[Sasha Volokh] Oliver Hart and Bengt Holmström win Nobel Prize in Economics

Oliver Hart and Bengt Holmström have just won the Nobel Prize in Economics. They’re both important economists in the area known as “contract theory”, which is important for the theory of the firm — so this work is significant for legal scholars who work in business associations, antitrust (e.g. vertical integration), etc. You can look at Marginal Revolution for a general discussion of Hart and Holmström. (See also here.)

Hart was my professor and one of my advisors in graduate school. This blog post tries to give a taste — in language that might be comprehensible to the non-economist — of what his contribution is to the theory of the firm. Here’s an excerpt from his article An Economist’s Perspective on the Theory of the Firm, 89 Colum. L. Rev. 1757 (1989). You should read the whole thing, where he spends the first part summarizing the various other theories of the firm, since Coase’s seminal 1937 article, before describing his own (“property rights”) theory, which I excerpt below. After this excerpt, he discusses in greater detail how his theory differs from the previous theories.

One way to resolve the question of how integration changes incentives is spelled out in recent literature that views the firm as a set of property rights. This approach is very much in the spirit of the transaction cost literature of Coase and Williamson, but differs by focusing attention on the role of physical, that is, nonhuman, assets in a contractual relationship.

Consider an economic relationship of the type analyzed by Williamson, where relationship-specific investments are important and transaction costs make it impossible to write a comprehensive long-term contract to govern the terms of the relationship. Consider also the nonhuman assets that, in the postinvestment stage, make up this relationship. Given that the initial contract has gaps, missing provisions, or ambiguities, situations will typically occur in which some aspects of the use of these assets are not specified. For example, a contract between GM and Fisher might leave open certain aspects of maintenance policy for Fisher machines, or might not specify the speed of the production line or the number of shifts per day.

Take the position that the right to choose these missing aspects of usage resides with the owner of the asset. That is, ownership of an asset goes together with the possession of residual rights of control over that asset; the owner has the right to use the asset in any way not inconsistent with a prior contract, custom, or any law. Thus, the owner of Fisher assets would have the right to choose maintenance policy and production line speed to the extent that the initial contract was silent about these.

Finally, identify a firm with all the nonhuman assets that belong to it, assets that the firm’s owners possess by virtue of being owners of the firm. Included in this category are machines, inventories, buildings or locations, cash, client lists, patents, copyrights, and the rights and obligations embodied in outstanding contracts to the extent that these are also transferred with ownership. Human assets, however, are not included. Since human assets cannot be bought or sold, management and workers presumably own their human capital both before and after any merger.

We now have the basic ingredients of a theory of the firm. In a world of transaction costs and incomplete contracts, ex post residual rights of control will be important because, through their influence on asset usage, they will affect ex post bargaining power and the division of ex post surplus in a relationship. This division in turn will affect the incentives of actors to invest in that relationship. Hence, when contracts are incomplete, the boundaries of firms matter in that these boundaries determine who owns and controls which assets. In particular, a merger of two firms does not yield unambiguous benefits: to the extent that the (owner-)manager of the acquired firm loses control rights, his incentive to invest in the relationship will decrease. In addition, the shift in control may lower the investment incentives of workers in the acquired firm. In some cases these reductions in investment will be sufficiently great that nonintegration is preferable to integration.

Note that, according to this theory, when assessing the effects of integration, one must know not only the characteristics of the merging firms, but also who wil