Incomplete Contracts and Ownership: Some New Thoughts

By Oliver Hart and John Moore*

Since Ronald H. Coase’s famous 1937 arti- and 1, B makes a noncontractible relationship- cle, economists have grappled with the ques- specific investment that increases his value from tion of what characterizes a firm and what receiving the service. The cost of the service is determines its boundaries. Transaction cost unaffected by this investment and is taken to be economics (see, e.g., Oliver Williamson 1975, a constant. B’s value exceeds S’s cost, so there 1985; Benjamin Klein, Robert G. Crawford, and are always gains from trade. An optimal con- Armen A. Alchian 1978) argues that firms are tract ensures that these gains from trade are important when contracts are incomplete, and realized and that B invests efficiently. parties make large relationship-specific invest- First, consider what happens if the parties post­ ments. Property rights theory (see, e.g., Sanford pone contracting until date 1 when B’s invest- J. Grossman and Oliver D. Hart 1986; Hart and ment is sunk. Suppose symmetric information John Moore 1990) refines this thinking by tak- about value and cost at this stage. According to ing the view that the owner of a nonhuman asset standard thinking, the parties will realize the ex possesses residual control rights over that asset, post gains from trade through bargaining and and that there is an optimal allocation of such will split the ex post surplus in some way, e.g., residual control rights. As a consequence, not 50-50. A 50-50 split, however, implies that B all activities should take place in a single firm. receives only half of an increase in the value of The modeling approach used in most of the service caused by his noncontractible invest- the incomplete contracting and property rights ment. Anticipating this, B underinvests. This is literature is one in which renegotiation of an the well-known hold-up problem. incomplete contract always leads to ex post effi- One solution to the hold-up problem is for ciency, and the focus is on distortions in ex ante B and S to write a contract at date 0 that fixes investments. In this paper, we argue that such the date 1 terms of trade before B invests. This an approach is restrictive. We suggest, in future may be problematic given that the nature of S’s work, it may be useful to broaden the approach service is uncertain at date 0. Property rights to include some new elements, such as behav- theory explores a second solution, which is to ioral ones. This will help to generate a theory of allocate ownership of the assets S works with ex post inefficiency. We describe a first attempt (e.g., a plant or factory) to B. Even in the absence along these lines based on Hart and Moore of a long-term contract, this strengthens B’s bar- (2006). gaining position at date 1 since B always has the option to replace S with someone else who can operate the assets. Given this, B will now I. A Simple Version of Property Rights Theory receive a greater fraction of the ex post surplus, which will strengthen his investment incentives. Consider a buyer B who requires a service This is the simplest example of how allocating from a seller S in the future at date 1. The nature asset ownership can reduce underinvestment of this service will be known at date 1 when the and increase efficiency. parties trade, but is uncertain at date 0 when This model, as it stands, has some weak- they first meet and contract. Between dates 0 nesses. First, the parties may be able to devise a clever mechanism that overcomes the fact that * Hart: Department of Economics, Harvard University, the nature of trade is uncertain as of date 0. Littauer Center 220, Cambridge, MA 02138 (e-mail: ohart@ Two such mechanisms have been proposed. In harvard.edu); Moore: Department of Economics,Edinburgh one, the parties try to allocate date 1 bargain- University, 336 William Robertson Building, Edinburgh, ing power. In the model described above, since Scotland, EH8 9JY, United Kingdom (e-mail: j.h.moore@ ed.ac.uk). The authors are grateful to Luigi Zingales for helpful comments.  For a recent survey see Robert Gibbons (2005).  For a formalization see Paul Grout (1984). 182 VOL. 97 NO. 2 Incomplete Contracts and Ownership: Some New Thoughts 183

