Congratulations to Hart and Holmström

By Peter Klein

The field of institutional and organizational economics has again been recognized by the Nobel Committee with the awarding of the 2016 prize to Oliver Hart and Bengt Holmström. The Laureates have made foundational contributions to contract theory, the theory of the firm, agency theory, and mechanism design, and their work is well-known to most SIOE members. Useful summaries are provided by Binyamin Applebaum, Tyler Cowen (here and here), and the rest of the usual places. Organizations and Markets has featured many posts on these ideas (look here and here). As of this morning, neither Laureate has a very good Wikipedia entry, though I suspect that will change in the coming days. 

I particularly like two longer and more technical commentaries by Kevin Bryan here and here. On Hart, Bryan points out that Hart has subtly changed his position on the theory of the firm, moving away from the Grossman-Hart-Moore incomplete-contracting approach in favor of a behavioral bargaining model based on "reference points." Key to understanding this is an insiders dispute among contract theorists. Eric Maskin and Jean Tirole published a paper arguing that Hart's assumption of contractual incompleteness was unjustified (basically, that clever mechanisms can be designed to make all relevant information verifiable, and hence models can be written as if contracts are complete). I go over this dispute in my PhD seminar (and have mentioned it in passing). Rumor has it that Hart largely accepts the critique -- indeed, was greatly affected by it -- and turned toward the reference points approach as an alternative. The Nobel citation didn't discuss this point, but if correct, it might be the first time a Nobel has been given partly for a contribution the Laureate has himself abandoned!

For me personally, the Maskin-Tirole critique is not that big a deal. My own thinking about the firm, from a Knightian perspective, justifies contractual incompleteness on the grounds of uncertainty. As Knight put it, entrepreneurial judgment is non-contractible. The exact cognitive, behavioral, and informational underpinnings of incompleteness are, for me, less important than the implications of incompleteness. I am content to accept the claim that we cannot write complete, contingent contracts as what Knight called a "sheer, brute fact."