Contracts and Markets: Toward a General Equilibrium Theory of Firms

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Contracting is at the heart of much of the modern theory of the firm. Previous research has focused on the role of supervision in team production, the need for which arises from the impossibility of contracting for (unobservable or unverifiable) effort. This large literature has provided enormous insight into the role of contracting and the nature of the firm. Unfortunately, most of this literature takes as given exogenously many things we would like to be determined endogenously: the set of firms that form, the contractual and organizational structure of those firms, the prices faced by those firms for inputs and outputs, the characteristics of members of those firms, and the incentives for agents to take particular actions within a firm or even to participate in a firm at all. The goal of the work proposed here is to develop and apply a model that integrates firm theory in the spirit of Alchian & Demsetz and Grossman & Hart, contract theory in the spirit of Holmstrom, and general equilibrium theory in the spirit of Arrow & Debreu and McKenzie, achieving a model in which all of these things are determined endogenously as part of the solution, rather than given exogenously as part of the data. An important feature of the intended model is that mis-coordination and self-fulfilling prophecies are possible at equilibrium. In particular, equilibria need not be Pareto optimal, and may even be Pareto ranked.The model has many applications to the understanding of institutions for production, for trade, and for the management of productive assets. The model illustrates how the range of available institutions can have a substantial effect on social welfare. Because the range of available institutions reflects the legal structure (in particular, the kinds of contractual arrangements that are legally enforceable), a particular implication of the model is that inactive or poorly developed legal systems may give rise to ineffcient institutional arrangements. Conversely, improvements in the legal system that enhance the range of available institutions may greatly enhance social welfare. Thus there is a potentially important role for government policy, and themodel has the potential to inform such policy. This is especially significant in under-developed countries, which frequently have weak legal systems.Results from this research will be published in leading journals of economics and policy..