412 Book reviews

result, I am certainly not, but those who argue that we can raise income taxes indefinitely
without getting a loss of revenue should be surprised.
This is the only example I can recall of direct policy effect of these experiments. In
general, they confirm what almost everybody in economics thinks about economics rules,
perhaps because the particular animals that they study do not have the human ingenuity of
avoiding routine behavior.
Thus, they support our theories but there are some exceptions. Where they find
exceptions to human presumptions, it is worthwhile to give careful thought and do further
work on the human side to make certain that this is not just a difference between species.
Altogether this is a most useful book.

References

Tullock, G., 1994, The Economics of Nonhuman Societies (Pallas Press, Tucson)

Gordon Tullock
Karl Eller Professor of Economics and Political Science
University of Arizona, Tucson
AZ 85721

PII SO167-2681(96)00849-9

Oliver Hart, Firms, Contracts, and Financial Structure (Oxford University Press, Oxford,
1995) pp. viii + 228.

The field of industrial organizations has struggled to develop a theoretical model that
provides a satisfactory explanation of the determinants of firm boundaries. The field of
financial economics also continues to grapple with explanations of why the financial
structure of firms should matter. This book by Oliver Hart represents a synthesis of his
work on how incomplete contracting and property rights can be used to derive models
that explain the size of firms as well as aspects of their financial structure. It is based on a
set of lectures presented at Oxford University in May 1993. The book is divided into two
distinct parts, the first of which (Chapters 1-4) addresses issues of integration and the
boundaries of firms. The second part (Chapters 5-8) is devoted to financial structure and
corporate control issues. Although the main ideas presented here have appeared
elsewhere in publications by the author and his collaborators, the mathematical rigor has
been sufficiently reduced making the book accessible to a much wider audience. It is an
excellent compilation of this work.
In Part I, Hart presents a model of optimal property rights to explain the economic
organization of production. He explains how three leading theories of the firm
(neoclassical, principal-agent and transaction costs) fail in some way or other to
effectively explain firm boundaries within a unified theoretical framework. While Hart
believes that the transaction costs theory comes the closest, he effectively argues that it
 Book reviews 473

does not provide a symmetric treatment of the benefits and costs from integration.
Transaction costs theory typically begins with a situation of asset-specificity and
contracting problems between a buyer and seller who behave opportunistically. Asset-
specificity occurs when the buyer and seller invest in assets that are specific to their
trading relationship. Since these investments must typically be made prior to trading, the
buyer and seller are effectively bound to each other ex post. Foreseeing this ex post
bilateral relationship, the buyer and seller anticipate being held-up by the other party.
Since the parties are unable to resolve this problem through a contract due to the
difficulty or impossibility of identifying all possible contingencies, it is optimal for the
transaction to move inside the firm.
Thus, vertical integration prevents this hold-up problem from materializing. Hart’s
model begins with a similar premise that ex ante decisions must be made that bind the
buyer and seller together ex post. He presents the problem as one where the buyer and
seller must make ex ante human capital investment decisions that enhance the
productivity of the nonhuman assets with which each party operates. In this model the
anticipated hold-up problem is better understood as an externality that neither party will
internalize since each is self-interested. Each party’s return is influenced by the other
party’s relationship-specific investment in human capital. Due to self-interest, they do not
internalize this externality and each party invests less than the social optimum. For
example, a supplier might invest time and effort to reduce production costs of an input
that is specific to a particular buyer. Once the investment is made, the seller is bound to
that particular buyer. Anticipating that the buyer will expropriate some of the return by
bargaining for a lower price, the seller reduces his level of relationship-specific
investment. Hart uses incomplete contracts and the value of ownership to explain how
these ex ante investment decisions are influenced by various ownership structures. It is
not the economizing on transaction costs that leads to integration but instead it is an
optimal allocation of property rights (more specifically, residual rights of control) that
explains whether or not the transaction is brought within a single firm, under a single
owner.
The key to Hart’s model is the recognition that, when contracts are incomplete,
ownership of nonhuman assets has value because the owner has the right to decide on
their unspecified uses. This ownership will in turn influence the levels of ex ante
relationship-specific investment. Therefore, whether a transaction between two separate
firms is brought within a single firm through integration or not depends on how the value
of increased ex ante investment by the acquirer, due to owning more nonhuman assets,
balances against the loss in value from a decrease in ex ante investment by the acquired
firm, for having lost control of assets. Thus, Hart has used a unified framework to explain
both the benefits and costs of integration. In contrast, the transaction costs model assumes
that integration removes the opportunistic behavior of the parties and simply attributes
any costs of integration to bureaucracy costs. Hart argues quite convincingly that when
the ex ante investment is not verifiable, such as a human capital investment or a level of
effort, one cannot argue that bringing the transaction inside the firm will necessarily
eliminate the hold-up problem. In fact, the party that loses control by being acquired will
have a lower incentive to invest than if it remained separate. In equilibrium, the
ownership structure which maximizes the difference between the benefits of increased
474 Book reviews

