Hart: Incomplete contracts and the theory of the firm

Hart. 1993. Incomplete contracts and the theory of the firm. In The Nature of the Firm, eds. Oliver Williamson and Sidney Winter, pp. 138-158. New York: Oxford University Press.

Hart begins with a minor complaint about existing theories of the firm (from Coase, Williamson, Klein/Crawford/Alchian): they use one theory to explain the benefits of vertical integration, and another to explain the costs. Hart seeks to develop a single theory to explain both.

Hart's work centers around RESIDUAL RIGHTS OF CONTROL. In a world of no transactions costs, we would always write perfect contracts (b/c it wouldn't cost anything to specify every possible contingency); even if we didn't, there would be no transactions costs to revise it. But with transactions costs, we necessarily right incomplete contracts. These contracts assign (sometimes explicitly, sometimes not) "residual rights of control." Example 1: I contract to buy car bodies from you. Demand goes up, and I want to get more bodies than the contract specifies. It is up to you whether to comply, since the contract doesn't obligate you to; you retain residual rights of control over use of your factory. Example 2: I contract to rent a house to you. You cannot repaint a room without my permission, though; I retain residual rights of control. If the paint all peels off and the house generally falls into disrepair, though, you may have residual rights of control that allow you to compel me (in court, perhaps) to clean up.

Some key points are summarized in this passage:

"Before embarking on this, however, let me remark that any theory of ownership worth its salt should be consistent with the following basic observations:

"A. If one individual is entirely responsible for the return of an asset, he should own it.

"B. If there are increasing returns to management, so that one person can manage two firms, then these firms should have a common owner-that is, we should see integration.

"C. If firm D wishes to be supplied by firm U, but firm D's business with U is only a small fraction of both U's and D's total business, then we would expect to see D sign a (long-term) contract with U rather than D buy U up or U buy D up. (We are assuming here that the spot market solution is infeasible.)

"D. If an industry is declining we would expect to see firms merge so as to save on overheads (their headquarters, advertising division, and so on), rather than stay independent and share these overhead activities via a long-term contract."