Oliver Hart and the nature of the firm

Kevin Bryan 01 November 2016

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A fundamental point about Oliver Hart, co-recipient of the 2016 Nobel Prize in Economic Sciences with Bengt Holmström, is that nearly all of his recent work ignores the theory of the firm for which he is most famous – that of ‘residual control rights’. He has changed his beliefs, and his research agenda, so radically not simply because of the whims of age or the pressures of politics, but rather because of the impact of a devastatingly clever, and devastatingly esoteric, argument made by the 2007 and 2014 Nobel laureates Eric Maskin and Jean Tirole. To understand Hart’s contributions then, it is necessary to take a brief sojourn through the history of the branch of economics known as the theory of the firm.

The fundamental strangeness of firms goes back to 1991 Nobel laureate Ronald Coase. We have wonderful theorems from 2007 Nobel laureate Leonid Hurwicz, among others, about how competitive market prices coordinate activity efficiently even when individuals only have very limited information about how various things can be produced by an economy.

A pencil somehow involves graphite being mined, forests being explored and exploited, rubber being harvested and produced, the raw materials brought to a factory where a machine puts the pencil together, ships and trains bringing the pencil to retail stores – and yet this decentralised activity produces a pencil costing ten cents. This is the case even though not a single individual anywhere in the world knows how all of those processes up the supply chain operate. It appears that markets are an amazing mechanism for coordinating economic activity.

Yet as Coase pointed out, a huge amount of economic activity (including the majority of international trade; see Atalay et al 2014) is not coordinated via the market, but rather through top-down communist-style bureaucracies called firms. Why on earth do these persistent organisations exist at all? When should firms merge and when should they divest themselves of their parts? These questions make up the theory of the firm.

Coase’s early answer is that something called transaction costs exist, and that they are particularly high outside the firm. That is, market transactions are not free. Firm size is determined at the point where the problems of bureaucracy within the firm overwhelm the benefits of reducing transaction costs from regular transactions.

There are two major problems here. First, who knows what a ‘transaction cost’ or a ‘bureaucratic cost’ is, and why they differ across organizational forms: the explanation borders on tautology.

Second, as a wonderful paper by Alchian and Demsetz (1972) points out, there is no reason we should assume firms have some special ability to direct or punish their workers. If your supplier does something you don’t like, you can keep them on, or fire them, or renegotiate. If your in-house department does something you don’t like, you can keep them on, or fire them, or renegotiate. The problem of providing suitable incentives – the contracting problem – does not simply disappear because some activity is brought within the boundary of the firm. 

Oliver Williamson, the 2009 Nobel laureate joint with Elinor Ostrom, has a more formal transaction cost theory: some relationships generate joint rents higher than could be generated if we split ways, unforeseen things occur that make us want to renegotiate our contract, and the cost of that renegotiation may be lower if workers or suppliers are internal to a firm. ‘Unforeseen things’ may include anything that cannot be measured ex post by a court or other mediator, since that is ultimately who would enforce any contract. It is not that everyday activities have different transaction costs, but that the negotiations that produce contracts themselves are easier to handle in a more persistent relationship.

As in Coase, the question of why firms do not simply grow to an enormous size is largely dealt with by off-hand references to ‘bureaucratic costs’ whose nature is largely informal. Though informal, the idea that something like transaction costs might matter seemed intuitive and had some empirical support. Firms are larger in the developing world because weaker legal systems means more ‘unforeseen things’ will occur outside the scope of a contract, hence the differential costs of holdup or renegotiation inside and outside the firm are first order when deciding on firm size.

That said, the Alchian-Demsetz critique, and the question of what a ‘bureaucratic cost’ is, are worrying. And as Eric van den Steen (2010) points out, can anyone who has tried to order paper through their procurement office versus just popping into an office supply store really believe that the reason firms exist is to lessen the cost of intra-firm activities?

Asset ownership and incomplete contracts

Grossman and Hart (1986) instead argue that the distinction that really makes a firm a firm is that it owns assets. Why does ownership matter? They retain the idea that contracts may be incomplete – at some point, I will disagree with my suppliers, or my workers, or my branch manager, about what should be done, either because a state of the world has arrived not covered by our contract, or because it is in our first-best mutual interest to renegotiate that contract.

They retain the idea that there are relationship-specific rents, so I care about maintaining this particular relationship. But rather than rely on transaction costs, they simply point out that the owner of the asset is in a much better bargaining position when this disagreement occurs. Therefore, the owner of the asset will get a bigger percentage of rents after renegotiation. Hence the person who owns an asset should be the one whose incentive to improve the value of the asset is most sensitive to that future split of rents.