B is the only investing party, it is desirable to specific investments is somewhat unsatisfactory allocate B all the ex post bargaining power. One because, almost by definition, such investments way to do this is for the parties to agree at date 0 are hard to measure empirically. Also, the that B has the right to make a take-it-or-leave-it assumption that parties always bargain to an offer to S at date 1. B will propose the efficient ex post efficient outcome using side payments service for a price just above S’s cost and will seems a poor description of what goes on inside receive all the surplus. One potential problem the firm. with such a scheme is that S might reject B’s offer All of this suggests that it is worth trying to and try to renegotiate a better deal. If there is a develop alternative models. deadline for trade, however, B can ignore such a rejection, confident that at the last moment S II. An Alternative Model of Ownership will accept B’s offer, since a small profit is better than nothing. Hart and Moore (2006) develop a theory of A second mechanism is based on the ideas of (incomplete) contracts based on the idea that a Eric Maskin (1999), Moore and Rafael Repullo contract is a reference point for parties’ feelings (1988), and Maskin and Jean Tirole (1999). These of entitlement, and that feelings of entitlement authors have argued that in a world of symmetric affect contractual performance. The basic ele- information there are ingenious ways of making ments of the theory are as follows. Consider this information verifiable, i.e., available to out- a situation similar to that above but without siders such as the courts. Enforceable contracts noncontractible investments—a buyer B wants can therefore be made contingent on this infor- a good or service from a seller S at date 1. To mation. In the model above, the parties could, simplify matters, suppose that the good is for example, agree as part of the date 0 contract homogeneous—a widget. Between dates 0 and that B can choose any service he wants at date 1, 1, a “fundamental transformation” occurs in but must pay S her cost. S will announce her cost the sense of Williamson (1985); there is perfect (which, recall, B observes). If he chooses, B can competition at date 0 but bilateral monopoly at challenge S’s announcement. In this event S pays date 1. This transformation may be the result of a large fine to a third party.B ’s challenge is then relationship-specific investments, but, if so, they “tested” by seeing whether S supplies the service are not modeled. at a price slightly below S’s announced cost. If When the parties meet at date 0, they are she does, i.e., B’s challenge is “validated,” the uncertain about the state of the world. This third party transfers S’s fine toB . If not, i.e., B’s uncertainty will be resolved shortly before challenge is “invalidated,” B also pays a large date 1. There is symmetric information through- fine to the third party. It is not difficult to show out, but the state is not verifiable. A date 0 con- that the unique subgame perfect equilibrium of tract can be thought of as specifying a set of this game has S reporting her cost truthfully, possible outcomes from B and S’s date 1 trans- i.e., B receives all the ex post surplus. action, where an outcome is a price-quantity These mechanisms, particularly the second, pair. (The outcomes cannot be state contingent are troubling. If the model described real- because the state is nonverifiable.) The contract ity accurately, one would expect to see such may also provide a mechanism for choosing ­mechanisms being used at least sometimes. The from this set. fact that they aren’t used suggests that the model Hart and Moore make the assumption that may be missing something important. the date 0 contract serves as a reference point The model can be criticized on other grounds. for the parties’ sense of entitlements at date 1. The reliance on noncontractible, relationship- Specifically, neither party feels entitled to an outcome outside those permitted by the con- tract. Implicitly the contract is regarded as “fair”  See Joel Watson (2007) for a recent analysis along by both parties because it was negotiated under these lines. competitive conditions at date 0.  A very recent paper by Philippe Aghion, Drew Fudenberg, and Richard Holden (2006) suggests that this mechanism may not be robust to small amounts of private information.  See Michael Whinston (2003) for a discussion. 184 AEA PAPERS AND PROCEEDINGS MAY 2007

