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promote efficient resource use are the exception rather than the norm.
In this chapter, I briefly outline the role property rights play in economic decision-making
and resource use. I then focus on transactions costs by emphasizing distributional
concerns and measurement problems that can prolong negotiations over property rights
and raise enforcement costs. To illustrate these conceptual issues, I focus on efforts to
assign property rights through unitization of oil and natural gas reservoirs in North
American to mitigate common-pool losses. Unitization contracts both designate a single
firm to exploit a hydrocarbon deposit and thereby eliminate the losses of competitive
extraction and define property rights to oil-field rents. Yet, as outlined below these
contracts typically are very difficult to write and often are incomplete. These results are
surprising given the large potential gains from early agreement. Transactions costs
associated with equity and measurement disputes delay and shape the nature of the
agreements that can ultimately be reached.[3] Examination of the oil and gas case
demonstrates the complexities involved in property-rights formation and modification.

[1]
The material here draws on my chapter in Anderson and McChesney (2001).

[2]
Yoram Barzel (1989) emphasizes transactions costs and measurement problems in
implementing property rights regimes.

[3]
The problem of the common pool was outlined early by Gordon (1954) and the notion of rent
dissipation clearly described by Cheung (1970).
2 Property rights: general concepts
Property rights are socially sanctioned uses of valuable assets by economic agents.
They range from defining the access, use, and transfer of physical property, such as land,
to the ownership of more intangible property, such as stocks and bonds. More broadly,
they define the positions and responsibilities of parties in market exchange and within
firms. In markets, property rights define sellers and buyers, the goods exchanged, the
nature of payments, timing of transactions, enforcement, and dispute resolution. In firms,
property rights define specialization of production, delivery, management, marketing, and
the distribution of costs and returns among owners and employees (Demsetz1995).

Property rights can assign ownership to private individuals, groups, or to the state, and
each arrangement has different transactions costs for decision-making and resource use.
How property rights are structured has important efficiency attributes because if
complete, they can directly align individual decisions with relevant social marginal
benefits and costs, eliminating externalities. Regardless of the nature of the allocation,
property rights must be clearly specified, enforced, and exclusive to be effective, and the
degree of specificity depends upon the value of the asset covered (Demsetz1967;
Libecap 1978).

For relatively low-valued assets and/or in cases where the number of parties is small and
where there is a history of interaction, informal norms and local customs generally are
sufficient for defining and enforcing property rights (Ostrom 1990). For higher-valued
assets where the number of competitors is large and where new entry is common and
profitable (so that the parties are heterogeneous and have little or no previous
relationships), more formal governance structures, such as legally defined private
property rights, become necessary. In this latter case, the power of the state is required
to supplement informal constraints on access and use. State intervention involves
politics and broadens the number and heterogeneity of constituencies that must be
considered in negotiations for property-rights assignment and enforcement. Political
competition among constituent groups may delay or limit the property rights that can be
assigned. In the best case, formal documentation of ownership via title facilitates trade
and investment. Trade is promoted through a broadening of the market beyond only
those who recognize informal, local ownership arrangements (Alston, Libecap and
Mueller 1999a). Investment is encouraged because title allows for property to serve as
collateral for accessing capital markets (Feder and Onchan 1987; De Soto 2000). In the
worst case, state intervention may not recognize informal property allocations and may
not define property rights quickly or effectively. These problems have been evident on
the Amazon frontier of Brazil where settlers have been slow to receive title from land
agencies owing to bureaucratic and political factors (Alston, Libecap and Schneider
1996). Alternatively, the state may force a property-rights arrangement that harms some
parties without compensation, potentially reducing aggregate welfare. Libecap and Smith
(2001) argue that compulsory unitization regulation may have this effect by imposing unit
agreements in oil and natural gas fields that had been resisted by some parties for
legitimate measurement reasons.
Furubotn and Richter (1997) outlined the basic elements of property rights. They include:
(a) the right to use the asset (usus), (b) the right to appropriate the returns from the asset
(usus fructus), and (c) the right to change its form, substance, and location (abusus),
including the right of transfer to others through market trades or to heirs through
inheritance. This latter characteristic expands time horizons in resource use decisions
because it forces owners to consider the impact of current uses on the longer-term value
of the asset.

