On Oct. 10th, Royal Swedish Academy of Sciences announces that the 2016 Nobel Prize in Economics has been awarded jointly to Oliver Hart and Bengt Holmstrom “for their contributions to contract theory”. The photo taken on the same day shows that Oliver Hart is checking emails congratulating him for winning the Nobel Prize in Economics at home in Lexington, Massachusetts, US. (Xinhua/Reuters/Picture)

Hart’s theory shows that the optimal contractual arrangement is a trade-off between a rigid contract protecting feelings of rights and a flexible contract advancing effects afterwards. Hart’s property rights theory can be the most directly applied to the boundary problem between the government and the market, so it is especially significant for China, which is in the process of the market economic reform.

Optimal Contractual Arrangement

2016 Nobel Prize in Economics has been rewarded to Oliver Hart, Professor of Economics at Harvard University, and Bengt Holmstrom, Professor of Economics at MIT, for their outstanding contributions to contract theory. As for Nobel Prize, Professor Hart is somewhat indifferent, for he has been nominated for Nobel Prize for many years, without winning it. In 2014, when I served as a visiting scholar at Harvard University, I told him that even as a layman in economics I thought he deserved a Noble Prize, so probably he would get it in recent years. But he replied “Who knows?” and he also told me that if he could win the prize, his theory would be applied more, and the property rights theory was in urgent need of being applied.

Economists have been considering the institutional problem in social and economic activities from the perspective of contracts or agreements for a long time and have developed the New Institutional Economics, which has become an important branch of economics. The traditional contract theory attempted to stipulate the rights and duties of the person concerned in different possible situations through devising various complicated contract terms, so this contract is called “complete contract” or “rigid contract”, which is Holmstrom’s main contribution. However, economists represented by Hart have realized that contracts are incomplete in reality due to limited rationality in some degree, but they can still be used to cope with different possible problems through renegotiation, such as a flexible adjustment of the rights and duties of the two parties concerned in the contract, so they are called “incomplete contracts” or “flexible contracts”. Where there is a transaction, there is a contract, and most contracts in real life are incomplete, including long-term business contracts, laws and regulations, marriage, mentorship, etc. Therefore, the theory of incomplete contracts can also be applied extensively.

Privately, Hart describes his own theory as “Old theory” and “New theory”. “Old theory” refers to the property rights theory put forward by Grossman, Hart and Moore. It believes that under circumstances with much uncertainty, effective transactions can be made through signing an incomplete contract, arranging a reasonable structure of property rights and making a renegotiation afterwards. Property rights decide the policy-making power and profit-gaining power between the two parties concerned in the contract, so property rights should be given to the more important party in decision making in uncertain situations, such as the decision of investment of specific assets. Since the theory ignores the costs of renegotiation afterwards, critics argue that the original contract is not necessary as long as property rights are properly arranged, because it can be realized through countless renegotiations and it cannot explain why there exist so many rigid contracts in real life.

“New theory” refers to the reference point theory put forward by Hart, Moore and Fehr, which plays an extremely important role in supplementing property rights theory. According to the theory, the two concerned parties of a contract will take the price set when the contract is made as a “reference point”, and if one party tries to damage the other party’s interests through renegotiation, the other party will fulfill the contract “passively” instead of “actively”. The two different attitudes towards the contract will lead to dramatic difference in the total surplus of transactions, which is the efficiency loss brought about by the flexibility of incomplete contracts. This theory indicates that the optimal contractual arrangement is a trade-off between a rigid contract protecting feelings of rights and a flexible contract advancing effects afterwards.

Hart’s Theory and PPP

Hart’s property rights theory carries forward Coase’s ideas and is the most directly applied to the boundary problem of the government and the market, so it is especially significant for China as a country in the process of market economic reform. In more than 30 years of market economic reform in China, the government has opened the supply of personal products to private enterprises, but state-owned enterprises still take a leading role in the supply of public products at present. The research made by Hart and the others indicates that efficiency can be improved in various aspects if we run the PPP model (Public Private Partnerships) and open the supply of public products/service to private enterprises.

PPP model, also called the cooperation model between the government and the social capital in China, is mainly applied to the fields of public infrastructure and social services, such as highway, urban sewage treatment, power stations, rail transit, indemnificatory housing, urbanization, hospitals, elder care, water conservation, environmental protection, etc. The main bodies of this model are the government and the social capital, with the former responsible for regulation and supervision, and the latter, for raising funds for, designing, constructing, operating and maintaining the project. The government gives certain period (usually 20 to 30 years) of franchises to the social capital, and after that the project will be transferred to the government. Since 2014 a PPP wave has been spreading across China, where the National Development and Reform Commission and the Ministry of Finance have approved PPP projects amounting to 16 trillion altogether, becoming a breakthrough point of the present economic restructuring in China.

When Hart and his collaborators analyzed the supply of public products with property rights theory, they found that PPP model, compared with the traditional model of direct provision of the government, was more efficient in the following two aspects. Firstly, motivation is highly raised when PPP model is introduced to private enterprises. Private enterprises have more impetus in the innovation of business model and technology, so they can reduce the costs of supplying public products/services and satisfy diversified public demand so as to increase profits. Secondly, PPP model combines the construction period and the operation period, internalizing the external effect. There are negative external effects; for example, because of the outsourcing of public infrastructure in the construction period, private enterprises can absolutely cut corners by doing shoddy work and using inferior materials in whatever phase out of the supervision of the government, while combining the operation period and the construction period can stop this motive. And there are also positive external effects; for example, the deep involvement of operators in the construction period will certainly increase the possibility of maintenance and operation afterwards. This positive external effect will be greatly strengthened in the combination.

China’s economic restructuring has provided large potential for the application of property rights theory. For example, in the present PPP wave in China, if we can really improve the efficiency of the supply of public products, it will be a powerful empirical support for property rights theory.

Note: The author of this article is an assistant professor in Department of Public Administration at Tongji University. This article originally appeared in Southern Weekly on the following website: https://www.infzm.com/content/120304