Baker and Hubbard (2004) provide a nice empirical example: when on-board computers to monitor how long-haul trucks were driven began to diffuse, ownership of those trucks shifted from owner-operators to trucking firms. Before the computer, if the trucking firm owns the truck, it is hard to contract on how hard the truck will be driven or how poorly it will be treated by the driver. If the driver owns the truck, it is hard to contract on how much effort the trucking firm dispatcher will exert ensuring the truck isn’t sitting empty for days, or following a particularly efficient route.

The computer solves the first problem, meaning that only the trucking firm is taking actions relevant to the joint relationship that are highly likely to be affected by whether they own the truck or not. In Grossman and Hart’s ‘residual control rights’ theory, then, the introduction of the computer should mean the truck ought, post-computer, be owned by the trucking firm. If these residual control rights are unimportant – there is no relationship-specific rent and no incompleteness in contracting – then the ability to shop around for the best relationship is more valuable than the control rights provided by asset ownership.

Hart and Moore (1990) extend this basic model to the case where there are many assets and many firms, suggesting critically that sole ownership of assets that are highly complementary in production is optimal. Asset ownership affects outside options when the contract is incomplete by changing bargaining power, and splitting ownership of complementary assets gives multiple agents weak bargaining power and hence little incentive to invest in maintaining the quality of, or improving, the assets. Hart et al. (1997) provide a great example of residual control rights applied to the question of why governments should run prisons but not garbage collection.

(A brief aside: note the role that bargaining power plays in all of Hart’s theories. We do not have a ‘perfect’ – in a sense that can be made formal – model of bargaining, and Hart tends to use bargaining solutions from cooperative game theory like the Shapley value. After Lloyd Shapley’s Nobel prize alongside Alvin Roth in 2012, this makes multiple prizes heavily influenced by cooperative games applied to unexpected problems. Perhaps the theory of cooperative games ought still be taught with vigour in PhD programmes.)

Other theories of the firm

There are, of course, many other theories of the firm. The idea that firms in some industries are big because there are large fixed costs to enter at the minimum efficient scale goes back to Marshall. The agency theory of the firm going back at least to Jensen and Meckling (1976) focuses on the problem of providing incentives for workers within a firm actually to profit-maximise; Holmström and Milgrom’s multitasking paper (1991) is a great example of this, with tasks being split across firms so as to allow some types of workers to be given high-powered incentives and others flat salaries.

More recent work by Bob Gibbons, Rebecca Henderson, Jon Levin and others on relational contracting discusses how the nexus of self-enforcing beliefs about how hard work today translates into rewards tomorrow can substitute for formal contracts, and how the credibility of these ‘relational contracts’ can vary across firms and depend on their history.

Each of these theories of the firm has empirical support in certain circumstances. But a striking blow was dealt at the end of the twentieth century to all theories that rely on the incompleteness or non-verifiability of contracts by a brilliant paper by Maskin and Tirole (1999). Theories relying on incomplete contracts generally just hand-waved that there are always events which are unforeseeable ex ante or impossible to verify in court ex post, and hence there will always scope for disagreement about what to do when those events occur.

But as Maskin and Tirole correctly point out, agents don’t care about anything in these unforeseeable/unverifiable states except for what the states imply about the mutual valuations of carrying on with a relationship. Therefore, every ‘incomplete contract’ should just involve the parties deciding in advance that if a state of the world arrives where you value keeping our relationship in that state at 12 and I value it at 10, then we should split that joint value of 22 at whatever level induces optimal actions today. Do this same ex ante contracting for all future profit levels, and we are done. Of course, there is still the problem of ensuring incentive compatibility: why would the agents tell the truth about their valuations when that unforeseen event occurs?

Maskin and Tirole show a (somewhat convoluted yet incredibly clever) mechanism that induces truthful revelation of private value by each agent. Taking the model’s insight seriously but the exact mechanism less seriously, the paper basically suggests that incomplete contracts don’t matter if we can truthfully figure out ex post who values our relationship at what amount, and there are many real-world institutions such as mediators who do precisely that. If as Maskin and Tirole prove (and Maskin describes more simply in a short note in 2002), incomplete contracts aren’t a real problem, we are back to square one: why have persistent organisations called firms?

Why firms exist

What to do? Some theorists have tried to fight off Maskin and Tirole by suggesting that their precise mechanism is not terribly robust to, for example, assumptions about higher-order beliefs (for example, Aghion et al 2012). But these quibbles do not contradict the far more basic insight of Maskin and Tirole: that situations we think of empirically as ‘hard to describe’ or ‘unlikely to occur or be foreseen’ are not sufficient to justify the relevance of incomplete contracts unless we also have some reason to think that all mechanisms that split rent on the basis of future profit, such as a mediator, are unavailable. Note that real world contracts regularly include provisions that ex ante describe how contractual disagreement ex post should be handled.

