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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.

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JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.Most analyses of the principal-agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent's utility being at a stationary point. An important paper of Mirrlees has shown that this approach is generally invalid. We present an alternative procedure. If the agent's preferences over income lotteries are independent of action, we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem. We use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem. 'Support from the U.K. Social Science Research Council and NSF Grant No. SOC70-13429 is gratefully acknowledged. We would like to thank Bengt Holmstrom, Mark Machina, Andreu Mas-Colell, and Jim Mirrlees for helpful comments. 2These and other applications are discussed in a number of recent papers. See, for example, Harris and Raviv [6], Holmstrom [7], Mirrlees [10, 11, 12], Radner [15], Ross [17], Rubinstein and Yaari [18], Shavell [19, 20], Spence and Zeckhauser [21], Stiglitz [22], and Zeckhauser [24]. 7 This content downloaded from 128.210.126.199 on Fri, 19 Jun 2015 11:53:54 UTC All use subject to JSTOR Terms and Conditions 3The reason for this can be seen quite easily in Figure 1 (we are grateful to Andreu Mas-Colell for suggesting the use of this figure). On the horizontal axis, I represents the agent's incentive scheme and on the vertical axis a represents the agent's action. The curve ABCDE is the locus of pairs of actions and incentive schemes which satisfy the agent's first order conditions, i.e., given I the agent's utility is at a stationary point. Of these points, only those lying on the segments AB and DE represent global maxima for the agent, e.g. given the incentive scheme I the agent's optimal action is at P', not at P2 or p3. Indifference curves-in terms of a and I-are drawn for the principal (C is on a higher curve than B). The true feasible set for the principal are the segments AB and DE and the optimal outcome for the principal is therefore B. However, B does not satisfy the first order conditions of the problem: maximize the principal's utility subject to (a, I) lying on ABCDE, i.e., subject to (a, I) satisfying the agent's first order conditions (the solution to this problem is at C). In other words, B does not satisfy the necessary conditions for optimality of the problem which has been studied in much of the literature. Note finally that perturbing Figure 1 slightly does not alter this conclusion. This content downloaded from 128.210.126.199 on Fri, 19 Jun 2015 11:53:54 UTC All use subject to JSTOR Terms and Conditions PRINCIPAL-A...

other colleagues for comments. We have also benefited from the reactions of seminar audiences at USC, Cal Tech, Harvard, McGill University, L. S.E., University of Chicago, Princeton University, University of Miami, Cornell University Law School, ECARE, George Washington University, Johns Hopkins University, University of Washington, Seattle, the Industry Economics Conference at Australian National University, Canberra, and the Harvard Political Economy group. Finally, we are grateful to the National Science Foundation for support of this work. This paper is part of NBER's research programs in Corporate Finance and Public Economics. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research.O 1996 by Oliver Hart, Andrei Shleifer and Robert W. Vishny. All rights reserved. Short sections of text, not to exceed two paragraphs, maybe quoted without explicit permission provided that full credit, including 0 notice, is given to the source. NBER Working Paper 5744September 1996 THE PROPER SCOPE OF GOVERNMENT: THEORY AND AN APPLICATION TO PRISONS ABSTR4CTWhen should a government provide a service inhouse and when should it contract out provision? We develop a model in which the provider can invest in improving the quality of service or reducing cost, If contracts are incomplete, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on non-contractible quality. The model is applied to understanding the costs and benefits of prison privatization.

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