When property rights are not well defined or when they are restricted by a group or the
state, there are implications for economic behavior and performance. The attenuation of
property rights in an asset affects the owner's expectations about its use, timing, value,
and, consequently, the terms of trade. Whatever specific form it takes, attenuation of
property rights implies shrinkage of economic options for asset owners, and a
corresponding reduction of the asset's value. Time horizons and incentives for
investment and trade can be reduced. Lower-valued uses may be substituted for higher-
valued uses, if the latter have become less attractive owing to weaker property rights. If
widespread in a society, attenuation of property rights can result in lower economic
[4]
performance, diminished wealth, and fewer economic opportunities for its members.

Assessment of the impact of property-rights institutions on economic performance,
however, is complicated because causality also runs in the opposite direction. That is,
while more secure property rights can raise asset values, more valuable assets require
more precisely defined property rights to avoid the rent dissipation associated with
increased competition for control (Alston, Libecap and Schneider 1996). Technological
change, population expansion, new sources of supply, and other changing market
conditions exert pressure for adjustment of the existing rights structure to make it
commensurate with higher asset values and to facilitate responses to new economic
opportunities (Davis and North 1971; Libecap 1978).

Both historical and contemporary experiences, however, reveal that the process of
institutional change is neither smooth nor complete. Indeed, most institutional change is
incremental with the existing rights structure having a durable and in some cases,
negative effect on long-term production and distribution (path dependence). In general,
there can be no assurance that institutional change (property rights) will always be
structured so as to bring about rational resource use and rapid economic growth
(Libecap 1989b).

The process of institutional change is complex, and can become derailed by high
transactions costs. The bargaining underlying the creation or modification of institutions
involves debate over the aggregate benefits of the new arrangement and the distribution
of those benefits among the various interested parties. Negotiations can break down if
there are serious disagreements about either the net benefits of institutional change or
their allocation. Conflicts, blocking cooperative solutions, can arise from, among other
things, serious information asymmetries among the parties regarding anticipated benefits
and costs, measurement problems, and an inability to devise side payments to
compensate those who believe they will be harmed by institutional change. These
problems increase with the size and heterogeneity of the bargaining group (Libecap
1989a). As a result, institutional changes that would be anticipated in a transaction-cost-
free environment may not take place or emerge only in abbreviated form.

[4]
Of course, if the rights structure already is incomplete, such that there are divergences
between the net private and social returns of resource use (externalities), then regulations on
resource use can be socially beneficial.
3 Transaction-costs issues in the assignment and
modification of property-rights adjustment: equity issues
Any important redefinition of ownership of valuable assets brings about shifts in the
distribution of wealth and political power within a group, or if broad, within a society. The
response to proposed institutional changes depends upon how the various parties
perceive their position under the new property arrangement relative to the status quo. In
the unusual case that all parties can be made better off and these effects are broadly
anticipated, then institutional change can be rapid. As described below, this situation is
illustrated by the rapid unitization of oil reservoirs where deposits are relatively uniform
and where the parties are homogeneous.

In the more usual case, the anticipated results will not be that obvious and some parties
will not benefit without some form of compensation or modification in the proposed
arrangement. Side payments will be demanded to entice support for institutional change,
and disagreements over the size of such payments, their form, who will receive them,
and who will pay for them will dominate most political negotiations over property-rights
changes.[5] The slow and halting path of oil-field unitization where deposits are not
distributed uniformly and where they include both oil and gas demonstrates this situation.

In negotiations, demands for compensation or other changes in proposed property rights
can reflect legitimate concerns about the distributional and production effects of a new
property-rights regime that may arise from incomplete information. Compensation
demands also can be part of rent-seeking efforts as parties engage in extortion, holding
up agreement unless they are offered more. The resulting political compromises may
lead to the establishment of a rights structure that diverges sharply from what had been
originally proposed and from what otherwise would have been viewed as optimal.

