1. Rethinking Incomplete Contracts By Oliver Hart Nov 2, 2012 LACEA-LAMES

2. Background and Motivation Coase (1937) asked why we have firms. Answer: Using the market is costly. Authority may be better. Williamson (1971),(1975), (1985) and Klein, Crawford, and Alchian (1978) : Costs of using market high when relationship-specific investments large and future uncertainty causes contractual incompleteness=>haggling and adaptation costs. Integration may improve matters.

3. No formal model here. Formal model: Grossman & Hart 86 / Hart & Moore 90  Ex-ante incomplete contract  Coasian renegotiation implies ex-post efficiency  But renegotiation leads to distorted ex-ante investments  Allocation of residual control rights/asset ownership can mitigate this distortion.  Leads to a theory of optimal asset ownership/firm boundaries.

4. Positives: Level playing field: costs and benefits of asset ownership/integration. Can use ideas to understand allocation of control between entrepreneurs and venture capitalists (Aghion and Bolton (1992)); role of collateral (Hart-Moore(1994) and Bolton- Scharfstein (1996)). Has been used extensively in outsourcing models in international trade (e.g., Antras(2003)).

5. Negatives: (Very) ingenious revelation mechanisms—”Moore-Repullo-Maskin- Tirole”-- can make observable information verifiable, turn incomplete contracts into complete ones, and achieve the first best. Asset ownership no longer has a role. We do not see these mechanisms but the question is why not. Not very helpful for understanding the internal organization of large firms.

6. Is introducing asymmetric information the answer to the negatives? Revelation mechanisms can still be used but perhaps more important it will be hard to explain something that Coase noted in his 1937 paper: “It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism”.

7. For these reasons I think that we need to consider moving outside the usual paradigm…

8. Complementary Approach: Contracts as Reference Points  See Hart-Moore(2008) and follow up papers.  Competitively negotiated contracts act as reference points Contracts define entitlements If a contracts allows for more than one outcome, trading parties may prefer different outcomes  conflicting entitlements If a party does not receive what he feels entitled to, he is aggrieved and shades  Ex-post trade not fully contractible Parties can provide perfunctory instead of consummate performance, i.e., shade Performing party roughly indifferent, but large impact on other party Simplifying assumptions: Each party feels entitled to best possible outcome within contract. Shading = θ times shortfall where 0< θ<1.

9. Complementary Approach (Continued) Leads to tradeoff between contractual flexibility and rigidity. A flexible contract is good in that parties can adjust to the (observable but unverifiable) state of the world but bad in that there is a lot of aggrievement and shading. A rigid contract is good in that there is little aggrievement and shading but bad in that the parties cannot adjust to the state of the world. Two new ingredients: Ex post trade is only partially contractible, and behavioral elements affect performance. Renegotiation not costless !

10. How can this approach help with the theory of the firm? Consider following example drawn from Hart and Moore ( 2008, Section 4) and Hart- Holmstrom (2010). Two parties 1 and 2. 2 can choose to “coordinate” or “not coordinate” with 1. Assume the coordination decision is ex ante noncontractible but ex post contractible. Example: Cisco/Stratacom and coordination of technological platforms

11. The payoffs are as follows: 2’s decision: C NC Party 1 13 8 Party 2 7 9 Surplus 20 17

12. Two leading organizational forms: - nonintegration—1 and 2 are separate firms - integration—there is a single firm and 1 is the boss. (One can also consider the case where 2 is the boss.) Under non-integration, 2 has the right to choose NC or C since it is ex ante non- contractible. Under integration 1 has the right to make decision and will tell 2 what to do. 2 must follow the instructions but may be aggrieved and shade.

13. Start with nonintegration. 2 will be inclined to choose NC. However, must worry about 1’s shading. Will choose NC as long as 2> 5 θ, i.e., θ<0.4. Shading costs are 5 θ. Of course, renegotiation is possible: the gains from switching to C are 3. However, not surprisingly, can be shown that renegotiation does not reduce shading costs: they are still 5 θ.

