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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.
9
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.
10
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.
Incomplete
Contracts and Control
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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