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The Impact of Incomplete Contracts on Economics

Edited Book
Philippe Aghion, Mathias Dewatripont, Patrick Legros, Luigi Zingales
Oxford University Press

The 1986 article by Grossman and Hart “A Theory of Vertical and Lateral Integration” has provided a framework for understanding how firm boundaries are defined and how they affect economic performance. The property rights approach has provided a formal way to introduce incomplete contracting ideas into economic modeling.

The Impact of Incomplete Contracts on Economics collects papers and opinion pieces on the impact that this property right approach to the firm has had on the economics profession. It shows that the impact has been felt sometimes in significant ways in a variety of fields, ranging from the theory of the firm and their internal organization to industrial organization, international trade, finance, management, public economy, and political economy and political science. Beyond acknowledging how the property rights approach has permeated economics as a whole, the contributions in the book also highlight the road ahead—how the paradigm may change the way research is performed in some of the fields, and what type of research is still missing. The book concludes with a discussion of the foundations of the property rights, and more generally the incomplete contracting, approaches and with a series of contributions showing how behavioral considerations may provide a new way forward.

Demand-Driven Integration and Divorcement Policy

Peer Reviewed Article
Patrick Legros, Andrew Newman
International Journal of Industrial Organization, in press

Traditionally, vertical integration has concerned industrial economists only insofar as it affects market outcomes, particularly prices. This paper considers reverse causality, from prices – and more generally, from demand – to integration in a model of a dynamic oligopoly. If integration is costly but enhances productive efficiency, then a trend of rising prices and increasing integration could be due to growing demand, in which case a divorcement policy of forced divestiture may be counterproductive. Divorcement can only help consumers if it undermines collusion, but then there are dominating policies. We discuss well-known divorcement episodes in retail gasoline and British beer, as well as other evidence, in light of the model.

(revised version of  CEPR DP 10914, November 2015)

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Audit Competition in Insurance Oligopolies

Peer Reviewed ArticleWorking Paper
Nicolas Boccard, Patrick Legros
Frontiers of Economics in China, forthcoming,

We provide a simple framework for analyzing how competition affects the choice of audit structures in an oligopolistic insurance industry. When the degree of competition increases, fraud increases but the response of the industry in terms of investment in audit quality follows a U-shaped pattern. Following increases in competition the investment in audit quality will decrease if the industry is initially in a low competition regime while it will increase when the industry is in a high competition regime. We use these results to show that firms will benefit from forming a joint audit agency only when the degree of competition is intermediate and that cooperation might improve total welfare we also analyze the effects of contract innovation on the performance of the industry.

(This is a revised version of CEPR DP 3478, July 2002)

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Smithian Growth Through Creative Organization

Peer Reviewed Article
Patrick Legros, Andrew Newman, Eugenio Proto
Review of Economics and Statistics, Volume 86, Issue 5, December 2014, 796-811

We consider a model in which appropriate organization fosters innovation, but because of contractibility problems, this benefit cannot be internalized. The organizational design element we focus on is the division of labor, which as Adam Smith argued, facilitates invention by observers of the production pro- cess. However, entrepreneurs choose its level only to facilitate monitoring their workers. Whether there is innovation depends on the interaction of the mar- kets for labor and for inventions. A high level of specialization is chosen when the wage share is low. But low wage shares arise only when there are few en- trepreneurs, which limits the market for innovations and therefore discourages inventive activity. When there are many entrepreneurs, the innovation market is large, but the rate of invention is low because there is little specialization. Rapid technological progress therefore requires a balance between these oppos- ing effects, which occurs with a moderate relative scarcity of entrepreneurs and workers. In a dynamic version of the model in which a credit constraint limits entry into entrepreneurship, this relative scarcity depends on the wealth distri- bution, which evolves endogenously. There is an inverted-U relation between growth rates driven by innovation and the level of inequality. Institutional im- provements have ambiguous effects on growth. In light of the model, we offer a reassessment of the mechanism by which organizational innovations such as the factory may have spawned the industrial revolution.

 

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Contracts, Ownership, and Industrial Organization: Past and Future

Peer Reviewed Article
Patrick Legros, Andrew Newman
Journal of Law, Economics and Organization, Volume 30, Supplement 1, 2014, i82-i117

We review the formal literature in industrial organization that incorporates organizational models of the firm into the analysis of industry behavior. Although many insights have been generated, this “organizational industrial organization” is still in its early stages: a complete theory of the relationship between organizational design and traditional IO variables such as price, quantity or welfare has yet to be developed. We show how the insights emanating from the incomplete contract literature can be used to address these questions and others of interest to both IO and organization economists: endogenous heterogeneity; the role of liquidity and surplus division in organizational design; the relationship between product price, industry supply and organizational choices; the response of industry supply to shocks in fundamentals.