investment by the owner against the costs of decreased investment by the acquired will
obtain, is predicted. Hart demonstrates how various parameters of the system influence
the optimal ownership structure. For example, if one of the two parties’ relationship-
specific investment is either unresponsive to incentives or is relatively unimportant to the
productivity of the nonhuman assets, then that party should not have ownership rights and
integration should occur. Also, since each party’s relationship-specific investment
benefits a particular nonhuman asset, the interdependency of the nonhuman assets has
implications for optimal ownership. If the nonhuman assets are independent, then there is
no benefit to integration since increased ownership of assets by one of the parties doesn’t
increase the human capital investment by that owner due to the independence, yet it will
cause a reduction in human capital investment by the acquired party. The model also
predicts that complementary nonhuman assets will lead to integration since, without
integration, neither party will be motivated to make the relationship-specific investment
because he is denied access to the necessary complementary asset.
To summarize the model, the value of control rights and incomplete contracts in the
presence of relationship-specific investments can explain the boundaries of firms as
optimal ownership structures. Hart backs up his model with sufficient discussion of how
the basic results can explain certain stylized facts about takeovers. He also provides a
good explanation of how his theory of optimal property rights can explain the traditional,
neoclassical U-shaped average cost curve. In the remainder of Part I, Hart addresses some
of the simplifications that were made to the model and how the model might be enriched
to explain additional aspects of economic organization. For example, he argues that we
can use the theory of property rights to understand authority. That is, control over
nonhuman assets leads to control over human assets to the extent that human assets
require nonhuman assets to be productive. Hart also includes a discussion about how
ownership structure can influence workers’ incentives, why it is more intuitive to think of
ownership as having residual control rights instead of just residual income rights, why the
use of reputation cannot substitute for integration to mitigate the hold-up problem, and
how ownership changes will affect the flow of information within the organization, but
not necessarily improve it. These extensions are not formally modeled but the discussion
leaves the reader with an appreciation of the theory’s relevancy as well as fruitful avenues
for future research.
In Part II of the book, Hart deviates from the buyer-seller relationship of the first half
and focuses on the consequences of incomplete contracts and opportunistic behavior on
the part of owners and investors. He demonstrates how various automatic mechanisms
can be used to control the associated agency problems. These mechanisms include
financial structure, bankruptcy rules, and voting rights of equity. Although researchers
have long recognized the benefits of financial structure to mitigate agency problems, Hart
argues that a formal theoretical model of how financial structure can be used to solve
agency problems is lacking. Furthermore, existing research has not explicitly accounted
for the incompleteness of contracts. If it were possible to write a comprehensive contract
between the relevant parties, then there would be no need to study financing decisions or
control structures. There would be no role for debt contracts nor for equity holders to
have voting rights since all possible contingencies could be identified and specified in a
contract. Therefore, Hart starts with the first principle that contracts are inevitably
 Book reviews 475

incomplete and adds the assumption of opportunistic behavior by stakeholders to derive

