We consider a buyer and seller who contract over a service. The contract encourages investment and provides a reference point for the transaction. In normal times the contract works well. But with some probability an abnormal state occurs and the service must be modified. The parties expect each other to behave “reasonably”, but given self-serving biases their views of reasonableness may not coincide, leading to aggrievement and deadweight losses. The adoption by the parties of guiding principles such as loyalty and equity in their contract can help. We provide supporting evidence in the form of case studies and interviews.
What is so special about banks that their demise often triggers government intervention? In this paper we show that, even ignoring interconnectedness issues, the failure of a bank causes a larger welfare loss than the failure of other institutions. The reason is that agents in need of liquidity tend to concentrate their holdings in banks. Thus, a shock to banks disproportionately affects the agents who need liquidity the most, reducing aggregate demand and the level of economic activity. The optimal fiscal response to such a shock is to help people, not banks, and the size of this response should be larger if a bank, rather than a similarly-sized nonfinancial firm, fails.
Why are contracts incomplete? Transaction costs and bounded rationality cannot be a total explanation since states of the world are often describable, foreseeable, and yet are not mentioned in a contract. Asymmetric information theories also have limitations. We offer an explanation based on “contracts as reference points”. Including a contingency of the form, “The buyer will require a good in event E”, has a benefit and a cost. The benefit is that if E occurs there is less to argue about; the cost is that the additional reference point provided by the outcome in E can hinder (re)negotiation in states outside E. We show that if parties agree about a reasonable division of surplus, an incomplete contract can be strictly superior to a contingent contract.
Parties often regulate their relationships through “continuing” contracts that are not fixed term but roll over: employment is a leading example. Our premise is that parties apply fairness when they revise a continuing contract and that prior terms, together with market information, will be a reference point. A continuing contract can reduce (re)negotiation costs relative to a short-term or long-term contract. However, fair bargaining makes adjusting to outside options difficult and may cause inefficient outcomes. An implicit promise of a long-term relationship, as in employment, can improve matters.
What is the appropriate objective function for a firm? We analyze this question for the case where shareholders are prosocial and externalities are not perfectly separable from production decisions. We argue that maximization of shareholder welfare is not the same as maximization of market value. We propose that company and asset managers should pursue policies consistent with the preferences of their investors. Voting by shareholders on corporate policy is one way to achieve this.
The notion of contracts as reference points provides the basis for a deeper understanding of important phenomena such as the employment contract, vertical integration, firm scope, authority and delegation. Previous experiments lend support to this notion but they ignore realistic aspects of trading relationships such as informal agreements and ex post renegotiation or revision. Here we show that the central behavioral mechanism underlying contractual reference points is robust to such considerations. Our data reveal that informal agreements can mitigate the trade-off between rigidity and flexibility but they do not fully resolve the problem of misaligned reference points. Our experiments also show that contract revision is a more nuanced process than the previous literature has recognized. We find, for example, that it is sometimes better for parties to write a simple (rigid) contract and then revise it ex post if needed, rather than to anticipate and include future contingencies in a (flexible) contract from the outset.
We study consumer liquidity in a general equilibrium model where the friction is the non-pledgeability of future income. Liquidity helps to overcome the absence of a double coincidence of wants. Consumers over-hoard liquidity and the resulting competitive equilibrium is constrained inefficient. Fiscal policy following a large negative shock can increase ex ante welfare. If the government cannot commit, the ex post optimal fiscal policy will be too small from an ex ante perspective.
Courts have articulated a number of legal tests to distinguish corporate transactions that have a legitimate business or economic purpose from those carried out largely, if not solely, for favorable tax treatment. We outline an approach to analyzing the economic substance of corporate transactions based on the property rights theory of the firm, and describe its application in two recent tax cases.
We analyze noncontractible investments in a model with shading. A seller can make an investment that affects a buyer’s value. The parties have outside options that depend on asset ownership. When shading is not possible and there is no contract renegotiation, an optimum can be achieved by giving the seller the right to make a take‐it‐or‐leave‐it offer. However, with shading, such a contract creates deadweight losses. We show that an optimal contract will limit the seller’s offers, and possibly create ex post inefficiency. Asset ownership can improve matters even if revelation mechanisms are allowed.
We design a new capital requirement for large financial institutions (LFI) that are “too big to fail.” Our mechanism mimics the operation of margin accounts. To ensure LFIs do not default on systemically-relevant obligations, we require that they maintain a cushion of equity and junior long-term debt sufficiently great that the credit default swap price on the long-term debt stays below a threshold level. If the CDS price moves above the threshold, either LFIs issue equity to bring it down or the regulator intervenes. This mechanism ensures that LFIs are always solvent, while preserving some of the benefits of debt.
In this review, I describe how economists have moved beyond the firm as a black box to incorporate incentives, internal organization, and firm boundaries. I then turn to the way that the theory of the firm is treated in Daniel Spulber’s book The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations. Spulber’s goal is to explain why firms exist, how they are established, and what they contribute to the economy. To accomplish this, Spulber defines a firm to be a transaction institution whose objectives differ from those of its owners. For Spulber, this separation is the key difference between the firm and direct exchange between consumers. I raise questions about whether this is a useful basis for a theory of the firm. ( JEL D21)
Hart and John Moore (2008) introduce new behavioral assumptions that can explain long-term contracts and the employment relation. We examine experimentally their idea that contracts serve as ref- erence points. The evidence confirms the prediction that there is a trade-off between rigidity and flexibility. Flexible contracts—which would dominate rigid contracts under standard assumptions—cause significant shading in ex post performance, while under rigid con- tracts much less shading occurs. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about out- comes within the contract.
The formal literature on ﬁrm boundaries has assumed that ex post conﬂicts are resolved through bargaining. In reality, parties often simply exercise their decision rights. We develop a model, based on shading, in which the use of authority has a central role. We consider two ﬁrms deciding whether to adopt a common standard. Nonintegrated ﬁrms may fail to coordinate if one ﬁrm loses. An integrated ﬁrm can internalize the externality, but puts insufﬁcient weight on employee beneﬁts. We use our approach to understand why Cisco acquired StrataCom, a provider of new transmission technology. We also analyze delegation.
We study two parties who desire a smooth trading relationship under condi- tions of value and cost uncertainty. A contract ﬁxing price works well in normal times because there is nothing to argue about. However, when value or cost is unusually high or low, one party will deviate from the contract and hold up the other party, causing deadweight losses as parties withhold cooperation. We show that allocating asset ownership and indexing contracts can reduce the incentives to engage in hold-up. In contrast to much of the literature, the driving force in our model is payoff uncertainty, rather than noncontractible investments.