Incomplete Contracts and Control

Oliver HartNobel Prize Lecture December 8, 2016

Howmyworkinthisareastarted

• Inearlysummer1983,SanfordGrossmanandIbecameinterestedinthefollowingquestion:

Whywouldonefirmeverbuyanotherfirmratherthanconductbusinesswiththatfirmthroughacontract?

• Inotherwords,whatarelimitsofcontracts?

• Weknewthattherewasaliteratureonthisquestionandthat RonaldCoaseandOliverWilliamson,amongothers,hadmadenotablecontributions.Buttheirworkwas“informal”.Aseconomictheoristsourgoalwastodevelopaformalmodelofthedifferencesbetweenarms-lengthcontractingandintegrationoramerger.

• Weworkedintensivelyfortendays.WithapologiestoJohnReed,itwastendaysthatshookmyworld.Atsomepointwerealizedthatthekeyelementstounderstandingthedifferencearecontractualincompletenessandthenotionofresidualcontrol(ordecision)rights.

• Toillustratetheseideas,considerapowerplantthatlocatesnexttoacoalminewiththepurposeofburning coaltomakeelectricity.

• Itcouldsignalong-termcontractwiththecoalmine,specifyingthequantity,quality,andpriceofcoalformanyyearstocome.

• Butanysuchcontractwillbeincomplete.Eventswilloccurthatthepartiescouldnotfullyforeseewhentheystartedout.

• Forexample,supposethatthepowerplantneedsthecoaltobepurebutthatitishardtospecifyinadvancewhatpuritymeansgiventhattherearemanypotentialimpurities.

• Imaginethattenyearson,ashcontentistherelevantimpurityandthathigh-ash-contentcoalismoreexpensiveforthepowerplanttoburnbutcheaperforthecoalminetoproduce.

• Giventhatthecontractisincomplete,ifthepowerplantandthecoalmineareseparatecompanies,thecoalminemaybewithinitsrightsunderthecontracttosupplyhigh-ash-contentcoal.

• Thepowerplantcan,ofcourse,offertopaythecoalminetoswitchtolow-ash-contentcoal,butthecoalmineisinaverystrongbargainingposition.Itcandemandaveryhighprice:ithasthepowerplant“overabarrel."

• Anticipatingthepossibilityofbeing“held-up”,thepowerplantmaybereluctanttobecometotallydependentonthecoalmineforitssourceofcoal,eventhoughthisisefficient.

• Itisworthgoingintomoredetailaboutthesourceofthecoalmine’s“hold-up”power.GrossmanandIarguedthatitisbecausetheownerofthecoalminehasresidualrightsofcontrol:therighttodecideonusesofthecoalmineaboutwhichthecontractissilent.

• Indeed,GrossmanandIessentiallydefinedownershiptomeanthis.

• Inthiscasethekeyresidualrightofcontrolisthedecisionaboutwhatkindofcoaltomine.

• Isthereanythingthepowerplantcandotoavoidthissituation?

• Shortofwritingabettercontract,onethingitcoulddoistobuythecoalmineinadvance.

• Thatwaythepowerplantasownerofthecoalminewillhavethekeyresidualcontrolright.Thecoalminecannolongerextractahighpricebythreateningtoproducehigh-ash-contentcoal:thepowerplantcanorderthecoalminemanagertominelow-ash-contentcoal.

• Inanextremecase,ifthecoalminemanagerthreatenstodisobeytheorder,thepowerplantcanfirethemanagerandreplacehimwithsomeoneelse.

• Oneconsequenceisthatthepowerplantmaynowbewillingtobecomedependentonthecoalmine.

• Thisisthebenefitofintegration—thepurchaseofthecoalminebythepowerplant.

• But,andthisveryimportant,themanagerofthecoalmine,who,say,previouslyownedit,isnowMOREvulnerable.

• Forexample,supposethatthemanagerhasanideaabouthowtominecoalmoreefficiently.Ifthemanagerownsthecoalminehecanbeconfidentaboutreapingthereturnsfromthisidea.Butifthepowerplantownsthecoalmine,themanager’spositionismuchlesssecure:forexample,thepowerplantcouldfirehimandusehisideaanyway.Anticipatingthis,themanagerhasalowerincentivetoinnovate.

• Bottomline:Integrationhascostsaswellasbenefits.

n Ina1990paperwithJohnMooreIgeneralizedtheanalysistothecaseofmanyassetsandworkers,andmorecomplicatedownershipstructures,suchasjointownership.

• Twomaindifferencesfromthepreviousliterature.

• Theanalysisismoreformal(can’tseeitfromtoday!)

• Thefocusisoncontroloverphysical(moregenerally,non-human)assetsratherthanauthorityoverpeople.

• Ownershipofthecoalmineisnotworthmuchtothepowerplantifthemanagerofthecoalmineisindispensable.

• Aswellashelpingustounderstandmergers,thisapproachhasotherapplications.

• Oneistocorporatefinance.

• Intheelectricity-coalexample,replacethepowerplantbyafinancialinvestor.

• Thatis,supposethecoalmineneedsmoneytoexpand/modernize.Itapproachessomeonewithdeeppocketsandpromisesthemasubstantialshareoffutureprofittopersuadethemtoinvest.

