3.3 Incomplete contracts

In a paper that continues to have a profound impact on the literature on contracting and the theory of the firm, Grossman and Hart (1986) argued that transaction costs provided an incomplete theory of the nature and boundaries of the firm. Transaction costs could account for the benefits of integration of activities within a firm so long as the costs of monitoring by management were lower, but transaction costs provided only a partial approach to the analysis of the costs and incentive effects of different allocations of ownership and different configurations of the principal-agent relationship. Grossman and Hart argued that the boundaries of the firm were actually determined by the efficiency of allocating the residual rights of control to different parties rather than by transaction costs and management costs per se. So, while transaction costs provide a partial theory of the costs of ownership in different hands, a much broader conception of the costs and benefits of ownership was required to understand the boundaries of the firm.

The starting point for this approach to the theory of the firm is the incompleteness of contracts. Since humans are boundedly rational, not all issues of relevance to a contract can be anticipated at the time of writing the contract. Since information is costly to acquire, it may not be efficient to acquire some of the information that could be used to address contractual incompleteness even in situations where that information might be available. Further, not all future actions can be specified ex ante or verified ex post. Consequently, not all factors that are relevant to the creation of surplus in economic activity can or should be written into an enforceable contract. When contracts are incomplete, and consequently not all aspects of performance relevant to the contract are specified in advance, the contractor retains some discretion over those aspects of performance that are not explicitly identified in the contract.

Since their first identification of the importance of contractual incompleteness, developments in different parts of the economics literature have reinforced the importance of ownership as a means of solving contractual incompleteness. Management of risk often requires flexibility in the timing of investment and in the investment options chosen—a key component of the literature on real options which we consider in later chapters of this paper. In addition, modern understandings of the importance of dynamic efficiency focus on the fact that it is the process of decision-making under competitive pressure that is important for maximising the present value of social welfare over time. Neither the timing of investment nor the precise nature of competitive responses can be specific ex ante, suggesting that contractual incompleteness is both necessary and desirable in maximising dynamic efficiency.

Grossman and Hart (1986) identify two types of contracts: contracts that specify particular rights over the assets of another party and contracts that allocate residual rights. Ownership is the possession of those residual rights of control. “When it is too costly for one party to specify a long list of the particular rights it desires over the party's assets, it may be optimal for that party to purchase all the rights except those explicitly mentioned in the contract” (Grossman and Hart, 1986:692). From the perspective of this theory of the firm, the efficiency of different structures for the organisation of production will hinge on whether residual rights of control (ownership) are correctly allocated. For example, backward integration through the purchase of a supplier may be inefficient if the removal of residual rights of control over the production of the input distorts the decisions of the manager of the supplier in a way that reduces total surplus derived from the vertical supply chain. In this case, even if there were substantial transaction costs associated with the writing of a contract with the supplier, if non-contractible elements of supplier performance were critical in determining the contribution of the supplier to total surplus, the efficient allocation of ownership and production may require that residual ownership rights for supply be left with an independent supplier.

The analysis of Grossman and Hart (1986) focuses on incentives for investment (in any of assets, knowledge or effort) under different ownership structures. In particular, they observe that ownership confers the rights to the surplus generated by any investment. Thus, if ownership rights are conferred on an entity that does not have the ability to control the investments that have the greatest impact on the generation of surplus, then investments and total surplus will be below their optimal levels. The allocation of ownership rights, and thus the boundaries of the firm and of contractual relationships, will be determined by the value that is generated by allocating residual control rights to the parties whose non-contractible investments (effort) in production have the greatest impact on total surplus. From the perspective of this theory of the firm, the difference between employee and contractor relationships with a principal lies in the fact that the principal retains discretion over all non-contractible elements of the work, while the contractor retains residual rights of control over all those elements of the work not specified in the contract (Grossman and Hart, 1986:717). This example usefully illustrates the way in which the incomplete contracts theory of ownership extends earlier principal-agent and transaction cost frameworks for understanding the organisation of production.

Thus, in Grossman and Hart (1986) and Hart and Moore (1990) the firm is a collection of assets that are jointly owned. In the absence of complete contracts, ownership matters because it provides the right to make decisions on all unspecified contingencies. Rajan and Zingales (1998) extended this approach by proposing that the firm is a network of specific investments (including in human and physical capital) that cannot be replicated by the market.