Firms, Contracts, and Financial Structure (Clarendon Lectures in Economics)

Rating:
Summary: A classic on the theory of the firm
Review: Consider an economic relationship where relationship-specific investments are important and transaction costs make it impossible to write a comprehensive long-term contract to govern the terms of the relationship. Consider also the nonhuman assets that, in the post-investment stage, make up this relationship. Given that the initial contract has gaps, missing provisions, or ambiguities, situations will occur in which some aspects of the use of these assets are not specified. Take the position that the right to choose these missing aspects of usage resides with the 'owner' of the asset. That is, ownership of an asset goes together with the possession of residual rights of control over that asset; the owner has the right to use the asset in any way not inconsistent with a prior contract, custom, or any law. Finally, identify a firm with all the nonhuman assets that belong to it, assets that the firms's owners possess by virtue of being owners of the firm. Included in this category are machines, inventories, buildings or locations, cash, client lists, patents, copyrights, and the rights and obligations embodied on outstanding contract to the extent that these are also transferred with ownership. Human assets, however, are not included. Since human assets cannot be bought or sold, management and workers presumably own their own human capital.

We now have the basic ingredients of a theory of the firm. This theory has become known as the property rights approach to the theory of the firm. In a world of transaction costs and incomplete contracts, ex post residual rights of control will be important because, through their influence on asset usage, they will affect ex post bargaining power and the division of ex post surplus in a relationship. This division in turn will affect the incentives of actors to invest in that relationship. Hence, when contracts are incomplete, the boundaries of firms matter in that these boundaries determine who owns and controls which assets. In particular, a merger of two firms does not yield unambiguous benefits: to the extent that the (owner-)manager of the acquired firm loses control rights, his incentive to invest in the relationship will decrease. In addition, the shift in control may lower the investment incentives of workers in the acquired firm. In some cases these reductions in investment will be sufficiently great that non integration is preferable to integration.

Note that, according to this theory, when assessing the effects of integration, one must know not only the characteristics of the merging firms, but also who will own the merged company. If firms A and B integrate and A becomes the owner of the merged company, then A will presumably control the residual rights in the new firm. A can use those rights to hold up the managers and workers of firm B. Should the situation be reversed, a different set of control relations would result in B exercising control over A, and A's workers and managers would be liable to holdups by B.

Hart's book gives us an introduction to this world of the property rights approach to the theory of the firm. In the first part Hart considers the traditional approaches to the firm and argues that these approaches can not explain why all production does not take place within one firm or even why firms matter at all. His answers to these problems are developed via the property rights approach to the firm. Development of this theory covers chapters 2-4. Chapter 2 outlines the property rights approach, chapter 3 looks at issues that arise from this approach and chapter 4 discusses the foundations of the incomplete contracting model. In part 2 of the book Hart considers the financial structure of firms. The nature of debt and equity, the capital structure decisions of public firms, bankruptcy procedures are all covered. The book is written in a very readable manner and is non-technical enough to mean that both (advanced) undergraduate and graduate students will be able to read it. For anyone with a interest in the theory of the firm this is a must read.

Rating:
Summary: Abstract Theory at its ugliest
Review: I had the unfortunate dislpeasure of having to read this as one of the required books for a PhD class in Managerial/Business Economics. Suffice to say...the book is a complete waste of time and not worth the trees it took to print it. I understand Hart is brilliant...teaches at Oxford & Harvard...receives full salary at both...he's tops in his field. Yet, what this book contains has absolutely nothing to do with reality. It is abstract theory at its finest...or rather, worst! PhD work is theoretical...that's a given. But this book is still worthless, even for someone like myself studying for my PhD in Business Economics. You learn nothing about corporations, business practices or strategy, finance...etc. What is the point to studying this theory of financial structure that is so far removed from reality that you finish the semester wondering..."gee, what have I actually learned in the last four months". If your aim is for applied work, your likely answer will be NOTHING. Even though the mathematics used are fairly basic,the book is very difficult to read. Turning the pages is a very slow process. You learn nothing about the workings of real world finance by reading through this intellectuals collection of useless writings. I'm sure it boosted his ego, but it does nothing for the business student to understand the reasons for different choices of capital structure. Your time would be much better spent reviewing the chapters in Brealy and Meyers on capital structure, or Damodoran's book on Corporate Finance: Theory & Practice.(now that is a good book). If you want to learn about the nature of contracts WITHIN firms and how they are used to accomplish managerial objectives and provide proper incentives where needed, read Milgrom & Roberts or any good book on Managerial Economics. Even for Phd students in Finance, this book is a waste of your time!

Rating:
Summary: THE Classic
Review: This book is regarded as THE classic by most professional economists. We can't talk about the theory of the firm without referring to this book, which is written with exceptional clarity and depth.