Bengt Holmstrom

Moral Hazard and Observability

The role of imperfect information in a principal-agent relationship subject to moral hazard is considered. A necessary and sufficient condition for imperfect information to improve on contracts based on the payoff alone is derived, and a characterization of the optimal use of such information is given.

Moral Hazard in Teams

This article studies moral hazard with many agents. The focus is on two features that are novel in a multiagent setting: free riding and competition. The free-rider problem implies a new role for the principal: administering incentive schemes that do not balance the budget. This new role is essential for controlling incentives and suggests that firms in which ownership and labor are partly separated will have an advantage over partnerships in which output is distributed among agents. A new characterization of informative (hence valuable) monitoring is derived and applied to analyze the value of relative performance evaluation. It is shown that competition among agents (due to relative evaluations) has merit solely as a device to extract information optimally. Competition per se is worthless. The role of aggregate measures in relative performance evaluation is also explored, and the implications for investment rules are discussed.

Financial Intermediation, Loanable Funds and the Real Sector

We study an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained. We analyze how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring. We show that all forms of capital tightening (a credit crunch, a collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that interest rate effects and the intensity of monitoring will depend on relative changes in the various components of capital. The predictions of the model are broadly consistent with the lending patterns observed during the recent financial crises.

AGGREGATION AND LINEARITY IN THE PROVISION OF INTERTEMPORAL INCENTIVES

The authors develop two themes in the theory of incentive schemes. First, one need not always use all of the information available in an optimal incentive contract. Accounting information, which aggregates performance over time, is sufficient for optimal compensation schemes in certain classes of environments. Second, optimal rules in a rich environment must work well in a range of circumstances and cannot, therefore, be complicated functions of the observed outcome. The authors illustrate these ideas in a particular model where the agent has a rich space of controls, showing that the unique optimal compensation scheme is a linear function of profits. Copyright 1987 by The Econometric Society.

The theory of contracts

This paper was presented at the World Congress of the Econometric Society, Cambridge, Massachusetts, 1985

Market Liquidity and Performance Monitoring

This paper studies the value of the stock market as a monitor of managerial performance. It shows that the stock price incorporates performance information that cannot be extracted from the firms current or future profit data. The additional information is useful for structuring managerial incentives. The amount of information contained in the stock price depends on the liquidity of the market. Concentrated ownership, by reducing market liquidity, reduces the benefits of market monitoring. Integration is associated with weakened managerial incentives and less market monitoring. This may explain why shares of divisions of a firm are rarely traded. The model offers a reason why market liquidity and monitoring have both a private and a social value, a feature missing in standard finance models. This is used to study the equilibrium size of the stock market as a function of investor preferences and the available amounts of long- and short-term capital.

Private and public supply of liquidity

This paper addresses a basic, yet unresolved, question: Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the state have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means? In our model, firms can meet future liquidity needs in three ways: by issuing new claims, by obtaining a credit line from a financial intermediary, and by holding claims on other firms. When there is no aggregateuncertainty, we show that these instruments are sufficient for implementing the socially optimal (second‐best) contract between investors and firms. However, the implementation may require an intermediary to coordinate the use of scarce liquidity, in which case contracts with the intermediary impose both a maximum leverage ratio and a liquidity constraint on firms. When there is only aggregate uncertainty, the private sector cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income. Government bonds command a liquidity premium over private claims. The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government‐supplied liquidity and for its active management.

The theory of the firm

Publisher Summary The theory of the firm has long posed a problem for economists. This chapter discusses the analytical models of the firm that go beyond the black-box conception of a production function. The firm is seen as a contract among a multitude of parties. The main hypothesis is that contractual designs, both implicit and explicit, are created to minimize transaction costs between specialized factors of production. This follows Coases original hypothesis that institutions serve the purpose of facilitating exchange and can best be understood as optimal accommodations to contractual constraints rather than production constraints. There are three problems that need attention. A first step is to develop and apply techniques that deal with nonstandard problems, such as incomplete contracts, bounded rationality, and multi-lateral contracting. The second step ought to integrate observations from neighboring fields, such as sociology and psychology, in a consistent way into the theoretical apparatus. The third step will be to increase the evidence/theory ratio, which is currently very low in this field.

A Theory of Wage Dynamics

A dynamic, equilibrium model of long term (implicit) labour contracts under incomplete but symmetric information is developed. Workers are assumed to be risk averse and of unknown ability or productivity. Risk neutral firms learn, as do workers, about each workers productivity by observing the workers output over time. It is shown that equilibrium contracts provide for wages which never decline with age and increase only when the workers market value increases above his current wage. In addition to characterizing the equilibrium wage contract, we also derive some of its implications for the behaviour of aggregate wages across various groups of workers. These implications explain some findings in the recent empirical literature on age-earnings profiles. In particular our model can explain why earnings may be positively related to experience even after controlling for productivity, as some empirical studies have indicated.

Agency costs and innovation

Stylized facts indicate that small firms are responsible for a disproportionate share of innovative research. There are many possible explanations for this facto The paper seeks to understand this phenomena as the outcome of an optimal assignment of tasks across individuals and organizations. It is shown that incentive costs associated with a given task depend on the total portfolio of tasks that an individual or an organization undertakes. Mixing, hard to measure activities (innovation) with easy to measure activities (routine) is particularly costly, since it will either lead to misallocation of attention across tasks or to misallocation of risk. Larger firms are at a comparative disadvantage in conducting highly innovative research, because of the costs associated with managing a heterogeneous set of tasks. It is further argued that optimal organizational responses to coordination and control of routine tasks will lead to bureaucratization within the firm and to financial constraints imposed by capital markets, both of which are hostile to innovation.