This article was originally published at VoxEU.
Oliver Hart and Bengt Holmström have been jointly awarded the 2016 Nobel Prize in Economic Sciences. The prize was so well deserved that the news was received with comments from fellow Nobel laureates such as “Didn’t they have it already?” (Paul Krugman) and “Nobel prize at its best” (George Akerlof). In this column, I focus on Oliver Hart’s contributions to contract theory, in particular to our understanding of incomplete contracts.
— The Nobel Prize (@NobelPrize) October 10, 2016
Incomplete contracts and the theory of the firm
The cornerstone of Hart’s contribution to incomplete contracts theory is his 1986 paper with Sandy Grossman on the costs and benefits of ownership. In this paper, they develop the formal theory of incomplete contracts and with it introduce the notions of control and power that have had great impact in many fields beyond the theory of the firm (see Aghion et al 2016).
Even in market economies, a significant proportion of transactions do not take place in the market but within firms. Grossman and Hart (1986) build on the foundations laid by previous Nobel laureates Ronald Coase and Oliver Williamson in asking what determines whether a transaction occurs inside the firm or in the market – that is, whether there is vertical integration or non-integration.
Coase’s (1937) answer was that both market and internal transactions have their costs and they are organised so that the transaction costs are minimised. Williamson (1975, 1985) emphasised a particular cost of transacting in the market: the hold-up problem. When a productive relationship requires an investment that has much lower value in other uses, the investor may only make the investment if the relationship is within the firm, since in the market, such relationship-specific investment is vulnerable to expropriation in bargaining when contracts are incomplete. Williamson was less clear about the costs of integration, which, in his view, related to bureaucratic decision-making.
Grossman and Hart (1986) formalised the analysis of the boundaries of the firm and provided a rationale not just for the benefits but also for the costs of vertical integration. When contracts are incomplete, a trading relationship can be governed by allocating the control rights – or power – to a party. Ownership of an asset brings with it control rights as the owner has the right to refuse to trade with a supplier/buyer (unless a prior contract is in place). The question then arises of not just whether the assets should be integrated or not, but also who should be the owner.
Ownership gives power to an agent in the sense that his default payoff is increased. If buyer B owns the asset that supplier S works with — and therefore S becomes B’s employee — B can get a higher share of the surplus in bargaining. The benefit of integration is that B’s incentives in relationship-specific investments are stronger. But the hold-up problem does not disappear inside the firm as he still needs to bargain with his employee to complete the production.
The cost of integration is the other side of the coin: S as an employee has weaker incentives than as an independent supplier. Given this trade-off, if one of the parties is a key investor, then it is optimal for him to become the owner of the integrated firm. That guarantees the best incentives for the key investment while the cost of weaker incentives for the party with less important investment is not significant.
Hart’s 1990 paper with John Moore developed the theory for a multi-asset and multi-party setting. Ownership – or power – is distributed among the parties to maximise their investment incentives. Hart and Moore show that complementarities between the assets and the parties have important implications. If the assets are so complementary that they are productive only when used together, they should have a single owner. Separating such complementary assets does not give power to anybody, while when the assets have a single owner, the owner has power and improved incentives.
Furthermore, if there are such strong complementarities between an asset and a party that the asset is productive only with that party, then this indispensable party should own the asset. Ownership of the asset would not give power to anybody else and the incentive effect would be wasted.
This theory of the firm is now known as Grossman-Hart-Moore (GHM) property rights theory. It has been applied in various fields, including corporate finance, public economics, political economy and international trade.
Hart’s 1997 paper with Andrei Shleifer and Robert Vishny applies the property rights theory to privatisation of tax-funded welfare services, such as schools, prisons and refuse collection. Government contracts with a service provider but the contract is incomplete, particularly regarding the quality of the service. The provider can invest in cost reduction but the owner has the control rights to decide whether the cost innovation will be implemented.
Under privatisation, the provider has the control rights and will implement cost innovation even if it damages the quality of the service. Since the provider gets the full benefit from cost-cutting and ignores the quality-reducing effect, his incentives for cost reduction are too strong.
Under public ownership, the provider needs government approval for any innovations, and therefore a quality-damaging innovation would not go ahead. This means that the provider will take into account the quality-reducing effect but has generally weak incentives to reduce costs.
