Oliver Hart Prize Lecture: Incomplete Contracts and Control

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The Nobel Prizes

the approach from those of Williamson and Klein et al. Most of Williamson’s 

work is concerned with ex post bargaining inefficiencies and how integration can 

reduce these. Klein et al. do discuss ex ante inefficiencies but do not distinguish 

between contractible and noncontractible investments.

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Fourth, the prior work of Coase and Williamson emphasizes authority 

over human capital as the defining feature of the firm: An employer can tell an 

employee what to do. In contrast, PRT emphasizes control over physical (more 

generally non-human) assets. When the power plant purchases the coal mine it 

acquires residual control rights over the mine. To see the difference, note that, 

according to PRT, purchasing the mine would not be worth much if the coal 

mine manager is indispensable. In that case the manager would retain her hold-

up power even as an employee. If the power plant wants a shift from high-ash-

content coal to low-ash-content coal, the coal mine manager could demand a 

huge increase in salary for doing this. It is because typically the coal mine man-

ager is somewhat replaceable that the power plant is in a stronger bargaining 

position after it has acquired the mine than before.

3. APPLICATION TO FINANCIAL CONTRACTING

As well as helping us to understand asset ownership and firm boundaries, PRT 

has a number of applications. One is to financial contracting.

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Understanding the financial structure of a firm has been challenging since 

Modigliani and Miller (1958) showed that under some plausible assumptions, 

a firm’s financial structure has no effect on its total value. One strand of the lit-

erature (notably, Jensen and Meckling (1976)) argues that the Modigliani-Miller 

irrelevance result no longer holds if managers cannot be relied on to act on behalf 

of shareholders. However, a problem with this approach is that it supposes that 

financial structure is used to solve an incentive problem. Once incentive schemes 

are allowed to fulfill this task the irrelevance result is restored.

PRT offers a different perspective in which financial structure is thought of in 

control terms.

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 To understand the approach, replace the power plant by a finan-

cial investor. Specifically, suppose that the coal mine needs money to expand/

modernize, and approaches an investor with deep pockets. How does it persuade 

this person to invest?

One possibility is to offer him a share of the future profit from the coal mine. 

But this may not be enough. The reason is that the financial contract between the 

investor and the coal mine is likely to be incomplete. There are many actions or 

decisions that will be taken during the course of the relationship that the contract 

will not (cannot) specify.

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Incomplete Contracts and Control 

377

For example, the investor may worry that the manager of the coal mine will 

divert earnings: she could pay herself a large salary or reinvest profits rather than 

paying dividends. Another possibility is that the manager could adopt a strategy 

for running the coal mine that the investor does not approve of. Or the manager 

might hold on to her position as CEO even when a different CEO might be better.

Opportunistic behavior is similar to hold-up in the previous analysis. One 

way to protect the investor against such behavior is to give him residual control 

rights or votes. For example, the investor could become the owner of the coal 

mine, rather than having an arms-length contract with the coal mine. This would 

allow him to intervene to stop opportunistic behavior, e.g., he could control the 

manager’s salary or replace her.

But as we have seen, there can be a downside to taking away control from 

the manager. According to the previous analysis one cost is that the manager’s 

incentive to have ideas may be reduced. Thus there will be an optimal balancing 

of control between the investor and the manager.

This optimal balancing of control has been analyzed in an important paper 

by Aghion and Bolton (1992). Aghion and Bolton dispense with noncontractible 

investments by the manager (the incentive to have ideas) and focus instead on 

her private benefits.

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 These private benefits include the psychic satisfaction from 

pursuing a vision for the company, the job satisfaction from being CEO, and the 

remuneration associated with being in a position of power. The private benefits 

are something that only the manager enjoys; they cannot be transferred to the 

investor. In contrast, monetary returns are verifiable and can be transferred to 

the investor.

In the Aghion-Bolton model the cost of allocating control to the investor is 

that the investor may pursue a ruthless profit-maximizing strategy that destroys 

managerial private benefits. The manager could try to offer a side-payment to the 

investor to persuade the investor not to choose such a strategy, but the problem 

is that the manager is wealth constrained and so her ability to renegotiate with 

the investor is limited. The Coase theorem fails because one party is wealth-

constrained. Thus there is a fundamental trade-off. On the one hand, allocating 

all the control rights to the manager means that the manager may pursue private 

benefits at the expense of profit; as a result, the investor may not be compensated 

adequately and may not invest in the project. On the other hand, allocating all 

the control rights to the investor means that ex post decisions may not be first-

best efficient.

Aghion and Bolton show that under some assumptions, the solution to this 

trade-off is to make control state-contingent. Specifically, the manager will have 

control in states of the world where private benefits are important relative to 

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