A Price Theory of Vertical and Lateral Integration

Peer Reviewed Article
Patrick Legros, Andrew Newman
The Quarterly Journal of Economics, Volume 128, Issue 2, May 2013, 727-770

This article presents a perfectly competitive model of firm boundary decisions and study their interplay with product demand, technology, and welfare. Integration is privately costly but is effective at coordinating production decisions; nonintegration is less costly but coordinates relatively poorly. Output price influences the choice of ownership structure: integration increases with the price level. At the same time, ownership affects output, because integration is more productive than nonintegration. For a generic set of demand functions, equilibrium delivers heterogeneity of ownership and performance among ex ante identical enterprises. The price mechanism transmutes demand shifts into industry-wide reorganizations and generates external effects from technological shocks: productivity changes in some firms may induce ownership changes in others. If the enterprise managers have full title to its revenues, market equilibrium ownership structures are second-best efficient. When managers have less than full revenue claims, equilibrium can be inefficient, with too little integration.

 

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Trade Liberalization and Organizational Change

Peer Reviewed Article
Paola Conconi, Patrick Legros, Andrew Newman
Journal of International Economics, Volume 89, Issue 2, August 2013, 197-208

We embed a simple incomplete-contracts model of organization design in a standard two-country perfectly-competitive trade model to examine how the liberalization of product and factor markets affects the ownership structure of firms. In our model, managers decide whether or not to integrate their firms, trading off the pecuniary benefits of coordinating production decisions with the private benefits of operating in their preferred ways. The price of output is a crucial determinant of this choice, since it affects the size of the pecuniary benefits. Organizational choices also depend on the terms of trade in supplier markets, which affect the division of surplus between managers. We show that, even when firms do not relocate across countries, the price changes triggered by the liberalization of product markets can lead to changes in ownership structures within countries. The removal of barriers to factor mobility can also induce widespread restructuring, which can lead to increases in product prices (or declines in quality), hurting consumers worldwide.

 

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Firm organisation: What we know and why we should care

Web Article
Laura Alfaro, Paola Conconi, Harald Fadinger, Patrick Legros, Andrew Newman
VOX column, 2 December 2012

Increasingly, people are pointing the finger of blame for economic woe at large firms. This column argues that organisation design is often affected by government trade policy. If firm organisation design has implications for consumer welfare (in terms of prices and quality of product), evidence suggests that governments should make sure that in future, trade policy and corporate governance policy are more complementary.

 

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Rock and Roll Bands: (In)Complete Contracts and Creativity

Conference ProceedingsPeer Reviewed Article
Cédrice Ceulemans, Victor Ginsburgh, Patrick Legros
American Economic Review (Proceedings), Volume 101, Issue 3, 2011, 217-221

Members of a rock and roll band are endowed with different amounts of creativity. They come together (match), compose songs, and share credit and royalties for their compositions. The presence of more creative members increases the probability that the band will succeed, but those more creative members may also claim a larger share of the pie. In our theoretical model, the nature of matching (postive or negative assortative) as well as the covariation between the probability of having a hit and the allocation (dispersion) of credit among individual members are a function of the completeness of contracting. When members adopt a “gentleman’s agreement” to share credit equally, the covariation between the probability of a hit and the dispersion of credit is negative–the consequence of positive assortative matching in creativity. The data show that the relation between dispersion and success is significantly negative. In other words, rock bands tend to enter into incomplete contracts.

 

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Competing for Ownership

Peer Reviewed Article
Patrick Legros, Andrew Newman
Journal of the European Economic Association, Volume 6, Issue 6, 2008, 1273-1308

We develop a tractable model of the allocation of ownership and control within firms operating in competitive markets. The model shows how scarcity in the market translates into ownership structure inside the organization. It identifies a price-like mechanism whereby local liquidity or productivity shocks propagate, leading to widespread organizational restructuring. Among the model’s predictions: firms will become more integrated when the terms of trade become more favorable to yhe short side of the market, when the liquidity of the poorest firm increases sufficiently relative to the mean, and following a uniform increase in productivity. Shocks to the first two moments of the liquidity distribution have multiplier effects on the corresponding moments of the distribution of ownership structures.