Accordingly, agreement on a new rights structure will be affected by the distribution of
wealth that it authorizes. All things equal, very skewed rights arrangements lead to
pressure for redistribution through further negotiations, a lack of enforcement of existing
ownership, theft, and other forms of violence (Alston, Libecap and Mueller 1999b, 2000).
If the wealth allocation under the existing property-rights regime is so highly
concentrated that few have a stake in it, then it will lack legitimacy (viewed as "unfair")
and likely be unstable. Enforcement costs will be high, and those costs will drain wealth
and resources from productive endeavors. Further, if the property system is perceived to
be closed; that is, if nonowners have few practical means of becoming owners (either
through legal restrictions or through the size of the capital accumulation necessary to
acquire assets), then owners and non-owners will have different incentives to maintain
the property system. Some parties may prefer an incomplete specification of property
rights because such an arrangement allows for greater redistribution. The tension that
can exist between the wealth creation brought about by secure property rights and
redistribution pressures to redress a skewed distribution of wealth presents problems for
economic development.

By contrast, if entry is relatively open, that is, if there are recognized opportunities for
social and economic mobility, pressures for redistribution may be mitigated. With
economic mobility, the wealth assignment over time will be seen as more flexible so that
more parties can anticipate improvements in well being. If that is not the case, however,
and the proposed system of property rights is seen as having very narrow beneficiaries,
then a broad group consensus for property rights change may not occur.

[5]
These problems may be less critical in small-group settings where there is a history of
interaction, relative homogeneity of the bargainers, and strong social norms (Rose 2000).
4 Transaction-costs issues in the assignment and
modification of property-rights: measurement issues
The transactions costs of property-rights definition and change include the costs of
negotiating the assignment and transfer of rights, which are affected by equity disputes,
the measurement of asset value and individual allotments, monitoring compliance, and
the enforcement of the rights arrangement. These costs determine how property
institutions respond to changing economic conditions. In general, agreement on a new
property structure depends upon a number of factors. These include (1) the size of the
aggregate gains to be shared, (2) the number and heterogeneity of the bargaining
parties involved, (3) extent of limited and asymmetric information, (4) the physical nature
of the resource, including spatial constraints, and (5) the distributional issues discussed
above (Libecap 1989a, 1989b).

The larger the expected aggregate gains, the more likely some agreement will take place.
The total benefits of a new or modified property-rights regime often will not be
controversial. The wealth losses associated with common-pool competition will be
apparent to all. If the alternative of no agreement is so clear and dismal, then
negotiations can proceed quickly. This notion is illustrated empirically by the desire
among oil producing firms to unitize oil fields early to avoid the potentially large losses of
common-pool extraction.

In some cases, however, the gains from agreement are not so obvious and developing a
consensus for institutional change is difficult. The nature of the common-pool problem
may not be clear or the relative advantages of the proposed property-rights or regulatory
structure. For example, in many fisheries, incumbent fishers dispute the data presented
by fishery biologists regarding depletion of the stock. They resist the imposition of
regulatory controls. Only when the fishery is so depleted that there is little alternative will
a new rights arrangement be accepted. This condition explains why institutional change
frequently occurs late in the history of the exploitation of a resource after common-pool
losses have become so large that distributional concerns are relatively unimportant
(Wiggins and Libecap 1985). Unfortunately, by that time, much wealth has been lost.

The number and heterogeneity of the bargaining parties makes initial agreement and
subsequent adherence to it more difficult. This is a standard outcome in cartels and other
collective action settings (Schmalensee 1987). The greater the number of competing
interests with a stake in the new definition of property rights, the more claims that must
be addressed in negotiations to build a consensus on institutional change. But the
problem is compounded if the parties are also quite different in their expectations, costs,
wealth, size, or other important attributes. Under these conditions, it will be much more
difficult to reach agreement on a definition and distribution of property rights that satisfies
all parties.