14. Now consider integration. 1 will instruct 2 to choose C, and 2 will follow instructions. 2 will be aggrieved by 2 and will shade by 2θ. Total deadweight losses are 2θ.

15. Conclusion : with these parameters integration is better: net surplus = 20- 2θ, rather than 20- 5 θ. Of course, with different parameters non- integration can be better (change 9 to 15). Note some similarity to rent-seeking theories such as Tullock (1967) and influence cost theories such as Milgrom and Roberts (1990).

16. A theory like this rests on strong behavioral assumptions: determination of entitlements/shading… Broadly consistent with established behavioral concepts  Ref.-dep. preferences (e.g., Kahnemann & Tversky 79, Köszegi & Rabin 06)  Self-serving bias (e.g., Messik & Sentis 79, Loewenstein & Babcock 97)  Social preferences (e.g., Rabin 93, Fehr & Schmidt 99, Falk & Fischbacher 06) No direct evidence until recently. In the remainder of the talk I will describe two experiments that I have carried out with Ernst Fehr and Christian Zehnder—the first published in AER,2011, and the second unpublished. For various reasons these experiments concern a version of the buyer/seller payoff uncertainty model from Hart- Moore(2008, Section 3) rather than the coordination model just described. (But see Holger Herz’s recent work…)

17. Experimental design in AER paper Market setup (in each of our 5 experimental sessions):  ( Approx.) 28 participants: 14 buyers and 14 sellers  Interaction groups of 4 participants: 2 buyers and 2 sellers  15 periods (random re-matching in every period) Competition:  Each buyer can buy at most 1 unit per period  Each seller can sell at most 2 units per period States of nature (  ): Uncertainty about costs but not value  Good state (  = g): seller’s costs are low  Prob(  = g) = w g = 0.8  Bad state (  = b): seller’s costs are high  Prob(  = b) = w b = 0.2 Sellers’ performance levels (q):  Normal quality (q = q n )  Low quality (q = q l )

18. Design (2): Parameters Seller’s production costs conditional on state of nature Good State:Bad State:  c(q n,g) = 20  c(q n,b) = 80  c(q l,g) = 25  c(q l,b) = 85 Buyer’s valuation of the product  v(q n ) = 140  v(q l ) = 100 No trade payoffs (can be earned ex-ante or ex-post)  Buyer: x B = 10  Seller: x S = 10

19. Details of Contract Conclusion Step 1: Formation of groups Step 2: Buyer determines contract type  Rigid: Fixed price p r  Flexible: Price range [p l, p u ] Step 3: Sellers compete for contracts in auctions  In each group the two contracts are auctioned off sequentially  “Clock auction” with starting point at 35  Price increases by one unit every half second  First seller who clicks “accept” button gets the contract  Rigid contract: Auction determines fixed price p r  Flexible contract: Auction determines lower bound p l Upper bound is fixed at p u = v(q n ) = 140

20. Design (4): Details of trade Step 4: Determination of the state of nature  Trade takes place if and only if contracts allows for mutually beneficial outcome  Under rigid contracts trade occurs only if the state of nature is good  In the no trade case buyer and seller realize their outside option Step 5: Buyer chooses the price  Rigid contract: p = p r  Flexible contract: p  [p l, p u ] Step 6: Seller chooses performance  Normal quality: q n  Low quality: q l, where c(q l ) > c(q n )

21. Design (5): Procedures Subject pool:  Students of UZH and ETHZ (no economists or psychologists) Sessions:  5 sessions in experiment ( +….) Payoffs:  ~50 Swiss Francs per participant (~$ 50) for about 2 hours Implementation:  Recruitment: ORSEE (Greiner 2004)  Computerized experiment: z-Tree (Fischbacher 2007)

22. Predictions under Self-Interest Model: No shading Buyers always pay the lowest price possible Competition implies: p r = p l = 35 Flexible contract chosen by buyer What we find…

23. Results: Overview

24. NOT EXPLAINED BY STANDARD BEHAVIORAL THEORIES

25. One criticism of the baseline experiment is that it ignores communication. Since the state of nature is observable,even though not verifiable, the buyer could try to manage the seller’s expectations. Would this solve the problem ? In second paper two new treatments.

