Economists have a very well-established theory of market trading, and are on the way to a similarly well-developed theory of contractual transactions. However, the economic analysis of institutions is in a much more rudimentary state. This article discusses a recent literature that tries to provide a framework for thinking about economic institutions such as finns. The basic idea is that finns arise in situations in which people cannot write good contracts, and in which the allocation of power or control is therefore important.[1]
The starting point of this recent literature--which is sometimes called the "incomplete contracting" approach is that it is prohibitively expensive for parties to write a contract governing their economic relationship that is all-inclusive, that is, that anticipates all the many things that may happen. Instead, parties will write a contract that is incomplete, and that will be revised and renegotiated as the future unfolds. The contract they write can be seen as a backdrop or starting point for such renegotiations, rather than a specification of the final outcome. Thus, the parties look for a contract that will ensure that, whatever happens, each side has some protection, both against opportunistic behavior by the other party and against bad luck.[2]
In a world of incomplete contracts, the ex post allocation of power (or control) matters. Here power refers roughly to the position of each party if the other party does not perform (for example, if the other party behaves opportunistically). These two ideas--contractual incompleteness and pow-er--can be used to understand a number of economic institutions and arrangements. I discuss some of these in the remainder of this article.
The Meaning of Ownership
Economists have written a great deal about why property fights are important, and in particular why it matters, for example, whether a machine is privately owned or is common property. However, they have been less successful in explaining why it matters who owns a piece of private property. To understand the difficulty, consider a situation in which I want to use a machine that you own. I can buy the machine from you or rent the machine from you. If there are no contracting costs, then we can sign a rental agreement that is as effective as a change in ownership. In particular, the rental contract can specify exactly what I can do with the machine; when I can have access to it; what happens if the machine breaks down; what rights you have to use the machine; and so on. Given this, however, it is unclear why changes in asset ownership ever need to take place.
In a world with contracting costs, though, renting and owning are no longer the same. If contracts are incomplete, not all the uses of the machine will be specified in all possible eventualities. The question then arises; who chooses the unspecified uses? A reasonable view is that the owner of the machine has this right; that is, the owner has residual rights of control over the machine, or residual powers. For example, if the machine breaks down or requires modification and the contract is silent about this, then the owner can decide how and when it is repaired or modified.
Now it is possible to understand why it might make sense for me to buy the machine from you, rather than to rent it. If I own the machine, I will have more power in our economic relationship, since I will have all the residual rights of control. To put it another way, if the machine breaks down or needs to be modified, I can ensure that it is repaired or modified quickly, so that I can continue to use it productively. Knowing this, I will have a greater incentive to look after the machine, to learn to operate it, to acquire other machines that create a synergy with this machine, and so on.
The Boundaries of Firms
A long-standing issue in organization theory concerns the determinants of the boundaries of firms. Why does it matter if a particular transaction is carried out inside a finn, or through the market, or via a long-term contract? To put it another way, given any two firms (A and B), what difference does it make if the firms transact through an arms-length contract, or merge and become a single firm?
It is difficult to answer these questions using standard theory for the same reason that it is hard to explain why asset ownership matters. If there are no contracting costs, then the two finns can write a contract governing their relationship that specifies the obligations of all parties in all eventualities. Since the contract is all-inclusive, it is unclear what further aspects of their relationship could be controlled through a merger. This is true whether firm A is buying an input from firm B, or firms A and B sell complementary products and want to save on some duplicative production costs.
