Thursday, October 13, 2016

Property rights and sub-economies

Of all the work of Oliver Hart and Bengt Holmstrom there are two articles that I have discussed with my students and mentioned in my own work and classes, and that I think are especially relevant. One is the article by Hart (co-auhtored with Shleifer and Vishny) on prisons, and the other is Holmstrom's article on the firm as a subeconomy. The first is an application of Hart's theory of incomplete contracts to the problem of privatizing prisons. The theory of property rights with incomplete contracts argues that, when a contract that contemplates all possible contingencies cannot be written or enforced, then the allocation of property rights is a crucial ingredient of the provision of incentives. Property rights confer residual rights of control, which are accompanied by rents when the parties bargain if unforeseen contingencies arise. Then if quality is difficult to measure and therefore cannot by specified in the contract, then the party with the residual control rights will economize on quality if this is costly to provide. This is very dangerous in sectors where quality is important, like prisons. In general, property rights should be allocated, if the objective is to maximize social welfare, to the party that can do more to promote the social good when unforeseen contingencies arise. For example, in some firms where the protection of the rents from talent is important, talented professionals should have the residual control rights (law firms?). If no private party can be found that promotes dimensions that are socially valuable but not contractible, then things should remain in the public sector and rely on intrinsic incentives or external monitoring. In the article by Holsmtrom on the firm as a subeconomy, he argues that efficient managers are those that internalize externalities, and efficient firms are those that better coordinate the complementarities of the different units, or that best alleviate the negative externalities that may arise between these units of the firm. Shopping malls or sports leagues are good examples of firms that operate like sub-economies. It is nothing more than a formalization of the old idea by Ronald Coase that firms are just one type of hierarchy that are better than market-based transactions when they minimize all costs, including transaction costs. These are all very important aspects in modern economics, which illustrate that this branch of social sciences is much more than supply and demand.

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