26. Informal Agreement Treatment : 5 sessions The basic setup is the same as in the baseline treatment But in this condition, buyers who choose a flexible contract have the possibility to combine their contract with a non- binding, state-contingent price announcement: “If costs are low, I plan to pay a price of p A (g). If costs are high, I plan to pay a price of p A (b).” The price announcements are in no way binding for the buyer, i.e., the message does not affect the range of actual prices available to the buyer ex post. ( Sometimes price announcements may not be ex post feasible.) The availability of messages is common knowledge in the experiment

27. Results: Overview Table 2 (Informal Agreements / Baseline): Comparison of Contracts

28. Results: Outcomes

29. Summary: Informal Agreements The availability of informal agreements does not destroy the trade-off between rigidity and flexibility  Strong result: If anywhere informal agreements should work here  Completely symmetric information regarding states  Only two states (messages are very simple)  Messages very salient

30. Robustness? Recent paper by Brandts, Charness, and Ellman (2012) finds a greater role for communication.

31. A second criticism of the baseline treatment is that it does not allow for renegotiation. In the second new treatment we allow for it. Renegotiation can be mutually beneficial, e.g, in the case of the rigid contract in the bad state. But it can also open the door to opportunism. Also contracts may cease to be reference points in the presence of renegotiation ( gasp !).

32. Renegotiation: Treatment ( 5 sessions) We capture renegotiation simply and crudely: We allow the buyer unilaterally to overturn the existing contract at no cost: p(  =g)  [35, 140] / p(  =b)  [95, 140] Since the seller cannot veto the change this is actually closer to what lawyers call a “repudiation” than an actual “renegotiation” We consciously choose this particular form of renegotiation, because it provides a powerful stress test for the relevance of contractual reference points The easier a contract is to overturn, the less likely it is that it serves as a reference point (lower bound estimates)

33. Results: Non-Renegotiated Contracts

34. Results: Outcomes

35. Summary: Renegotiation Contracts seem to remain reference points in the presence of renegotiation ( which is very salient)  Even if buyers can overturn contracts unilaterally sellers do not seem to hope for outcomes outside the contract  Rigid contracts still lead to significantly higher profits in the good state of the world Opportunistic renegotiation =>lots of shading  If buyers renegotiate the contract to grab a larger share of the gains from trade in the good state, sellers punish them with shading Mutually beneficial renegotiation seems to turn rigid contracts into flexible ones=>rigid contracts do very well  Moderate amount of shading (not significantly different from shading in flexible contracts). Robustness ?

36. More realistic view of renegotiation than in literature.

37. The experiments I have described seem to provide some support for the idea that contracts are reference points. The behavioral forces seem to be real. However, much remains to be done before we can conclude that the behavioral forces are “first- order”. Are business people (as opposed to students) subject to these forces? Here field studies may be useful. There is some encouraging early work on this by Iyer and Schoar, and Bartling and Schmidt.

38. We also need to extend the theory, and see what it can deliver: the proof is in the pudding. I have given a simple example to show how it can shed light on the trade-off between nonintegration and integration. This is developed more in Hart- Holmstrom (2010). The same paper also shows how the theory can be used to analyze the trade-off between centralization and decentralization—something that traditional theory finds it hard to do (at least if it wants to explain firm boundaries too).

39. In another paper, Hart(2009), I have shown that the approach can explain why it is hard to manage contractual relationships in a volatile environment, and why integration may be a solution, something for which there is considerable empirical support. I believe that there are other fruitful applications. One may to be explain why so many contracts are incomplete and why third parties (arbitrators, judges, courts) are left to fill in the gaps. Another may be to throw light on the age-old question of why (nominal) wages are sticky…

40. There is considerable reluctance by contract theorists to introduce behavioral elements in their theories, at least in the way I have done ( !). I will be very happy if I’ve overcome this reluctance a bit, and convinced you that there is something here. I will be extremely happy if some of you are encouraged to work on these topics.

41. THANK YOU !!