(revised version of  CEPR DP 2573, October 2000. The WP version allows for any level of share of output and shows that the degree of control over decisions and the share of output of an agent covary. The PDF of the WP is available at this link.)

 

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Study on the Economic and Technical Publication Markets in Europe

Scientific Report
Mathias Dewatripont, Jean-Pierre Devroey, Pierre Dubois, Jéroöme Foncel, Victor Ginsburgh, Marc Ivaldi, Dominique Heusse, Patrick Legros, Françoise Verdooren, Alexis Walckiers
Final Report - Commissioned by Dg-Research, European Commission, January 2006

Dissemination and access to research results is a pillar in the development of the European Research Area. Aware of current public debates that reveal worries about the conditions of access and dissemination of scientific publica- tions, the European Commission’s Directorate- General for Research has commissioned a study that seeks: (i) to assess the evolution of the market for scientific publishing; and (ii) to discuss the potential desirability of European- level measures to help improve the conditions governing access to and the exchange, dissemination and archiving of scientific publications (taking into account all actors/ stakeholders of the sector).

The report builds on a voluminous existing literature. It therefore updates the “state of the art” in terms of reports, studies, surveys, and articles. It has also benefited from considerable interaction with various actors/stakeholders of the sector, policy bodies, corporate associations and interest groups. Discussion meetings took place as well as participation and exchange in scientific conferences and policy forums. Three ‘consultation days’ were also organized, where preliminary results were discussed with publisher representatives, scholarly societies, research-funding organizations, and library representatives.

The report considers the specificities of the market for current journal issues. In doing so, it discusses the broad facts about the market; it undertakes a quantitative analysis of journal prices; it discusses the implications of technological innovation on pricing strategies and the dynamics of entry; and it analyzes the implication of these developments in terms of competition policy.

It also discusses the various alternatives for disseminating and accessing scientific publica- tions. This includes the question of access to research results on individual web pages or in public repositories, the development of open- access journals as well as other alternatives, such as pay-per-view, the question of the long- term preservation of electronic publications and the use of standards to ensure interopera- bility between systems.

The attention of public decision makers is required for two reasons. First it is well-establi- shed that science has a key role in fostering economic growth, and because scientific journals are an essential means of disseminating new knowledge in the academic community but also beyond. Secondly, much of scientific activity is publicly funded: the output of research is typically not bought by journals but ‘donated’ by publicly-funded researchers; so are to a large extent refereeing services for the evaluation of research; and finally, journals are bought by publicly-funded researchers or, more often now, by publicly-funded libraries. It is therefore crucial for public authorities to form a view on the relative efficiency of the scientific publication process.

Public Private Partnerships: Contract Design and Risk Transfer

Book Chapter
Mathias Dewatripont, Patrick Legros
in

This paper critically assesses the implications of contract design and risk transfer on the provision of public services under public-private partnerships (PPPs). Two results stand out. First, the alleged strength of PPPs in delivering infrastructure projects on budget more often than traditional public procurement could be illusory. This is – to put it simply – because there are costs of avoiding cost overruns and, indeed, cost overruns can be viewed as equilibrium phenomena. Second, the use of external (i.e., third-party) finance in PPPs, while bringing discipline to project appraisal and implementation, implies that part of the return on efforts exerted by the private-sector partner accrues to outside investors; this may undo whatever beneficial effects arise from ‘bundling’ the construction and operation of infrastructure projects, which is a hallmark of PPPs.

 

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Auditing and Property Rights

Peer Reviewed Article
Elisabetta Iossa, Patrick Legros
The Rand Journal of Economics, Volume 35, Issue 2 , Summer 2004, 356-372

In a regulatory setting, audit provides incentives to an agent whose actions affect the future value of an asset. The principal does not observe the audit intensity nor the audit outcome and audit generates soft information. We show that with interim participation constraints, the principal may strictly prefer not to use the information of the agent but to rely only on the information given by the auditor. When this occurs, the auditor obtains property rights on the asset when he reports that the future value of the asset is high, while the agent is compensated by a monetary payment.

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Book Review
Patrick Legros
La chronique des livres, Reflets et Perspectives, XLII, 2003/4, pages 129-130

Moral Hazard and Capital Structure Dynamics

Peer Reviewed Article
Mathias Dewatripont, Patrick Legros, Steven Matthews
Journal of the European Economic Association, Volume 1, Issue 4, June 2003, 890-930

We base a contracting theory for a start-up firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: the entrepreneur must be given limited liability, and the investor’s earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maximize the entrepreneur’s incentives to exert effort. These contracts are optimal if the entrepreneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a non-debt simple contract achieves efficiency — the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.

