Main works of Oliver Hart
The Nobel Prize in Economic Sciences in 2016 was jointly awarded to Oliver Hart, then at Harvard University and Bengt Holmström, then at Massachusetts Institute of Technology, “for their contributions to contract theory”.
Hart did his undergraduate studies in mathematics from Kings College, Cambridge, which he finished in 1969. After this, he did a Masters in economics from Warwick University in 1971 and his PhD from Princeton University in 1974. His doctoral work was on the theory of general equilibrium with incomplete markets and his thesis supervisor was Michael Rothschild. After completing his PhD, Hart taught at the University of Essex for a while and then moved to Cambridge University where he stayed till 1981. From 1981 to 1984, Hart taught at the London School of Economics, and thereafter, he moved to MIT where he stayed till 1993. In 1993, Hart joined Harvard University as faculty.
Holmstrom did his undergraduate studies in mathematics, physics and statistics, from the University of Helsinki, which he finished in 1972. After this, he moved to Stanford in 1974 for doing Masters in operations research, transitioning to his PhD in decision sciences from the Graduate School of Business at Stanford, which he completed in 1977. His thesis was on incentives, information asymmetries and contracts. His thesis supervisor was Bob Wilson. After his PhD, Holmstrom went back to Finland to work for a while at Hansen School of Economics and then came back to the US and taught at North-western University during 197983. In 1983, he moved to Yale where he stayed till 1994. In 1994, he joined the Sloan School of Management at MIT as faculty, where he continues to teach.
In this article, we will review the main works of Hart and Holmstrom and look at how they continue to be relevant for many policy decisions across the world.
Hart is best-known for his work on incomplete contracts and its implications on principal-agent theory. Hart’s work began with his doctoral thesis and continued thereafter in collaboration with other economists. The first collaboration was with Sandy Grossman in 1976 with whom he explored the managershareholder dynamic. This work expanded and looked at the best ways to incentivise management, and was captured in their 1983 paper, ‘An Analysis of the PrincipalAgent Problem’, published in Econometrica. The authors argued that market allocations under uncertainty, and when moral hazard exists, are not optimal. They gave a mathematical model of the principal-agent theory in this paper.
Hart was inspired by the works of Coase on the nature of the firm and Oliver Williamson’s work on markets versus firms and transaction costs. This was also the reason that Hart had started thinking of contracts as a unit of analysis, rather than markets. After the 1983 paper, Hart began asking the same question that Coase had asked in 1937: why do firms exist? But Hart’s context was different: he wanted to examine the limits of contracts and how contracts are different from firms. This led Hart to his defining work on incomplete contracts. Incomplete contracts, as we know, are those where all eventualities are not completely specified. This could be due to poor wording, ambiguity or a simple inability to comprehend all situations. Hart went
deep into these questions: which parts of an incomplete contract will be decided by whom and under what circumstances? On what basis? Who has the residual control rights and why are those important? Hart treated residual control rights as a good that needed to be allocated optimally. To quote Hart from his Nobel lecture:
Residual control rights are like any other good: there is an optimal allocation of them. Sometimes it is more efficient for one owner to hold all the residual control rights, and sometimes it is more efficient for these control rights to be split between several owners. Which is the case will determine whether firms A and B should merge or stay as separate entities. Grossman and I constructed a formal model along these lines (see Grossman and Hart (1986)), and I developed the ideas and model further in work with John Moore (see Hart and Moore (1990)). Collectively these papers are often referred to as “property rights theory” (PRT).
To elaborate on the 1986 paper, ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, published in the Journal of Political Economy — Grossman and Hart argued that residual rights are critical and wrong allocation of
these rights can have harmful effects. To quote from their paper:
We present a theory of costly contracts that emphasises that contractual rights can be of two types: specific rights and residual rights. When it is too costly for one party to specify a long list of the particular rights it desires over another party’s assets, it may be optimal for that party to purchase all the rights except those specifically mentioned in the contract. Ownership is the purchase of these residual rights of control. We show that there can be harmful effects associated with the wrong allocation of residual rights. In particular, a firm that purchases its supplier, thereby removing residual rights of control from the manager of the supplying company, can distort the manager’s incentives sufficiently to make common ownership harmful. We develop a theory of integration based on the attempt of parties in writing a contract to allocate efficiently the residual rights of control between themselves.
Hart also underlined the importance
If incentives are given selectively then workers would tend to neglect other tasks and focus solely on incentivised tasks