Incomplete Contracts and Ownership: Some New Thoughts

Since Ronald H. Coase’s famous 1937 article, economists have grappled with the question of what characterizes a firm and what determines its boundaries. Transaction cost economics (see, e.g., Oliver Williamson 1975, 1985; Benjamin Klein, Robert G. Crawford, and Armen A. Alchian 1978) argues that firms are important when contracts are incomplete, and parties make large relationship-specific investments. Property rights theory (see, e.g., Sanford J. Grossman and Oliver D. Hart 1986; Hart and John Moore 1990) refines this thinking by taking the view that the owner of a nonhuman asset possesses residual control rights over that asset, and that there is an optimal allocation of such residual control rights. As a consequence, not all activities should take place in a single firm. The modeling approach used in most of the incomplete contracting and property rights literature is one in which renegotiation of an incomplete contract always leads to ex post efficiency, and the focus is on distortions in ex ante investments. In this paper, we argue that such an approach is restrictive. We suggest, in future work, it may be useful to broaden the approach to include some new elements, such as behavioral ones. This will help to generate a theory of ex post inefficiency. We describe a first attempt along these lines based on Hart and Moore (2006).