But since contracts are incomplete, it is possible to explain why a merger might be desirable. Consider the well-known example of Fisher Body, which for many years supplied car bodies to General Motors (GM). For a long time, Fisher Body and GM were separate firms linked by a long-term contract. However, in the 1920s, GM's demand for car bodies increased substantially. After Fisher Body refused to revise the formula for determining price, GM bought Fisher out.[3]
Why did GM and Fisher Body not simply write a better contract? Arguably, GM recognized that, however good a contract it wrote with Fisher Body, situations similar to the one it had just experienced might arise again; that is, contingencies might occur that no contract could allow for. GM wanted to be sure that next time around it would be in a stronger bargaining position; in particular, it would be able to insist on extra supplies, without having to pay a great deal for them. It is reasonable to suppose that ownership of Fisher Body would provide GM with this extra power by giving it residual control rights over Fisher Body's assets. At an extreme, GM could dismiss the managers of Fisher Body if they refused to accede to GM's requests.[4]
Of course, although the acquisition increased GM's power and made GM more secure in its relationship with Fisher Body, it arguably had the opposite effect on Fisher Body. That is, Fisher Body may have had more to worry about after the merger. For example, if Fisher Body's costs fall, GM is now in a stronger position to force a reduction in the (transfer) price of car bodies, hence reducing the return to Fisher managers. Anticipating this, Fisher managers may have less incentive to figure out how to reduce costs. Thus, there are both costs and benefits from a merger.[5]
Together with Sanford J. Grossman and John Moore, I have developed a theory of the finn based on the idea that firm boundaries are chosen to allocate power optimally among the various parties to a transaction.[6] This work argues that power is a scarce resource that never should be wasted. One implication of the theory is that a merger between finns with highly complementary assets enhances value, and a merger between firms with independent assets reduces value. If two highly complementary firms have different owners, then neither has real power, since neither can do anything without the other. It is then better to give all the power to one of the owners through a merger. On the other hand, if two firms with independent assets merge, then the acquiring firm's owner gains little useful power, since the acquired firm's assets do not enhance their activities. The acquired firm's owners lose useful power, though, since they no longer have authority over the assets they work with. In this case, it is better to divide the power between the owners by keeping the firms separate.
Financial Securities
A. Debt
Suppose you have an interesting idea for a business venture, but do not have the capital to finance it. You go to a bank to get a loan. In deciding whether to finance the project, the bank is very likely to consider not only the return stream from the project, but also the resale value of any assets you have or will acquire using the bank's funds; in other words, the bank will be interested in the potential collateral for the loan. In addition, the durability of your assets and how quickly the returns come in are likely to determine the maturity structure of the loan. The bank will be more willing to lend long-term if the loan is supported by assets such as property or machines than if it is supported by inventory, and if the returns arrive in the distant future rather than right away.
These observations fit in well with the ideas of incomplete contracts and power. The bank wants some protection against worst-case scenarios. If there is very little collateral underlying the loan, then the bank will worry that you will use its money unwisely or, in an extreme case, disappear with the money altogether. Similarly, if the collateral depreciates rapidly or the returns come in quickly, then the bank would be unhappy with a long-term loan: it would have little protection against your behaving opportunistically when the collateral was no longer worth much, or after the project returns had been realized (and "consumed"). Basically, the bank wants to ensure a rough balance between the value of the debt outstanding and the value remaining in the project, including the value of the collateral, at all times.
Moore and I have developed a theory of debt finance based on these ideas, and derived results about the kinds of projects that will be financed.[7]
B. Equity
Investors who finance business ventures sometimes take equity in the venture rather than debt. Unlike debt, equity does not have a fixed set of repayments associated with it, with nonpayment triggering default. Rather, equity-holders receive dividends if and when the firm chooses to pay them. This potentially puts equity-holders at the mercy of those running the firm, who may choose to use the firm's profits to pay salaries or to reinvest rather than to pay out dividends. Thus equity-holders need some protection. Typically, they get it in the form of votes. If things become bad enough, equity-holders have the power to remove those running the firm (the board of directors) and replace them with someone else.
However, giving outside equity-holders voting power brings costs as well as benefits. Equity-holders can use their power to take actions that ignore the (valid) interests of insiders. For example, they might close down an established, family-run business or force the business to terminate long-standing employees. Philippe Aghion and Patrick Bolton have analyzed the optimal allocation of power between insiders and outsiders.[8]
Dispersed Power
So far I have supposed that those with power wield it. That is, I have assumed that owners will exercise their residual control rights over assets; for example, equity-holders will use their votes to replace a bad manager. However, if many people hold power, then no one of them may have an incentive to be active in exercising this power. Then it is important that there be automatic mechanisms for achieving what those with power are unable or unwilling to do by themselves.