Within the contract there can be disagree- the trade price and the no-trade price matters, ment about the appropriate outcome, however. and that one can normalize the no-trade price To simplify matters, it is supposed that each to be zero. Note that lump-sum transfers can be party feels entitled to the best possible outcome used to redistribute surplus at date 0. permitted by the contract. Of course, this means Start with the case where there is no uncer- that typically at least one party, and possibly tainty: v, r are constants and v . r. Then the fol- both, will be disappointed or aggrieved by the lowing contract achieves the first-best outcome. outcome. The parties agree, at date 0, that S will supply What are the consequences of aggrievement? the widget to B at date 1 for a given price p, Hart and Moore make a second assumption that where r , p , v. Such a contract ensures trade the outcome from the transaction is not per- and causes no aggrievement because each party fectly contractible even at date 1. In particular, obtains the best outcome permitted by the con- assume that each party has the discretion to tract (the contract specifies only one outcome, provide “perfunctory” performance rather than trade at price p!). “consummate” performance. We refer to such Note that even in this simple situation there behavior as shading and suppose that it cannot are many contracts that are not optimal. For be observed or penalized by an outsider (e.g., a example, consider a contract that says that the court). (A court can, however, enforce perfunc- price can be anything in the [r, v] range, and that tory performance.) Consummate performance B will choose the price. Then B will choose the does not cost significantly more than perfunctory lowest price p 5 r at date 1. However, S will be performance (it may even be pleasurable), and a aggrieved that the best outcome for her, p 5 v, party will provide it if he feels well treated. He wasn’t chosen and she will shade, causing a will shade if he is aggrieved (“negative reciproc- deadweight loss of u (v – r). ity”). Shading hurts the other party and causes a Matters become more interesting if v, r are deadweight loss. uncertain. Now a contract that specifies a single To be more precise, Hart and Moore assume trading price p will lead to trade if and only if v that, if the outcome chosen from the contract $ p $ r, i.e., both parties gain from trade. The causes S to feel aggrieved by $k, i.e., S’s pay- difficulty is that, if v, r are stochastic, it may off is $k less than under the best possible out- be impossible to find a single price p that lies come, then S shades on her performance so that between r and v whenever v . r. B’s payoff falls by uk. Here, u is an exogenous Under these conditions, a contract_ that speci- parameter, 0 , u # 1. The situation is similar fies a range of trading prices [ _p , p ] may be supe- for B. Note that we assume symmetry. B and S rior. (Hart and Moore show that one does not can both shade and they face the same param- need to go beyond a contract that specifies a eter u. A final assumption is that parties cannot no-trade_ price of zero, a range of trading prices shade if they do not trade. Note that shading [ _p , p], and_ has B choose the price.) The larger the costs can be thought of as also capturing other range [ _p , p ] , the more likely it is that B can find kinds of transaction costs such as haggling, rent- a price between r and v whenever_ v . r. This is seeking, and influence costs. the benefit of a large range [ _p , p]. There is a cost To see the implications of the assumptions of a large range, however; typically there will above, let B’s value from the widget at date 1 be many feasible prices between r and v when be v. Assume that this widget is costless for S v . r. B will pick the lowest price but S will feel to produce, but that it has an opportunity cost aggrieved that B didn’t pick the highest and will r. Trade is efficient if and only if v $ r. As of shade, causing a deadweight loss. The optimal date 0, v and r are random variables with a prob- contract trades off these effects. ability distribution that is common knowledge. There is one important issue that we have (Recall that there are no ex ante investments.) ignored. If_ v . r, but there is no price in the Make the additional assumption that, if trade range [ _p, p] such that v $ p $ r, one might ex- does not occur at date 1, the responsible party pect the parties to renegotiate their contract. cannot be ascertained. Thus ex post trade is Renegotiation does not change the analysis fun- ­voluntary. Under these conditions, Hart and damentally, and so, for simplicity, we rule it out Moore show that only the difference between (see Hart and Moore 2006 for a discussion). VOL. 97 NO. 2 Incomplete Contracts and Ownership: Some New Thoughts 185