Privatisation is therefore not desirable for services where cost reduction can damage quality. Hart and his co-authors argue that prisons meet this condition reasonably well. Federal authorities in the US are indeed ending the use of private prisons partly because of quality issues.
In contrast, privatisation works well for services where the quality-reducing effect is likely to be trivial, such as refuse collection. Finally, for some welfare services such as schools, competition can discipline quality-damaging cost-cutting, and therefore there is a reasonably valid case for privatisation.
Property rights theory analyses optimal ownership of assets but does so assuming there are no wealth constraints. If the optimal owner is wealth-constrained, he will need to obtain finance. The incomplete contract between the entrepreneur and the investor then needs to determine not just the repayments to be made but also the allocation of control rights over the assets. This is the question raised in Hart and Moore (1994, 1998).
An entrepreneur cannot credibly promise all the future returns as repayments to the investor because he has the ability to divert cash from the project (Hart and Moore 1998) or he may withdraw his essential human capital from the project (Hart and Moore 1994). But the physical assets can be offered as a collateral.
Control rights over the physical assets play an important role in motivating the entrepreneur to make repayments rather than, for example, diverting the cash. Hart and Moore show that it is optimal for the entrepreneur to keep the control rights as long as he makes the agreed repayments. But control rights are shifted to the investor if there is default. The investor then has the right to liquidate the assets, but he may instead choose to renegotiate with the entrepreneur.
In other words, debt contracts are the optimal incomplete contracts. Venture capital contracts also typically have the feature that the entrepreneur retains more control rights in well-performing firms while investors obtain full control of poorly performing firms. Hart and Moore were the first to model the shift of control triggered by default. 
In recent work, Hart has introduced the theory of contracts as reference points (Hart and Moore 2008). The basic idea is that the role of a contract is to shape the parties’ expectations and to get them ‘on the same page’ to avoid future misunderstandings. Misunderstandings cause parties to feel aggrieved and lead to shading in ex post performance, causing deadweight losses. 
The benefit of a rigid contract is that it fixes expectations, avoiding arguments. But it may not perform well when there is uncertainty. A flexible contract can adjust to the state of nature, but there is also room for arguments. This theory shifts the focus from ex ante investment incentives to ex post inefficiencies caused by shading and, importantly, is not subject to the Maskin and Tirole (1999) critique.
Hart and co-authors have applied the contracts as reference point approach to the scope of the firm (Hart and Holmström 2010) and most recently to continuing contracts (Halonen-Akatwijuka and Hart 2016).
I would like to conclude with a personal note. I have been fortunate to have Oliver Hart as my mentor and co-author. Over the years, I have developed a great respect not only for his intellectual clarity and depth but also for his character.
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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(2-3): 561-72.
Fehr, E, O Hart and C Zehnder (2011), ‘Contracts as Reference Points – Experimental Evidence’, American Economic Review 101(2): 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): 1-28.
Grossman, S and O Hart (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, Journal of Political Economy 94(4): 691-719.
Halonen-Akatwijuka, M and O Hart (2016), ‘Continuing Contracts’, mimeo.
Hart, O and B Holmström (2010), ‘A Theory of Firm Scope’, Quarterly Journal of Economics 125(2): 483-513.
Hart, O and J Moore (1990), ‘Property Rights and the Nature of the Firm’, Journal of Political Economy 98(6): 1119-58.
Hart, O and J Moore (1994), ‘A Theory of Debt Based on the Inalienability of Human Capital’, Quarterly Journal of Economics 109(4): 841-79.
Hart, O and J Moore (1998), ‘Default and Renegotiation: A Dynamic Model of Debt’, Quarterly Journal of Economics 113(1): 1-41.
Hart, O and J Moore (2008), ‘Contracts as Reference Points’, Quarterly Journal of Economics 123(1): 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(4): 1127-61.
Maskin, E and J Tirole (1999), ‘Unforeseen Contingencies and Incomplete Contracts’, Review of Economic Studies 66: 83-114.
Williamson, O (1975), Markets and Hierarchies, Free Press.
Williamson, O (1985), The Economic Institutions of Capitalism, Free Press.