his models that show the optimality of certain financial structures. Hart demonstrates how
financial structure can improve upon the inefficiencies that arise due to these agency
problems.
Hart begins with a simple model of a small owner-manager who is wealth-constrained
and thus in need of an investor. The two parties have objectives that do not necessarily
align because the owner-manager receives private benefits from controlling the assets.
Hart demonstrates how these conflicts can be minimized with a standard debt contract
that gives the investor the right to liquidate the firm for failure of nonpayment. That is,
the debt contract defines the situations in which control over the assets will shift between
the owner-manager and the investor. The model is capable of explaining many aspects of
a standard debt contract and how certain problems of opportunistic behavior and
incomplete contracts are solved with them.
In the following chapter, Hart shifts to the agency problems associated with a
separation of ownership and control when there are multiple investors. Once again,
agency problems result when the manager of the firm enjoys private benefits from
managing the firm. Since the manager derives benefits only if the firm continues
operating and these benefits are increasing in the size of the firm, there are two potential
inefficiencies. One is where the manager desires to keep the firm running when in fact it
ought to be liquidated because it has a negative net present value, and the other is where
the manager wants to expand the size of the firm by taking on projects with negative net
present value. Hart demonstrates how the capital structure and specifically the term
structure of the debt can be used to solve these problems. He argues that short-term debt
can be used to bring about efficient liquidation whereas long-term debt can be used to
bring about efficient expansion opportunities. The efficacy of debt as well as its term
structure to solve agency problems depends crucially on the assumption that managers
behave opportunistically. Hart points out that if managers are not self-interested because
they do not derive private benefits from having control, then there is no benefit of having
debt in the capital structure except for tax advantages. But tax advantages alone cannot
explain the term structure of debt. Therefore, Hart concludes that what is needed to
explain observable capital structures is a theory of agency, incomplete contracts and
opportunistic behavior.
The last two chapters of the book present two different issues of control changes. In the
first of these, Hart discusses the inefficiencies of current bankruptcy procedures. Since
firms typically have several classes of claimants, each behaving opportunistically, there
may be situations where a firm may be forced into bankruptcy when in fact it would be
efficient for it to continue. Likewise, there might be the opposite situation in which a firm
is kept going when in fact it ought to be liquidated. Hart presents an informal discussion
of how these inefficiencies may be resolved by restructuring the bankruptcy code. The
idea involves replacing the various classes of claims by a single type of claim in the event
of bankruptcy. This action will align the objectives of the various parties and thus prevent
an inefficient liquidation or inefficient continuation. In the last chapter he discusses how
the voting structure of equity holders influences the efficacy of the market for corporate
control to check the opportunistic behavior of managers. Specifically, the structure of
one-share one-vote is shown to be efficient when the manager or the raider’s private
476 Book reviews

benefits from controlling the firm are not large compared with the value of the firm. In
this case the one-share one-vote structure should generate efficient transfers of control
through takeovers.
Overall, the issues raised in this book have been the topic of discussion in the
economics and finance literature for many years now. This book presents the issues in a
theoretically uniform way and thus brings cohesion to the way we think about the issues
of and solutions to agency problems and opportunistic behavior when contracts are
incomplete. Hart has used opportunistic behavior and the incompleteness of contracts as
the first principles to build his models. Some of the models suffer from overly restrictive
assumptions and cannot provide strong predictions, yet this is not a weakness of Hart’s
models relative to other models but is reflective of the relative newness of the theory and
the ideas. Throughout the book, he complements the formal models with important
narratives that serve to initiate non-experts to the relevancy and importance of incomplete
contracting problems. The author also presents excellent references to related literature as
well as many ideas for future research that will be especially welcome to researchers.

Joanne M. Doyle
Department of Economics
James Madison University
Harrisonburg, VA 22807
U.S.A.

PII SO167-2681(96)00852-9

Richard England, ed., Evolutionary Concepts in Contemporary Economics (The

University of Michigan Press, Ann Arbor, 1994) pp. xiii + 255, $42.50.

This edited volume comprises eleven loosely connected essays exploring the
evolutionary theme in economics. The book originated as an AEA panel on “evolutionary
concepts in contemporary economics.” Like other recent multi-authored books on
evolutionary economics the authors share at least two common goals: (1) to make the
evolutionary paradigm palatable to the mainstream of the economics profession and (2) to
explain complex economic phenomena that cannot be handled within the standard
framework. Heterodoxy, however, is something highly resisted by mainstream
economists-and the tension shows in this collection of essays.
One way for the evolutionary approach to gain currency is to give its past. Geoffrey
Hodgson attempts this task in an introductory chapter, “Precursors of Modem
Evolutionary Economics: Marx, Marshall, Veblen, and Schumpeter.” To what authority
may (and do) modem evolutionary economists turn to? The neoclassical economists have
their Samuelson and their Walras, and the classical economists have their Ricardo and
their Smith-but what authority can evolutionary economists appeal to? Ultimately,
Hodgson argues that modem evolutionary economists’ choice of an authority figure is
malapropos.