 

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Courts, Contracts and Interference

Conference ProceedingsPeer Reviewed Article
Patrick Legros, Andrew Newman
European Economic Review, Volume 46, Issues 4-5 (Proceedings)http://www.sciencedirect.com/science/article/pii/S0014292101002100, 2002, 734-744

his paper shows that the possibility of interference in court proceedings, or more generally jamming other agents’ messages, has significant consequences for the form of optimal contracts and the flexibility of decisions that can be made inside firms. Our approach offers a new view of authority, basing it on the ability of parties to have their say in court. Interference gives authority a role in worlds where it is traditionally absent in contract theory, like simple employment relationships without specific investments.

 

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Interference Contracts and Authority with Insecure Communication

mimeoWorking Paper
Patrick Legros, Andrew Newman
mimeo ECARES

We develop a theory of mechanism design when agents are able to interfere with each others communication channels. We develop a kind of revelation principle — the noninterference principle — which permits representation of arbitrary mechanisms by direct ones the incentives to interfere will depend on the mechanism chosen interference thus constrains contractual design. For instance authority emerges as a governance mechanism which may economize on the costs of securing channels particularly when the organization needs to be flexible and there is diversity in its members preferences. We also show that there are environments in which the possibility of interference actually facilitates full implementation by providing a means of protest in undesired equilibria.

 

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Wealth Effects, Distribution, and the Theory of Organization

Peer Reviewed Article
Patrick Legros, Andrew Newman
Journal of Economic Theory, Volume 70, Issue 2, August 1996, 312-341

We construct a general equilibrium model of firm formation in which organization is endogenous. Firms are coalitions of agents providing effort and investment capital. Effort is unobservable unless a fixed monitoring cost is paid, and borrowing is subject to a costly state verification problem. Because incentives vary with an agent’s wealth, different types of agents become attractive firm members under different circumstances. When borrowing is not costly, firms essentially consist of one type of agent and are organized efficiently. But when the costly state verification problem is sufficiently severe, firm organization will depend on the distribution of wealth: with enough inequality, it will tend to be dictated by incentives of rich agents to earn high returns to wealth, even if the chosen organizational form is not a technically efficient way to provide incentives.

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Bankruptcy as a Control Device in Economies in Transition

Peer Reviewed Article
Patrick Legros, Janet Mitchell
Journal of Comparative Economics, Volume 20, Issue 1, 265-301

We examine in this paper the design of a liquidation or bankruptcy policy in a partially centralized economy characterized by imperfect information. We employ a two period model to analyze the effects of an optimal liquidation rule on the efficiency of resource allocation and choice of managerial effort when managers have private information about effort and firm productivity. First period investment is used by the regulator to discipline the manager and to extract information. The tradeoff between disciplinary effect and information extraction might be best solved by implementing inefficient liquidation policies inefficiencies in liquidation policies can occur even if the regulator believes that he is facing a given type of firm with probability close to one.

 

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Efficient and Nearly Efficient Partnerships

Peer Reviewed Article
Patrick Legros, Steven Matthews
The Review of Economic Studies, Volume 60, Issue 3, July 1993, 599-611

This paper shows in two ways that the degree to which free-riding diminishes the performance of deterministic partnerships may be less than has been generally thought. First, a necessary and sufficient condition is provided for a partnership to sustain full efficiency. It implies that many non-trivial partnerships sustain efficiency, such as generic ones with finite action spaces, and neoclassical ones with Leontief technologies. Second, approximate efficiency is shown to be achievable in a large class of partnerships, including ones with smooth and monotonic production and disutility functions. Approximate efficiency is achieved by mixed-strategy equilibria: one partner takes, with small probability, an inefficient action. The degree to which efficiency is approximated is restricted only by the amount of liability the partners can bear. Nonetheless, their equilibrium payments are not arbitrarily large.

 

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Efficiency in Partnerships

Peer Reviewed Article
Patrick Legros, Hitoshi Matsushima
Journal of Economic Theory, Volume 55, Issue , December 1991, 296-322

We provide the necessary and sufficient condition for a partnership to be able to sustain efficiency when the output is stochastic. When limited liability is imposed, we show that only the level of the average liability of the partnership is important; the individual levels of liability are irrelevant. However, the allocation of the total liability among the partners is crucial when additional conditions such as neutrality or individual rationality are imposed.

 

 

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