A leading example of dispersed power is the case of a public company with many small shareholders. Shareholders cannot run the company themselves on a day-to-day basis, so they delegate power to a board of directors and to managers. This creates a free-rider problem: an individual shareholder does not have an incentive to monitor management, since the gains from improved management are enjoyed by all shareholders, whereas the costs are borne only by those who are active. Because of this free-rider problem, the managers of a public company have a fairly free hand to pursue their own goals: these might include empire-building, or the enjoyment of perquisites.
Two "automatic" mechanisms can improve the performance of management: debt (in combination with bankruptcy) and takeovers. Debt constrains managers. If a company has a significant amount of debt, then management is faced with a simple choice: reduce slack--that is, cut back on empire-building and perquisites--or go bankrupt. If there is a significant chance that managers will lose their jobs in bankruptcy, then they are likely to choose the first option.
Takeovers provide a potential way to overcome problems involving collective action among shareholders. If a company is badly managed, then there is an incentive for someone to acquire a large stake in the company, improve performance, and make a gain on the shares or votes purchased. The threat of such action can persuade management to act in the interest of shareholders.
The view of debt as a kind of constraint can explain the types of debt that a company issues (for example, how senior the debt is, or whether it can be postponed).[9] The possibility of takeovers can explain why many companies bundle votes and dividend claims together-that is, why they adopt a one share-one vote rule. One share-one vote protects shareholder property rights: it maximizes the chance that a control contest will be won by a management team that provides high value for shareholders, rather than high private benefits for itself.[10]
Bankruptcy
Of course, if a company takes on debt, then there is always the chance that it will go bankrupt. If there were no contracting costs, then there would be no need for a formal bankruptcy procedure, because every contract would specify what should happen if some party could not meet its debt obligations. However, in a world of incomplete contracts, there is a role for bankruptcy procedure. A bankruptcy procedure should have two main goals: First, a bankrupt company's assets should be placed in their highest-value use. Second, bankruptcy should be accompanied by a loss of power for management, to ensure that management has the right incentive to avoid bankruptcy. Aghion, Moore, and I have been working on a procedure that tries to meet these goals, and at the same time avoids some of the inefficiencies of existing U.S. and U.K. procedures.[11]
Our basic idea of the procedure is that a bankrupt company's debts are canceled and the company is put up for auction (the auction would be supervised by a judge, say). However, in contrast to a standard auction, noncash bids are permitted. A noncash bid allows existing management, or any other management team for that matter, to propose a reorganization plan. As an example of a noncash bid, incumbent management might offer former claimants shares in a new (debt-free) company managed by the old management team. Alternatively, managers might offer former claimants a combination of shares and bonds in the post-bankruptcy company.
At the same time that bids are being made for the company, an automatic debt-equity swap takes place. Senior creditors of the company receive equity in the new (post-bankruptcy) company, while junior creditors and former shareholders receive options to buy equity (the exercise price of the options issued to each class is set equal to the amount owed to classes senior to that class).[12] After the bids come in--three months might be allowed for this--another month or so is allowed for option-holders to exercise their options. The final step in the process is that the company's equity-holders (that is, those people who hold equity in the company at the end of the fourth month) vote on which of the various cash and noncash bids to select. Once the vote is completed, the winning bid is implemented and the firm emerges from the bankruptcy process.
This procedure has the advantage relative to Chapter 7 of the U.S. Bankruptcy Code that it allows for the firm to be restructured as a going concern if this is efficient. It has the advantage relative to Chapter 11 of the U.S. Bankruptcy Code that bargaining between different claimant groups with possibly conflicting interests is avoided: instead the firm's future is decided by a simple vote by a homogeneous class of shareholders.
For a more extensive discussion of this literature, see O. D. Hart, Firms, Contracts, and Financial Structure, Oxford, England: Oxford University Press, forthcoming in late 1995. This article is based on the introduction to this book.
