Firms, Contracts, and Financial Structure

Abstract

This book provides a framework for thinking about economic relationships and institutions such as firms. The basic argument is that in a world of incomplete contracts, institutional arrangements are designed to allocate power among agents. The first part of the book is concerned with the boundaries of the firm. It is argued that traditional approaches such as the neoclassical, principal‐agent, and transaction costs theories cannot by themselves explain firm boundaries. The book describes a theory—the incomplete contracting or property rights approach—based on the idea that power and control matter when contracts are incomplete. If the terms of a transaction can always be renegotiated, the incentives of a party to undertake relationship‐specific investments will depend crucially on the ability to control the use of productive assets when renegotiation takes place. Asset ownership becomes an essential source of power. The theory suggests that firm boundaries are chosen to allocate power optimally among the various parties to a transaction. The foundations of incomplete contracting are also discussed. The remainder of the book applies incomplete contracting ideas to understand the financial structure of closely held and public companies. The analysis illustrates how debt acts as an automatic mechanism to constrain the behaviour of managers or owners of both kinds of companies. In closely held companies, debt can force an entrepreneur to pay out funds to investors rather than to himself. In a public company, ownership is dispersed among small shareholders causing a separation between ownership and control. It is argued that debt and equity choices, capital structure decisions, bankruptcy procedures, corporate governance, and takeovers, play a substantial role in limiting the ability of a (self‐interested) manager to make unprofitable but power‐enhancing decisions.