“The research here is deep microeconomic stuff. It’s about incentives, and imperfect information, and long-term relationships. It’s about delicate strategic interactions between people who don’t know each other’s capabilities or intentions. But it’s related to lots of real-world economic issues — performance pay, mergers and acquisitions, bank lending and corporate structure.”
“Contracts can be very hard to design if it’s hard for the person paying for a service to observe the provider’s effort. If you’re paying someone to produce a certain number of widgets, for example, then setting up that contract is quite easy.If enough widgets are produced, then the provider gets paid the agreed amount of money. But if it’s difficult to see how much effort someone is putting in, then writing a contract can be more difficult. This problem, the potential misalignment between a principal (the person paying) and an agent (the person providing the service) when there is asymmetric information (the agent knows how much work they are putting in and the agent doesn’t) is a problem that Holmström’s work centered around.
A good example of this problem is executive compensation. The shareholders of firms often want to structure the compensation of their chief executives to make sure the incentives of the CEOs are aligned with those of shareholders. This thinking leads firms to make executive compensation tied to the price of company stock. But Holmström’s theoretical work emphasizes that the contract should be based on information that is informative of the executive’s effort and performance. A company’s share price could move due to factors outside the executive’s control—say an increase in oil prices in the case of an oil executive. This thinking can also be expanded to situations where teamwork is important and therefore points toward pay that is more salary-based and less tied to share-price performance.
Hart’s work also involves contracts, but focuses more on what happens when contracts can’t be fully specified and are therefore “incomplete contracts.” The applications of his work often focuses less on contracts between individuals and more on contracts between firms. “
Modeling Contracts 2
“Suppose that you are a principal monitoring an agent who produces output. The output depends on the agent’s effort but also on noise. It wouldn’t be a very efficient contract to just reward the agent based on output since then you would mostly be responding to noise—punishing hard-working agents when the noise factors were bad and rewarding lazy agents when the noise factors were good. Not only is that unfair–if you setup a contract like this the agents will a) demand that you pay them a lot of money in the good state because they will be taking on a lot of risk and b) the agents won’t put in much effort anyway since their effort will tend to be overwhelmed by the noise, either good or bad. Thus, rewarding output alone gets you the worst of all worlds, you have to pay a lot and you don’t get much effort.
But perhaps in addition to output, y, you have a signal of effort, call it s. Both y and s signal effort with noise but together they provide more information. First, lesson – use s! In fact, the informativeness principle says you should use any and all information that might signal the agent’s effort in developing your contract. But how should you combine the information from y and s? According to some calculation you should put high weight on the factor which is relatively not noisy. 
When should you use absolute pay and when should you use relative pay? For example, sometimes we reward salespeople based on their sales and sometimes we reward based on which agent had the most sales, i.e. a tournament. Which is better? The great thing about relative pay is that it removes one type of noise, say economy.  And this work has lot of implications for structuring executive pay. 
But relative pay isn’t always better. If the sales agents come in different ability levels, for example, then relative pay means that neither the high ability nor the low ability agents will work hard. Tournaments work best when agent ability is similar which is why in sports tournaments we often have divisions (over 50, under 30) or rounds. Oddly, however, performance pay for executives rarely works like a tournament. As a result, CEOs are often paid based on noise.”
From my view, the contract problem can be generalized to the following 4 situations:
pay fixed, high risk -> not bad but no incentive = cost is limited
pay fixed, low risk -> not efficient as no incentive
pay floated, high risk -> not efficient as luck affects = high or less pay / effort
pay floated, low risk -> best
–>> The best way is to find a signal of effort which lower the risk of misallocation and then pay floated according to it.
However, finding such a signal is difficult and according to Hart’s theory, the principle always has different expectation with the agent even though they seemed to get a consensus. -> There is always something out of expectation that they just can’t imagine.
From Coase to Tirole
“much of Hart’s recent work repudiates the importance of his most famous articles…rather the impact of a devastatingly clever, and devastatingly esoteric, argument made by the Nobel winners Eric Maskin and Jean Tirole.”
” a huge amount of economic activity (including the majority of international trade) is not coordinated via the market, but rather through top-down Communist-style bureaucracies called firms. Coase’s early answer is that something called transaction costs exist, and that they are particularly high outside the firm. That is, market transactions are not free. Firm size is determined at the point where the problems of bureaucracy within the firm overwhelm the benefits of reducing transaction costs from regular transactions._
<- Problems: 1) what a “transaction cost” or a “bureaucratic cost” is, and why they differ across organizational forms; 2) as the wonderful paper by Alchian and Demsetz in 1972 points out, there is no reason we should assume firms have some special ability to direct or punish their workers.”: 3) as Eric van den Steen points out in a 2010 AER, can anyone who has tried to order paper through their procurement office versus just popping in to Staples really believe that the reason firms exist is to lessen the cost of intrafirm activities?
“some relationships generate joint rents higher than could be generated if we split ways, unforeseen things occur that make us want to renegotiate our contract, and the cost of that renegotiation may be lower if workers or suppliers are internal to a firm. It is not that everyday activities have different transaction costs, but that the negotiations which produce contracts themselves are easier to handle in a more persistent relationship.