Hart’s response, and this is both clear from his CV and from his recent papers and presentations, is to ditch incompleteness as the fundamental reason firms exist. Hart and Moore (2006, 2007) are very clear:

“Although the incomplete contracts literature has generated some useful insights about firm boundaries, it has some shortcomings. Three that seem particularly important to us are the following. First, the emphasis on noncontractible ex ante investments seems overplayed: although such investments are surely important, it is hard to believe that they are the sole drivers of organizational form. Second, and related, the approach is ill suited to studying the internal organization of firms, a topic of great interest and importance. The reason is that the Coasian renegotiation perspective suggests that the relevant parties will sit down together ex post and bargain to an efficient outcome using side payments: given this, it is hard to see why authority, hierarchy, delegation, or indeed anything apart from asset ownership matters. Finally, the approach has some foundational weaknesses [pointed out by Maskin and Tirole 1999].”

To my knowledge, Oliver Hart has written zero papers since Maskin-Tirole was published that attempt to explain any policy or empirical fact on the basis of residual control rights and their necessary incomplete contracts. Instead, he has been primarily working on theories which depend on reference points, a behavioural idea that when disagreements occur between parties, the ex ante contracts are useful because they suggest ‘fair’ divisions of rent, and induce shading and other destructive actions when those divisions are not given. These behavioural agents may very well disagree about what the ex ante contract means for ‘fairness’ ex post.

The primary result is that flexible contracts (for example, contracts that deliberately leave lots of incompleteness) can adjust easily to changes in the world but will induce spiteful shading by at least one agent, while rigid contracts do not permit this shading but do cause parties to pursue suboptimal actions in some states of the world.

This perspective has been applied by Hart to many questions over the past decade, such as why it can be credible to delegate decision-making authority to agents: if you try to seize it back, the agent will feel aggrieved and will shade effort (Hart and Holmström 2010). These responses are hard, or perhaps impossible, to justify when agents are perfectly rational, and of course the Maskin-Tirole critique would apply if agents were purely rational.

So where does all this leave us concerning the initial problem of why firms exist in a sea of decentralised markets? We have many clever ideas, suitable for particular contexts, but still do not have a believable, logically ironclad theory.

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organised as they are, why they persist over time, and why inter-firm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational – foolishness is not a good justification for institutions employed by millions of organisations.

Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many ‘resource’ type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.)

Coase, Williamson, and Ostrom are correct that there exist reasons why the costs of maintaining relationships – transaction costs – endogenously differ within and outside firms. And Hart is correct in focusing our attention on how asset ownership and decision-making authority affects incentives to invest. But these theories even in their most endogenous form cannot do everything we want a theory of the firm to accomplish.

Perhaps reputation – and hence relational contracts – plays a fundamental role, and therefore the nexus of conflicting incentives among agents within an organisation must as well. But we still lack the precise theoretical insight to clear up this muddle, and give us a straightforward explanation for why we seem to need ‘little communist bureaucracies’ to assist our otherwise decentralised and almost magical market system.

References

Aghion, P, D Fudenberg, R Holden, T Kunimoto, and O Tercieux (2012), ‘Subgame-perfect Implementation under Information Perturbations’, Quarterly Journal of Economics 2012: 1843-81.

Alchian, A, and H Demsetz (1972), ‘Production, Information Costs, and Economic Organization’, American Economic Review 62(5): 777-95.

Atalay, E, A Hortacsu, and C Syverson (2014), ‘Vertical Integration and Input Flows’, American Economic Review 104(4): 1120-48.

Baker, G, and T Hubbard (2004), ‘Contractibility and Asset Ownership: On-board Computers and Governance in US Trucking’, Quarterly Journal of Economics 119(4): 1443-79.

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.

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 (2006), ‘Contracts as Reference Points’, Quarterly Journal of Economics 123(1): 1-48.

Hart, O, and J Moore (2007), ‘Incomplete Contracts and Ownership: Some New Thoughts’, American Economic Review Papers and Proceedings: 182-86.

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.

Jensen, M, and W Meckling (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure’, Journal of Financial Economics 3(4): 305-60.

Maskin, E (2002), ‘On indescribable Contingencies and Incomplete Contracts’, European Economic Review 46: 725-33.

Maskin, E, and J Tirole (1999), ‘Unforeseen Contingencies and Incomplete Contracts’, Review of Economic Studies 66: 83-114.

Milgrom, P, and B Holmström (1991), ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’, Journal of Law Economics and Organization 7(Special Issue): 24-52

Van den Steen, E (2010), ‘Interpersonal Authority in a Theory of the Firm’, American Economic Review 100(1): 466-90.

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Topics:  Frontiers of economic research Industrial organisation

Tags:  Nobel Prize, Bengt Holmström, contract theory, nature of the firm

Assistant Professor of Strategic Management, University of Toronto Rotman School of Management

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