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

  • Philippe Aghion
  • Richard Holden

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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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.25.2.181
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Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 25 (2011)
Issue (Month): 2 (Spring)
Pages: 181-97

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Handle: RePEc:aea:jecper:v:25:y:2011:i:2:p:181-97
Note: DOI: 10.1257/jep.25.2.181
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  1. Francine Lafontaine & Margaret Slade, 2007. "Vertical Integration and Firm Boundaries: The Evidence," Journal of Economic Literature, American Economic Association, vol. 45(3), pages 629-685, September.
  2. Pol Antras, 2004. "Incomplete Contracts and the Product Cycle," 2004 Meeting Papers 19, Society for Economic Dynamics.
  3. Philippe Aghion & Drew Fudenberg & Richard Holden & Takashi Kunimoto & Olivier Tercieux, 2012. "Subgame-Perfect Implementation Under Information Perturbations," The Quarterly Journal of Economics, Oxford University Press, vol. 127(4), pages 1843-1881.
  4. Schmidt, Klaus M., 1996. "The costs and benefits of privatization: An incomplete contracts approach," Munich Reprints in Economics 19773, University of Munich, Department of Economics.
  5. Hart, Oliver & Shleifer, Andrei & Vishny, Robert W, 1997. "The Proper Scope of Government: Theory and an Application to Prisons," The Quarterly Journal of Economics, MIT Press, vol. 112(4), pages 1127-61, November.
  6. Williamson, Oliver E, 1971. "The Vertical Integration of Production: Market Failure Considerations," American Economic Review, American Economic Association, vol. 61(2), pages 112-23, May.
  7. Fehr, Ernst & Hart, Oliver & Zehnder, Christian, 2008. "Contracts as Reference Points: Experimental Evidence," IZA Discussion Papers 3889, Institute for the Study of Labor (IZA).
  8. Oliver Hart & John Moore, 2007. "Contracts as Reference Points," ESE Discussion Papers 170, Edinburgh School of Economics, University of Edinburgh.
  9. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  10. Patrick Bolton & Antoine Faure-Grimaud, 2009. "Thinking Ahead: The Decision Problem," Review of Economic Studies, Oxford University Press, vol. 76(4), pages 1205-1238.
  11. Philippe Aghion & Jean Tirole, 1994. "Formal and Real Authority in Organizations," Working papers 95-8, Massachusetts Institute of Technology (MIT), Department of Economics.
  12. Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 473-94, July.
  13. Klein, Benjamin & Crawford, Robert G & Alchian, Armen A, 1978. "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics, University of Chicago Press, vol. 21(2), pages 297-326, October.
  14. Mirrlees, J A, 1999. "The Theory of Moral Hazard and Unobservable Behaviour: Part I," Review of Economic Studies, Wiley Blackwell, vol. 66(1), pages 3-21, January.
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