• Likethecontractbetweenthepowerplantandthecoalmine,thefinancialcontractbetweentheinvestorandthecoalmineislikelytobeincomplete.Theinvestoristhereforeworriedaboutopportunisticbehavior(cf.hold-up)bythemanagerofthecoalmine.

• Forexample,themanagercoulddivertearnings:hecouldpayhimselfalargesalaryorreinvestprofitsratherthanpayingbacktheinvestor.

• Onewaytoprotecttheinvestoragainstopportunismisbygivingherresidualcontrolrightsorvotes.Forexample,shecouldbecometheownerofthecoalmine,ratherthanhavinganarms-lengthcontractwiththecoalmine.Thiswouldallowhertointervenetostopopportunisticbehavior,e.g.,shecouldcontrolthemanager’ssalaryorevenreplacehim.

• Butaswehaveseentherecanbeadownsideforthemanagerofthecoalmine:hisincentivetohaveideasmaybereducediftheinvestorhascontrol.

• Aghion andBolton(1992)showedthatonewaytobalancetheseeffectsistomakecontrolstate-contingent.Thatis,themanagerwillhavecontrolinsomesituations/statesoftheworld—typically,goodstates—andtheinvestorinothers—typically,badstates.ApaperbyKaplanandStromberg(2003)showedthatventurecapitalcontractsindeedhavethesefeatures.

• Inapaperwrittenin1989,andpublishedin1998,JohnMooreandIshowedthat,undersomeassumptions,theoptimalcontracttakestheformofadebtcontract:viz,

• Thecoalminepromisestomakeafixedstreamofpaymentstotheinvestor.Aslongasthesepaymentsaremadethemanagerofthecoalmineremainsincharge,i.e.,retains(residualrightsof)controloverthecoalmine.Ifapaymentisnotmadecontrolshiftstotheinvestor,whocandecidewhethertoreplacethemanagerorsellthemine.

• Debtcontractsare,ofcourse,ubiquitous,andtheanalysishelpstoexplainwhytheyareused.

• Theanalysisalsocastslightontheimportanceofcollateral.Theinvestorisbetterprotectedifthephysicalassetsofthemineareimportantrelativetothemanager’shumancapital.(SeealsoHartandMoore(1994).)Inthiscasetheinvestorcanappropriatealargefractionoftheproject’svalue.Thecoalminecanthereforeborrowmore.

• Further,themoreslowlythephysicalcapitaldepreciates(themore“durable”itis),thelongercanbethematurityofthedebtcontract.

• It’stheotherwayroundifthehumancapitalisimportantrelativetothephysicalcapital:nowit’shardforthecoalminetoborrowmuch.

• EmpiricalsupportfortheseimplicationshasbeenobtainedbyBenmelech (2009).

• Asecondapplicationistopublicvs.privateownership.Seemy1997paperwithAndreiShleiferandRobertVishny.

• Replacethepowerplantbythegovernmentandthecoalminebyaprison.

• Clearly,thegovernmenthastopayforprisonservicesbutdoesitneedtoowntheprison?

• Mightitbebettertocontractwithaprivatecompanytolookaftertheprisoners?

• Againitboilsdowntocontractualincompletenessandtheallocationofresidualcontrolrights.

• Iftheprisonisprivatelyrun,theprisoncompanymayfindwaysconsistentwiththecontracttosavemoneybutthismaybeattheexpenseofquality,whichisundesirableforthegovernment/society.

• Forexample,thecompanymighthirecheaperbutlesswell-trainedguards.(Thisisanalogoustothecoalminechoosingtominehigh-ash-contentcoal.)

• Ontheotherhand,aprivately-runprisonmighthaveagreaterincentivetoinnovate,e.g.,comeupwithsociallyvaluablerehabilitationprograms.(Thisisakintothemanagerofthecoalminehavingbetterideas.)

• Whicheffectismoreimportantwilldeterminewhetherpublicorprivateownershipisbetter.

• The1997paperarguedthatthefirsteffectislikelytodominatethesecondinthecaseofmaximumsecurityprisons,wherethequalityoftheguardsisparticularlyimportant.Thusprisonprivatizationisprobablyabadideainthiscase.

• Thereareothercaseswherethetrade-offgoestheotherwayandprivatizationisgood.

• Theanalysisisperhapsusefulinshowingthateconomicsratherthanpoliticscanguideusonthepublic-privatechoice.

If I had more time…

• IwouldtalkaboutwhyinrecentworkIhaveintroducedbehavioralelements—inparticular,aconcernbythecontractingpartiesforareasonableorfairoutcome—tounderstandatadeeperlevelwhycontractsareincomplete.

• IwouldalsotalkabouttwolegalcasesIwasinvolvedin,whereIusedtheworkIhavedescribedasanexpertwitnessfortheU.S.government.

• Youwillhavetowaitforthefulllecturetolearnaboutthese….

Someofmyco-authorsinthisendeavor…

• SanfordGrossman

JohnHardmanMoore

Some of my co-authors in this endeavor…

ChristianZehnder

Robert VishnyAndrei Shleifer

Ernst Fehr

Some of my co-authors in this endeavor…

n THANK YOU !!