Empirical support for informal “bureaucratic costs”: firms are larger in the developing world because weaker legal systems means more “unforeseen things” will occur outside the scope of a contract, hence the differential costs of holdup or renegotiation inside and outside the firm are first order when deciding on firm size.”
Hart and Grossman(1986):
“What really makes a firm a firm is that it owns assets. Contracts may be incomplete – at some point, I will disagree with my suppliers, or my workers, or my branch manager, about what should be done, either because a state of the world has arrived not covered by our contract, or because it is in our first-best mutual interest to renegotiate that contract. There are relationship-specific rents, but the owner of the asset is in a much better bargaining position when this disagreement occurs.Therefore, the owner of the asset will get a bigger percentage of rents after renegotiation. Hence the person who owns an asset should be the one whose incentive to improve the value of the asset is most sensitive to that future split of rents.” 
Hart and Moore(1990)
“extends this basic model to the case where there are many assets and many firms, suggesting critically that sole ownership of assets which are highly complementary in production is optimal. Asset ownership affects outside options when the contract is incomplete by changing bargaining power, and splitting ownership of complementary assets gives multiple agents weak bargaining power and hence little incentive to invest in maintaining the quality of, or improving, the assets.”
(There are, of course, many other theories of the firm. )
“Incomplete contracts theories: there are always events which are unforeseeable ex-ante or impossible to verify in court ex-post, and hence there will always scope for disagreement about what to do when those events occur. But, agent don’t care about anything in these unforeseeable/unverifiable states except for what the states imply about our mutual valuations from carrying on with a relationship. Therefore, every “incomplete contract” should just involve the parties deciding in advance that if a state of the world arrives where you value keeping our relationship in that state at 12 and I value it at 10, then we should split that joint value of 22 at whatever level induces optimal actions today. Do this same ex-ante contracting for all future profit levels, and we are done. Of course, there is still the problem of ensuring incentive compatibility – why would the agents tell the truth about their valuations when that unforeseen event occurs?
-> “Incomplete contracts don’t matter if we can truthfully figure out ex-post who values our relationship at what amount, and there are many real-world institutions like mediators who do precisely that.”
->> “If, as Maskin and Tirole prove (and Maskin described more simplyin a short note), incomplete contracts aren’t a real problem, we are back to square one – why have persistent organizations called firms?”
Should the management of prisons be contracted out to the private sector? The owners of a private firm have a strong incentive to cut costs and improve productivity because they get to keep the resulting profits. If a public prison cuts costs, there is more money in the public treasury but no one gets to buy a yacht so the incentive to cut costs is much weaker.
Hart say this profit motive is the problem! Suppose that we care about costs but we also care about prisoner rehabilitation, civil rights, and low levels of inmate and guard violence.What we pay for is cheap prisons, but what we want is cheap but high quality prisons. If we can’t measure and pay for quality, then strong incentives could encourage cost cutting at the expense of quality.
The principle is a general one, a strong incentive scheme that incentivizes the wrong thing can be worse than a weak incentive scheme. One car dealer in California advertises that its sales staff is not paid on commission. Why would a store advertise that its sales staff do not have strong incentives to help you? The answer is clear to anyone who has tried to buy a car. High-pressure dealers who pounce on you the moment you enter the showroom and bombard you with high-pressure sales tactics may sell cars to first-time buyers, but the strategy is too unpleasant to win many repeat customers. Car dealers who rely on repeat business usually prefer a low-pressure, informative sales staff….In theory, a car dealer could have strong incentives and repeat business by paying its sales staff based on their “nice” sales tactics, but in practice it’s too expensive to monitor how salespeople interact with clients. Cheating by the sales staff would be difficult to detect and thus would be common.
1. Are HSV correct that weak-incentive public prisons are better than strong incentive private prisons? Not necessarily. HSV assume that cutting quality is the way to cut cost. But sometimes higher quality is also a path to lower costs.
2. HSV may also underestimate how well quality can be measured. Measuring output pays off more when incentives are high. Unsurprisingly, therefore, private prison companies and government purchasers have made extensiveefforts to measure the quality of private prisons.
3. Finally, don’t forget that weak incentives reduce the incentive to cut costs but they don’t increase the incentive to produce high quality! Public prisons might use their slack budget constraints to offer high-quality rehabilitationprograms, or they might instead offer prison guards above-market wages. Which do you think is more likely?
Finally, I just find someone goes even further than my comment on last blog.
“Think of their work as consisting of three steps.
1. Identifying some real-world complexities that affect how businesses operate. For example, output may result from both effort and luck. Output may be joint. A worker’s job description may include more than one objective.
2. Construct a mathematical optimization model that incorporates such complexities.
3. Offer insights into designing appropriate compensation systems, including when to outsource an activity altogether.
In the eyes of the mainstream economics profession,step 2 is extremely important. Without it, you either do not get to step 3, or your claims in step 3 lack reliability and credibility. Step 2 is why Hart and Holmstrom earned the Nobel Prize.