The incomplete contracting approach borrows a great deal from the earlier transaction cost literature. See, in particular, R. H. Coase, "The Nature of the Firm," Economica 4 (1937), pp. 386405; B. Klein, R. Crawford, and A. Alchian, "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, "Journal of Law and Economics 21/2 ('1978), pp. 297-326. and O. Williamson, The Economic Institutions of Capitalism, New York: Free Press, 1985.
For interesting and informative discussions of the GM-Fisher Body relationship, see Klein, Crawford, and Alchian, op. cit.; and B. Klein, "Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited, "Journal of Law, Economics and Organization 4/1 (1988). pp. 199-213.
There has been some debate about whether GM did in fact increase its power over Fisher Body by buying Fisher Body out. See R. H. Coase, "The Nature of the Firm: Influence, "Journal of Law, Economics and Organization, 4/1 (1988) p. 45.
Sometimes the costs of a merger will exceed the benefits. This may explain why GM did not merge with A. O. Smith, which has supplied a significant fraction of its automobile frames for many years. For a discussion of the A. O. Smith case, see Coase, "The Nature of the Firm.. Influence," op. cit.; and Klein, "Vertical Integration as Organizational Ownership . . ., "op. cit.
See S. J. Grossman and O. D. Hart, "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, "Journal of Political Economy 94 (1986), pp. 691-719; and O. D. Hart and J. Moore, "Property Rights and the Nature of the Firm, "Journal of Political Economy 98 (1990), pp. 1119-1158. See also Hart, Firms, Contracts, and Financial Structure, op. cit., Chapters 2-4.
O. D. Hart and J. Moore, '"A Theory of Debt Based on the Inalienability of Human Capital, "NBER Reprint No. 1963, April 1995, and Quarterly Journal of Economics 109 (1994), pp. 841-879; and "Default and Renegotiation: A Dynamic Model of Debt, "MIT Working Paper No. 520, 1989. For related work, see P. Aghion and P. Bolton, "An 'Incomplete Contracts' Approach to Financial Contracting," Review of Economic Studies 59 (1992), pp. 473-494; and P. Bolton and D. Scharfstein, "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review 80 (1990), pp. 94106.
See Aghion and Bolton, "An 'Incomplete Contracts' Approach. . ., "op. cit.
O. D Hart andJ. Moore, "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," NBER Working Paper No. 4886, October 1994, and American Economic Review, (June 1995), pp. 567-585; and O. D. Hart, "Theories of Optimal Capital Structure: A Managerial Discretion Perspective," NBER Reprint No. 1806, September 1993, and in The Deal Decade: What Takeovers and Leveraged Buyouts Mean for Corporate Governance, M. Blair, ed. Washington, DC: The Brookings Institution, 1993, pp. 19-43. See also M. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers," American Economic Review 76 (1986), pp. 323-329.
S. J. Grossman and O. D. Hart, "One Share-One Vote and the Market for Corporate Control, "Journal of Financial Economics 20 (1988), pp. 175-202. See also M. Harris and A. Raviv, "Corporate Governance: Voting Rights and Majority Rules, "Journal of Financial Economics 20 (1988), pp. 203-235.
p. Aghion, O. D. Hart, and J. Moore, "The Economics of Bankruptcy Reform," in The Transition in Eastern Europe, O.J. Blanchard, K. A. Froot, and J. D. Sachs, eds. Chicago: University of Chicago Press, 1994; "Improving Bankruptcy Procedure, "Washington University Law Quarterly 72 (1994), pp. 849-872; and "Insolvency Reform in the United Kingdom: A Revised Proposal," Insolvency Law and Practice 11/3 (1995), pp. 4-11.
The use of options in the debt-equity swap is based on an idea of Lucian Bebchuk. See A. L. Bebchuk, "A New Approach to Corporate Reorganizations," Harvard Law Review 101 (1988), pp. 775-804.
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Source: NBER Reporter, Summer95, p18, 5p