For example in the unitization case described below, some firms with certain kinds of
leases may decide they are better off under the status quo (competitive extraction) than
under a new definition of property rights (unitization). They may chose not to join the unit,
even though there is consensus that the group as a whole would be better off under
unitization. Side payments are a way of compensating those who resist changes in
property rights, but deciding the amount to be paid, the nature and timing of the payment,
and the identities of the parties to fund and to receive the transfer can be contentious for
a number of reasons.

Measurement problems complicate an accord on any side payments that are under
consideration to draw in recalcitrant parties. Transfer payments require agreement on
the amount to be paid, which in turn depends on agreement on the value of current
holdings and of any losses that some parties expect as a result of the new definition of
property rights. Asset valuation under the current and proposed property-rights structure
can be a serious problem owing to uncertainty regarding income or cost projections or
the physical characteristics of the resource. The physical nature of the resource can
make it difficult to calculate share values for negotiations. It may make the costs of
marking and enforcing property rights more difficult. Relatively non-observable, migrating
resources are particularly difficult in the assignment of property rights, as experiences
with fish, water (especially aquifers) and oil demonstrate. Stationary, observable
resources with a history of stable prices are much more readily defined, valued, and
traded in property-rights negotiations.

Disagreements over measurement will be compounded if there are information
asymmetries among the parties regarding the value of individual holdings. These
disputes will occur quite aside from any strategic bargaining efforts if private estimates of
the value of current property rights and of potential losses from the new system cannot
be conveyed easily or credibly to the other bargaining parties.

In addition to honest disagreements over the values of individual claims, the information
problems encountered in devising side payments will be intensified if the parties engage
in deception or opportunistic behavior. Deception can be used to increase the
compensation given as part of an agreement on a new property-rights arrangement. It
occurs through willful distortion of the information released by various interests to inflate
the value of current property rights and the losses institutional change might impose.
Widespread deception by competing parties can make agreements more difficult by
reducing any trust that might otherwise promote the more rapid consideration of
individual claims in side payment negotiations.
5 Equity and measurement issues in property-rights
definition and change: oil-field unitization
5.1 The benefits of unit agreement: the incentive to assign property rights

Negotiation over the property rights implicit in oil-field unitization illustrates many of the
equity and measurement problems discussed in the previous sections. Oil-field
unitization involves the more precise assignment of property rights within oil and natural
gas reservoirs. It is especially important in the United States where the production of
crude oil and natural gas potentially involves serious common-pool losses (Libecap
1998a, 1998b; Libecap and Smith 1999). In the United States sub-surface mineral rights
are granted to surface landowners, and land ownership is fragmented. For stationary
resources, such as hard rock minerals, there is no serious common-pool problem.
Owners can mark their claims and produce from their deposits with little incentive to
compete with their neighbors. This is not the case with migratory hydrocarbons. Under
the common law rule of capture, private property rights to oil and gas are assigned only
upon extraction. Oil and gas can be attracted from one part of the reservoir to another
through production, which lowers subsurface pressures in that part of the formation,
encouraging migration. Landowners grant production leases to producing firms, and
these firms compete for the migrating oil and gas. At least initially, the more they produce,
the more they can drain their neighbors' leases. Firms competitively produce to increase
their private returns, even though these actions reduce the aggregate value of the
reservoir.

Oil reservoir value or rents are dissipated as capital costs are driven up with excessive
investment in wells, pipelines, surface storage, and other equipment. Rents also are
dissipated as production costs rise with too-rapid extraction. Rapid production of oil
results in the early venting of natural gas and/or water, which otherwise help drive the oil
to the surface. As natural gas and water are voided from the reservoir, costly pressure
maintenance or secondary recovery actions must be implemented. These actions involve
the use of additional pumps and injection wells. Total oil recovery falls as pressures
decline because oil becomes trapped in surrounding formations, retrievable only at very
high extraction costs. Finally, rents are dissipated as production patterns diverge from
those that would maximize the economic value of the reservoir over time.

