Oliver Hart, Nobel Laureate
Here is Hart’s most famous piece, with Sandy Grossman, 1986, “The Costs and Benefits of Ownership.” Think of it as an extension of Ronald Coase and Oliver Williamson, also two Nobel Laureates (hey, that’s a lot of prizes for one topic area…)
Why does one party ever purchase residual rights in the assets of another party? Say for instance there is a factory firm and a coal mining firm. The coal can be treated in a particular way to be more suitable for use in the factory. If the factory firm buys out the coal mining company, the incentives for coal treatment differ, that is the key insight behind this model. You can think of this as a very important modification of the Coase Theorem. It does matter who owns the asset. Why? If the coal mining company owns the coal, it has one set of incentives to make ex ante improvements in the values of those assets; if the factory firm owns the coal mine, it has another set of incentives. Part of the work in this paper is done by a bargaining axiom — if you own an asset outright, you keep a greater share of the proceeds from improving the value of that asset. Ownership should thus migrate to those parties who have the greatest ability to improve value.
And that is a very fundamental improvement on the Coase theorem, which suggests ownership won’t matter when there is ex post contractibility. This paper showed that for ownership not to matter there must also be ex ante contractibility about value-improving investments at earlier stages in the game, an unlikely assumption to hold.
This is a tricky paper to master. It has all kinds of assumptions built in about ownership, control, and residual claimancy, which do not move together in simple ways. Eventually Hart (working with others) cleaned up the assumptions and produced a more transparent model of this process. This paper is a — I should say the — starting point for thinking about mergers, vertical integration, and other questions of corporate ownership and contract and control. Bengt Holmström of all people wrote a very nice appreciation of the paper.
What about Grossman, I hear you wondering? I would have guessed he would have shared in the Prize, as he has other seminal papers about information and much of Hart’s key work is co-authored with him. On the bright side for him, he has made hundreds of millions of dollars running a hedge fund.
Hart is a true gentleman and he has a very nice British accent. He is very highly respected by his peers. Here is his Wikipedia page. Here is his home page, he is now at Harvard but spent part of his career at MIT. Here is his vita. Here is Hart on Google Scholar. Here is the Nobel survey essay from Sweden. Here is a video explanation.
His second best known piece is “Property Rights and the Nature of the Firm,” with John Moore, 1990. This is again a model and series of parables about ownership and the allocation of rights, but with some twists on the earlier Grossman and Hart piece. The key point is to not allow inessential agents to achieve blocking power of value creation. The authors tell a story about a venture with a tycoon, a boat owner, and a chef, all of whom might organize a voyage together. The tycoon and the boat owner are essential, so one of them should own the boat, and then they can split most of the surplus from the voyage and pay the chef his or her marginal product. Value creation then proceeds. Alternatively, if the chef owns the boat, he has potential blocking power and the surplus has to be split three ways. That may result in some loss of value, due to a tougher bargaining problem, higher transactions costs, and a chance there won’t be enough surplus to cover the most significant investments. Parties who create a lot of value should own things is the central message here, and this is another key paper for thinking about contracts, ownership, and what kind of business arrangements induce investment in idiosyncratic assets, yet another follow-up on the work of previous Laureates Coase and also Oliver Williamson.
In case you hadn’t figured it out by now, Oliver Hart is basically a theorist in his major lines of research.
Another famous paper by Grossman and Hart is “Takeover Bids, the Free Rider Problem, and the Theory of the Corporation.” One of Alex’s most interesting papers is an extension of this work, so I suspect he’ll be covering it in detail. In a nutshell, this model helps explain why a lot of value-maximizing takeover don’t happen, or why it is hard to buy up a whole city block and renovate it. Let’s for instance a corporation currently is valued at $80 a share, and a raider has a good plan to make the company worth $100 a share. The raider then comes along and offers you, a shareholder, $90 for each of your shares. Will you sell? Well, it depends what you think the other shareholders will do. But you might not sell, instead seeking to hold on for the ride. If others sell, you can get $100 in value instead of $90. But if everyone feels this way, then no one sells and the bid fails. Then you might sell at $90 after all, but then no one will sell after all…and so on. A tough problem, but this is a very important piece in understanding the limitations of various kinds of takeovers. Right now my security device won’t let me link to the paper but try googling the title.
Hart’s 1983 paper with Sandy Grossman was at the time a breakthrough and highly rigorous means of modeling the principal-agent problem. It is in Econometrica and quite hard for many people to read. Economists had been modeling principal-agent problems through the notion of a participation constraint. Have the contract give incentives, subject to the proviso that it is still worthwhile for the agents to be involved in the trades. But Mirrlees had pointed out this can give misleading results when there is not automatically a unique solution to the problem at hand. Grossman and Hart reconceptualized the math into a convex programming problem. Theorists love the paper, and it was highly influential when it came out.
Here is Hart and Moore on incomplete contracts and renegotiation. This paper is connected to the Nobel Prize for Jean Tirole two years ago. How can you write a contract so a) parties will make the appropriate relationship-specific investments, and b) it doesn’t have to be renegotiated all of the time? Again, Hart’s work is obsessed with this idea of value maximization within corporate endeavors and possible obstacles to such value maximization.
By the way, here is Hart, with Shleifer and Vishny, on why the private sector probably should not be allowed to own and run prisons. The incentive to cut costs is too strong! Government ownership will instead, in their view, create more value maximization because the government won’t have the same profit incentive to skimp on quality along various margins. This paper has been highly influential in recent debates over private ownership of prisons, which recently was countermanded at the federal level at least. You also probably wouldn’t want Air Force One owned by the private sector, though you do want it to be designed and produced by the private sector. This paper helped produce a framework for understanding the reasons why.
Hart’s 1979 piece on shareholder unanimity asks the important theory question of whether all shareholders will desire that firms maximize profits if markets are incomplete and some firm shares also serves secondary “insurance” purposes of helping protect against adverse states of the world. For instance, say there is no insurance market in wheat. You might use the shares of a wheat-producing firm for that purpose, and desire, for insurance purposes that the value of the firm covary with the value of wheat in ways that differ from simple firm profit-maximization. The upshot of this literature is that firm profit maximization is not as simple or as self-evident an assumption as people used to think.
By the way, here are the two Laureates together, on “A Theory of Firm Scope.” Here is their long, joint survey on theory of contracts.
Congratulations to Oliver Hart!