We now turn to the issue of ownership. So permitted. Even if we did allow this, however, far, we have implicitly supposed that B and S specific performance is no longer a panacea if v are separate entities (“nonintegration”). Assume , r with positive probability (respectively, v . now that B acquires S’s operations (assets) at date r with positive probability), and it can be shown 0 (“integration”). We will take this to mean that that there is still a role for integration (respec- B can get someone else to produce the widget tively, nonintegration). We leave the details to (costlessly) at date 1. In effect, B now owns and future work. possesses the widget. We suppose that S’s human We conclude with an observation. As Dennis capital is still required to realize the opportunity W. Carlton (1979) notes, business people often cost r. That is, to earn r, B must sell the wid- take the view that integration is useful for get back to S. Thus the model is the same as ­assuring input supply in an uncertain world. before except that the status-quo point at date 1 Our simple model captures this. When v . r is reversed. If no trade occurs, B earns v (since but v, r are stochastic, nonintegration is typically B “owns” the widget), while if trade occurs, S inefficient—either trade will not occur when it earns r and pays p. Trade is now efficient if and should or there will be shading—while integra- only if r $ v (it is still voluntary). A contract tion yields the first-best outcome. Note that the consists of a no-trade_ price of zero and a range of idea that integration assures supply has been trading prices [ _p, p], with S choosing the price. hard to capture using existing approaches (see S will choose the smallest price such that r $ p Patrick Bolton and Michael D. Whinston 1993). $ v, whenever r . v. As we do not have the space to conduct a complete analysis of the differences between REFERENCES nonintegration and integration, we confine our- selves to the following observations. Suppose v Aghion, Philippe, Drew Fudenberg, and Richard . r with probability 1. Then, as we have seen, Holden. 2006. “Subgame Perfect Implemen­ under nonintegration, it may be impossible to tation with Almost Perfect Information.” achieve the first-best. The reason is that in order Unpublished. to ensure trade with probability 1, it may be nec- Bolton, Patrick, and Michael D. Whinston. 1993. essary to have a range of trading prices, but this “Incomplete Contracts, Vertical Integration, leads to aggrievement and shading whenever and Supply Assurance.” Review of Economic there is more than one price such that v $ p $ Studies, 60(1): 121–48. r. In contrast, integration achieves the first-best Carlton, Dennis W. 1979. “Vertical Integration because the status-quo point is such that B pos- in Competitive Markets under Uncertainty.” sesses the widget, which is the efficient outcome. Journal of Industrial Economics, 27(3): S is irrelevant and does not (cannot) shade. 189–209. Of course, if v , r with probability 1, the situ- Coase, Ronald H. 1937. “The Nature of the Firm.” ation is reversed. Now integration leads to inef- Economica, 4(16): 386–405. ficiency because a range of prices is required Gibbons, Robert. 2005. “Four Formal(izable) to ensure that B always trades the widget to S. Theories of the Firm?” Journal of Economic This leads to aggrievement and shading when- Behavior and Organization, 58(2): 200–45. ever there is more than one feasible price in Grossman, Sanford J., and Oliver D. Hart. the range; while under nonintegration, the sta- 1986. “The Costs and Benefits of Ownership: tus quo point, in which S possesses the widget, A Theory of Vertical and Lateral Integra­ yields the efficient outcome without shading. tion.” Journal of Political Economy, 94(4): The reader will have noticed, that if v . r 691–719. with probability 1 (respectively, v , r with prob- Grout, Paul A. 1984. “Investment and Wages in ability 1), specific performance is an alternative the Absence of Binding Contracts: A Nash to integration (respectively, nonintegration) Bargaining Approach.” Econometrica, 52(2): as a way of achieving the first-best outcome. 449–60. Specific performance requires an outsider (a Hart, Oliver, and John Moore. 1990. “Property court) to be able to verify who was responsible Rights and the Nature of the Firm.” Journal of for the absence of trade, something we have not Political Economy, 98(6): 1119–58. 186 AEA PAPERS AND PROCEEDINGS MAY 2007

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