3.5 Linking transaction cost- and incentive-based theories of the firm with incomplete contracts

Understanding the contribution that Grossman and Hart (1986) and Hart and Moore (1990) made to the theory of the firm requires an explanation of its relationship to the other approaches to the definition of the firm used by economists in the past 40 years. Here we consider explicitly incentive-based theories of the firm, and transaction cost-based theories of the firm.[5]

Incentive-based theories of the firm

Incentive-based theories of the firm have their foundation in the analysis of the incentive problem between a principal and an agent. This approach assumes that there are many tasks and many instruments associated with the agency problems in a firm, and asset ownership is merely one of the instruments. Papers in this paradigm consider two ways to structure the agency problem: (i) where the agent does not own the asset (is an employee) and therefore has incentives provided by being paid on measured performance, and (ii) where the agent does own the asset (is an independent contractor) and receives both a payment based on measured performance and the value of the asset after production occurs.

This approach to the theory of the firm has in effect focused on the claimed distinction between the low-powered incentives associated with employment, and the high-powered incentives associated with contracting. Employees require low-powered incentives because they are not distracted by the contractor's incentives to increase the value of the assets used for production. More generally, joint optimisation over asset ownership and contract parameters determines whether to conduct activity within the firm or outside.

The incentive-system theory of the firm is therefore related to the incomplete contracts literature, both in its use of ownership as an instrument and in its ability to provide a unified account of the costs and benefits of integration. But this literature has one major shortcoming by comparison with the incomplete contracts literature: who owns the asset affects the payoff of agents, but not the behaviour of the agents. This means that incentive-system theories do not easily capture the ability of agents to respond to the same set of incentives with two different types of behaviour, only one of which is optimal for the principal.

Transaction cost-based theories of the firm

Both the transaction cost-based approach of Williamson (1979) and the incomplete contracts approach of Grossman and Hart (1986) and Hart and Moore (1990) rely on the potential for relationship-specific investments to create hold-up. Investment in relationship-specific assets generates ex post quasi-rents, and any contingency not explicitly specified within a contract will create opportunities for bargaining about the division of those rents. Williamson focuses on the way in which parties to a contract attempting to capture (ex post) a greater share of these quasi-rents generated transaction costs, whereas Grossman, Hart and Moore focus on the potential for this incompleteness to affect the incentives to make the initial investment in the specific asset. Williamson focuses on the ability of firms to avoid these transaction costs associated with ex post bargaining by bringing activities within the firm, while Grossman, Hart and Moore focus on the way in which allocation of control (ownership) rights to the party that is able to add the most value to the contract produces the best investment outcome.

The incomplete contracts approach adopted in this paper may therefore be thought of as an alternative lens on same issues that motivated the work of Coase and Williamson. The two approaches are, at least to some extent complementary, but they may also lead to quite different conclusions about the optimal structure and boundaries of a firm. The reason is that the focus of Grossman, Hart and Moore is on the potential for allocations of ownership rights to overcome the problems created by ex post bargaining about quasi-rents. Their focus on the ownership of activity, and its impact on the ex ante efficiency of the investment decision has two advantages over the transaction cost approach: it is consistent with competition between different potential owners of an activity rather than just focussing on the “inside the firm versus outside the firm” decision of one firm, and it has more direct application to the contemporary literature on investment decision-making, public ownership and governance than was the earlier transaction-cost approach. Those applications are the subject of the remainder of this paper.