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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.
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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.
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