Endogenous Outside Options, Incomplete Contracts and the Theory of the Firm

The article considers Oliver Hart and Bengt Holmström’s contributions to the development of contract theory. The contributions are represented by studies on the nature of optimal contract in view of motivation of contract agents and factors that affect their motivation. A particular attention is placed on the practical utility of the research done by Nobel Laureates in Economic Sciences 2016 that have fostered further studies on the theory of the firm, corporate finance, management, labour economics and the public sector, political science and law. The new theoretical tools created by O. Hart and B. Holmström serve for analysis of financial terms of contracts and for the distribution of supervisiory rights, property rights and decision-making rights. It is emphasized that O. Hart and B. Holmström’s contributions to the field of contract theory present formal treatment of motivation issues, moral hazard and incomplete contracts. The role of contracts in managing future interactions and ensuring conditions for establishing high-quality institutions is recognized. It is pointed out that the contract theory reveals working mechanisms of institutions, and presents potential hazard that may arise when new contracts are being drafted. Particular attention is paid to positioning of the contract theory within the theory of economic organization and the economic theory of information that is aimed at developing models with asymmetric information and taking into account non-observable actions. Real situations, game models and contract structure with the distinction between complete and incomplete contracts are examined (based on the informativeness principle). The performance of multi-task model and career-growth model in the contract theory is outlined. The paper analyzes the impact of the contract theory on changes in approaches to analyzing corporate relationships, which were previously based on the trade-off theory that includes balancing between the reduction of tax payments and corporate debt servicing.

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Incomplete Contracts and the Theory of the Firm

The Journal of Law Economics and Organization ◽

10.1093/oxfordjournals.jleo.a036940 ◽

1988 ◽

Cited By ~ 48

Keyword(s):

Theory Of The Firm ◽

Incomplete Contracts

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Endogenous outside options in coordination games: experimental evidence

Journal of Economic Behavior & Organization ◽

10.1016/s0167-2681(01)00205-0 ◽

2002 ◽

Vol 47 (2) ◽

pp. 221-236 ◽

Cited By ~ 1

Author(s):

Abdullah Yavas

Keyword(s):

Experimental Evidence ◽

Coordination Games ◽

Outside Options ◽

Endogenous Outside Options

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Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years?

The Journal of Economic Perspectives ◽

10.1257/jep.25.2.181 ◽

2011 ◽

Vol 25 (2) ◽

pp. 181-197 ◽

Cited By ~ 95

Author(s):

Philippe Aghion ◽

Richard Holden

Keyword(s):

Property Rights ◽

Optimal Allocation ◽

Theory Of The Firm ◽

Incomplete Contracts ◽

Governance Structure ◽

Costs And Benefits ◽

Intrafirm Trade ◽

Financial Decisions ◽

Recent Developments ◽

States Of Nature

Sanford Grossman and Oliver Hart used the theory of incomplete contracts to develop answers to the question “What is a firm, and what determines its boundaries?” in their path-breaking paper on “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration” (Journal of Political Economy, 1986, vol. 94, no. 4). Perhaps the central issue is that economic actors are only boundedly rational and cannot anticipate all possible contingencies. It might well be that certain states of nature or actions cannot be verified by third parties after they arise, like certain qualities of a good to be traded in the future, and thus cannot be written into an enforceable contract. When contracts are incomplete, and consequently not all uses of an asset can be specified in advance, any contract negotiated in advance must leave some discretion over the use of the assets; and the “owner” of the firm is the party to whom the residual rights of control have been allocated at the contracting stage. The optimal allocation of property rights—or governance structure—is one that minimizes efficiency losses. This produces a theory of ownership and vertical integration as well as a theory of the firm. First we spell out Grossman and Hart's argument using a simple numerical example. Then we show how the incomplete contracts approach can be used to analyze the firms' internal organization; the firms' financial decisions; the costs and benefits from privatization; and the organization of international trade between inter- and intrafirm trade. We discuss several criticisms of the incomplete contracts/property rights methodology and review recent developments of the incomplete contracts approach.

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