Coase (1937) and Simon (1951).

8. Paul Joskow has studied such situations and the relationships can last for decades 

(see Joskow (1987)).

9. Empirical support for the idea that ownership affects noncontractible investments 

can be found in Baker and Hubbard (2003, 2004) and Woodruff (2002). An interest-

ing application of PRT has been to explain the outsourcing decisions of multinational 

firms. See Antras (2003) and Antras and Helpman (2004).

10. The control rights approach is only one strand of a very active literature on financial 

contracting that has developed over the last thirty or so years. Important work has 

been done on asymmetric information by Townsend (1979) and Gale and Hellwig 

(1985), and on moral hazard by Innes (1990) and Holmström and Tirole (1998). The 

control rights approach is complementary to these contributions.

11. In what follows we consider the relationship between one party who needs funds and 

one party who has funds. For a more general discussion of corporate governance and 

control, see Shleifer and Vishny (1997).

12. They also assume that the financial investment is contractible. This is no longer an 

analytical issue since the manager, being wealth constrained, cannot compensate the 

investor for making it.

13. The first version of the Hart-Moore (1998) paper appeared in 1989 and circulated 

for several years before being published. A simple exposition of it is contained in 

Hart (1995, Chapter 5). Related and companion papers are Bolton and Scharfstein 

(1990, 1996).

14. It should be noted that while a debt contract is optimal when project returns are 

perfectly certain, contracts that shift control in more elaborate ways can perform 

better under uncertainty. For conditions for a debt contract to be optimal, see Hart 

and Moore (1998).

15. In reality the distinction between human and non-human assets is not quite as stark 

as we have suggested. There are ways that people can reduce their hold-up power, 

e.g., by signing non-compete contracts. However, there are limits to the control of 

human assets that do not exist in the case of non-human assets.

16. I have been involved in two legal cases where the question of what is a firm was 

important. In Black and Decker v. U.S.A., Black and Decker argued that it created a 

new entity to manage employee and retiree health care benefits for efficiency rather 

than tax reasons. I argued for the U.S. government that the new entity was equivalent 

---

Incomplete Contracts and Control 

397

to a division of Black and Decker since Black and Decker retained control. The case 

was settled. In a second case, WFC Holdings (Wells Fargo) v. U.S.A., WFC argued 

that there was a business purpose from moving its real estate lease operations into 

a separate subsidiary. I argued, again on behalf of the U.S. government, that the 

subsidiary was equivalent to a division of WFC given that WFC had total control. 

The case went to trial and the U.S. government won. For a discussion of these cases, 

see Borek et al. (2014).

17. Related ideas are developed in Schmidt (1996).

18. Further evidence can be found in the recent report of the U.S. Department of Justice 

(2016). Another way to discourage the choice of cost-saving, quality-reducing 

actions is to set up the private prison as a non-profit. However, to the extent that the 

non-profit can use cost savings to increase salaries this is unlikely to fully resolve 

the problem.

19. The idea that the prison manager can engage in some cost-reducing activities that 

are socially desirable and other quality-reducing activities that are socially undesir-

able is in the spirit of the multi-tasking model of Holmström and Milgrom (1991).

20. Another objection is that Maskin-Tirole mechanisms are not robust to small depar-

tures from common knowledge. See Aghion et al. (2012).

21. See, e.g., Matouschek (2004).

22. See, e.g., d’Aspremont and Gerard-Varet (1979).

23. For recent work along these lines, see Baliga and Sjostrom (2016).

24. See, e.g., Camerer (2003) and Fehr and Schmidt (2003).

25. See, e.g., Güth et al. (1982).

26. See Andersen et al. (2011).

27. Herweg and Schmidt (2015) develop an alternative and complementary theory of 

inefficient outcomes. In their model parties write a contract that has to be renegoti-

ated after the state of the world is realized. The parties take the initial contract as 

a reference point to which they compare the gains and losses of the renegotiated 

transaction. As a result of loss aversion some efficient renegotiations will not occur.

28. For some non-laboratory evidence consistent with the idea that contracts are refer-

ence points, see Hadfield and Bozovic’s recent study of how companies involved in 

innovation manage their relationships (Hadfield and Bozovic (2016)).

29. There is some evidence that terms implied by a contract are regarded as fair even in 

the absence of competition. See Bartling and Schmidt (2015).

30. Brandts et al. (2016), in a somewhat different setting, find that under free-form (ex 

post) communication flexible contracts dominate rigid contracts.