In my view, step 2 is unnecessary. If anything, it tends to get in the way, often creating a barrier to doing step 1 properly, because economists limit themselves to what is mathematically tractable. I think that Hart and Holmstrom sometimes (often?) made good choices in step 1, and that is what accounts for the value of where they arrived at in step 3.
I offer a number of asides that go from step 1 to step 3 directly. I think in terms of a dynamic process of trial and error. A manager tries an approach to compensation. As long as it seems to work, it persists. Once it gets gamed too much by the employees, something happens–the manager makes changes, the manager gets fired, or the firm goes out of business. Another point is that I believe that managers closer to the problem do a better job of solving it.”
“Think of the firm as a team in which the output of any one individual is difficult to value. Consider a computer programmer working on part of a bank’s software system. No one can state precisely the value to the bank of the particular section of code that the programmer works on. All that we know is that the bank cannot pay programmers too much, or else it would be unable to make a profit. and it cannot pay programmers too little, or they would choose to work elsewhere.
If it is possible to attach a precise value to a particular segment of work, then it is possible for that work to be broken out of the firm and outsourced to the market. Thus, if a bank can assign a precise value to a particular software system, it has the option of contracting with an outside firm to build the software for an agreed-upon price.
In short, when the value of different tasks can be isolated, specialization will tend to take place between firms, coordinated by the price system. When the value of a particular task is difficult to measure, because its value varies a great deal depending on how it is combined with other tasks, specialization will tend to take place within a firm, governed by instructions.”
I doubt if one could get to step 3 directly without using some abstract toolkit like math, and you can not just let the market tell you everything. But I do agree that economists should move some focus out of step 2.
“Suppose you write a contract where the agent is paid a wage, w=B0+By*y+Bs*s where Bo is the base wage, By is the beta on y, how much weight to put on output and Bs is the weight on the s signal–think of By as the performance bonus and Bs as a subjective evaluation bonus. Then it turns out you should weight By and Bs according to the following formula:
c is a measure of how costly effort is to the agent and so it also makes sense that the higher is c the less weight you put on performance incentives and the more on the base wage.
r is a measure of risk aversion for the agent. When r is zero:
(which means the agent is risk neutral and in the world where you put all the risk on the agent.
If r>0 then you don’t want to put all the risk on the agent because then the agent will demand too much so you take on some risk yourself and tamp down By and Bs and instead increase the base wage which acts as a kind of insurance against risk.)
-> It says that you should put a high weight on y when the s signal is relatively noisy and a high weight on s when the y signal is relatively noisy.”
“Suppose, for example, that sales depend on effort but also on the state of the economy. If you reward based on absolute sales then you are rewarding a lot of noise. Once again, that has two bad effects it means that you have to pay your agents a lot since you are imposing risk on them and it means that they won’t work that hard since they know they will be paid a lot when the economy is good and hardly at all when the economy is bad so in neither case do the agents have strong incentives to work hard. Suppose, however, that you have a relative pay scheme, a tournament. Now you have removed the noise coming from the state of the economy–since all the salespeople face the same economy and since there is always a first, second and third place the agent’s now have an incentive to work hard in good or bad times. Not only do they have an incentive to work hard you don’t have to pay them much of a risk premium since more of their pay is now based on their own effort rather than on noise.”
“In particular, executive pay often violates the informativeness principle. In rewarding the CEO of Ford for example, an obvious piece of information that should used in addition to the price of Ford stock is the price of GM, Toyota and Chrysler stock. If the stock of most of the automaker’s is up then you should reward the CEO of Ford less because most of the gain in Ford is probably due to the economy wide factor rather than to the efforts Ford’s CEO. For the same reasons, if GM, Toyota, and Chrysler are down but Ford is down less then you might give the Ford CEO a large bonus even though Ford’s stock price is down. “
“Baker and Hubbard (2004) provide a nice empirical example: when on-board computers to monitor how long-haul trucks were driven began to diffuse, ownership of those trucks shifted from owner-operators to trucking firms. Before the computer, if the trucking firm owns the truck, it is hard to contract on how hard the truck will be driven or how poorly it will be treated by the driver. If the driver owns the truck, it is hard to contract on how much effort the trucking firm dispatcher will exert ensuring the truck isn’t sitting empty for days, or following a particularly efficient route. The computer solves the first problem, meaning that only the trucking firm is taking actions relevant to the joint relationship which are highly likely to be affected by whether they own the truck or not. In Grossman and Hart’s “residual control rights” theory, then, the introduction of the computer should mean the truck ought, post-computer, be owned by the trucking firm. If these residual control rights are unimportant – there is no relationship-specific rent and no incompleteness in contracting – then the ability to shop around for the best relationship is more valuable than the control rights asset ownership provides.”
“The idea that firms in some industries are big because there are large fixed costs to enter at the minimum efficient scale goes back to Marshall. The agency theory of the firm going back at least to Jensen and Meckling focuses on the problem of providing incentives for workers within a firm to actually profit maximize;More recent work by Bob Gibbons, Rebecca Henderson, Jon Levin and others on relational contracting discusses how the nexus of self-enforcing beliefs about how hard work today translates into rewards tomorrow can substitute for formal contracts, and how the credibility of these “relational contracts” can vary across firms and depend on their history.”