Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years?
AbstractSanford 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoArticle provided by American Economic Association in its journal Journal of Economic Perspectives.
Volume (Year): 25 (2011)
Issue (Month): 2 (Spring)
Find related papers by JEL classification:
- D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Altomonte, Carlo & Rungi, Armando, 2013.
"Business groups as hierarchies of firms: determinants of vertical integration and performance,"
Working Paper Series
1554, European Central Bank.
- Carlo Altomonte & Armando Rungi, 2013. "Business Groups as Hierarchies of Firms: Determinants of Vertical Integration and Performance," Working Papers 2013.33, Fondazione Eni Enrico Mattei.
- Barrett, Christopher B. & Bachke, Maren E. & Bellemare, Marc F. & Michelson, Hope C. & Narayanan, Sudha & Walker, Thomas F., 2012. "Smallholder Participation in Contract Farming: Comparative Evidence from Five Countries," World Development, Elsevier, vol. 40(4), pages 715-730.
- Oliver D. Hart, 2011.
"Noncontractible Investments and Reference Points,"
NBER Working Papers
16929, National Bureau of Economic Research, Inc.
- Buehler, Stefan & Burghardt, Dirk, 2013. "Globalization and Vertical Structure: An Empirical Investigation," Economics Working Paper Series 1310, University of St. Gallen, School of Economics and Political Science.
- Tomoo Kikuchi & Kazuo Nishimura & John Stachurski, 2012. "Coase meets Tarski: New Insights from Coase's Theory of the Firm," KIER Working Papers 828, Kyoto University, Institute of Economic Research.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Jane Voros) or (Michael P. Albert).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.