Firms, Contracts, and Financial Structure

Abstract

This book provides a framework for thinking about economic relationships and institutions such as firms. The basic argument is that in a world of incomplete contracts, institutional arrangements are designed to allocate power among agents. The first part of the book is concerned with the boundaries of the firm. It is argued that traditional approaches such as the neoclassical, principal‐agent, and transaction costs theories cannot by themselves explain firm boundaries. The book describes a theory—the incomplete contracting or property rights approach—based on the idea that power and control matter when contracts are incomplete. If the terms of a transaction can always be renegotiated, the incentives of a party to undertake relationship‐specific investments will depend crucially on the ability to control the use of productive assets when renegotiation takes place. Asset ownership becomes an essential source of power. The theory suggests that firm boundaries are chosen to allocate power optimally among the various parties to a transaction. The foundations of incomplete contracting are also discussed. The remainder of the book applies incomplete contracting ideas to understand the financial structure of closely held and public companies. The analysis illustrates how debt acts as an automatic mechanism to constrain the behaviour of managers or owners of both kinds of companies. In closely held companies, debt can force an entrepreneur to pay out funds to investors rather than to himself. In a public company, ownership is dispersed among small shareholders causing a separation between ownership and control. It is argued that debt and equity choices, capital structure decisions, bankruptcy procedures, corporate governance, and takeovers, play a substantial role in limiting the ability of a (self‐interested) manager to make unprofitable but power‐enhancing decisions.

How Can Integration Reduce Inefficiencies Due to Ex Post Adaptation?

“…While the former approach, as in Coase (1937) and Williamson (1975 and1985), focuses on authority, the latter approach, as in Grossman and Hart (1986), Hart and Moore (1992), and Hart (1995), emphasizes ownership structure.…”

“…Hart (1995) observes "If there is less haggling and hold-up behaviour in a merged firm, it is important to know why. Transaction cost theory, as it stands, does not provide the answer" (Hart, 1995, p. 28).…”

“…Although this question is crucial to the understanding of transaction cost economics (TCE) and has been frequently asked (e.g., Hart (1995)), TCE has not provided any formal answer. This paper formally shows that integration indeed realizes immediate agreement more easily than non-integration.…”

Putting all One’s Eggs in One Basket: Relational Contracts and the Provision of Local Public Services

“…However, when executing the contract, the private operator of a service may come up with new innovative ways to adapt the service to users' need, or to reduce the costs of provision of these services. Such innovations are often difficult and costly to anticipate ex ante, which leads to some contractual incompleteness as defined by Grossman and Hart [1986], Hart and Moore [1990] or Hart [1995]. Hence, when such innovations turn up, parties will revise the contract ex post when it is clear to them what the relevant contingencies are.…”

Market Distortions and Corporate Governance

“…7 See Hart (1995), Shleifer and Vishny (1997), Allen and Gale (2000), Rajan and Zingales (2000) for a sample.…”