Unitization grants more definite property rights to oil-field rents by assigning ownership
shares to each of the leaseholders. It involves an institutional change from competitive
extraction to coordinated production. Instead of multiple firms competing in production, a
single unit operator is selected to develop the field with costs and revenues apportioned
among the other parties according to a pre-defined allocation formula. The resulting
individual shares are private property rights. Firm owners become shareholders in the
ownership of the complete reservoir, rather than owners of individual production leases.
Indeed, the production lease loses its significance. Under unitization, all leaseholders
effectively are residual profit claimants, with joint incentives to develop the reservoir in a
manner that maximizes its economic value over time. Wells and other equipment can be
placed to maximize recovery and to minimize costs, and output can be controlled to
maintain sub-surface pressures and to increase overall recovery. With unitized
development and operation of reservoirs, no difference exists between the amount of oil
and gas privately supplied and the socially optimal amount. When producers expect
unitization to occur, exploration is encouraged because greater recovery rates and
reduced costs are anticipated. Bonuses and royalties to landowners are higher because
the present value of the oil and gas resource is greater with unitization.

Unitization can occur through private negotiation or through government-imposed units
(compulsory unitization). The gains from unit agreement have been understood for a
very long time, and they can be huge, both from savings in capital costs and from
[6]
increases in overall production that can be from two to five times unregulated output.
With so much at stake and so many gains from agreement, owners of oil firms are
motivated to form complete units early before the losses of the common pool are
incurred.
5.2 Equity and measurement problems in unitization negotiations

Despite its advantages, complete unitization is much more limited than one would expect
[7]
and negotiations often are contentious, taking a long time to conclude. Even when
unitization agreements are reached, many are not complete, leaving the potential for
various forms of competition among owners that dissipate rents.[8] In an examination of
seven units in Texas, Wiggins and Libecap (1985) and Libecap (1989b) showed that
negotiations took from four to nine years before agreements could be reached. Moreover,
in five of the seven cases, the area in the final unit did not cover the complete reservoir,
allowing common-pool problems to persist as parties outside the unit competed for oil
and gas lodged below unit members. As some firms became frustrated with negotiations,
they dropped out to form sub-units. But sub-units led to a partitioning of the reservoir, the
[9]
drilling of additional wells, and generally, did not minimize common-pool losses.

Other costs of not completely unitizing are shown on Prudhoe Bay, North America's
largest oil and gas field, first unitized in 1977. Two unit operators, separate net revenue-
sharing formulas for oil and gas, and associated competition among the oil and gas
owners resulted in protracted and costly conflicts among the parties on the field. This
arrangement did not effectively address the common-pool problem. In 1996, concerns
about wasteful production practices led the Alaska Oil and Gas Conservation
Commission to initiate hearings on a mandatory restructuring of the Prudhoe Bay Unit.
The April 2000 purchase of ARCO by British Petroleum and the subsequent reallocation
of Prudhoe Bay holdings among Exxon, Phillips, and British Petroleum reduced the
losses involved. But this event occurred after over twenty years of production.

These empirical examples reveal that although unitization increases the aggregate
returns to be divided among the firms on a reservoir, those gains alone are not enough
to bring about rapid agreement on unitization plans. There are a variety of equity and
measurement issues to be settled in negotiations. The parties must negotiate a sharing
rule that allocates the costs and revenues from production. The resulting property rights
must be durable and responsive to considerable uncertainty over future market and
geological conditions because field production often lasts twenty years or more. To
protect exclusivity, entry or exit of parties from the unit must follow specified parameters
if property rights are to be stable.
Further, property rights to the unit must take a particular form. To align all of the interests
in maximizing the economic value of the reservoir, development, capital, and operating
cost shares must be equal to revenue shares. In that case, each party will be a residual
claimant to the profits from effective operation of the entire unit. Under these
circumstances, the parties would not want to hold up needed investment or delay new
production practices (such as drilling injection wells) in order to opportunistically force a
re-negotiation of the contract. Such actions would not only reduce unit profits, but would
invite similar strategic behavior by other parties, eroding the basis for any long-term
cooperation to maximize the value of the unit. As such, the property-rights arrangement
provides for self-enforcing, cooperative behavior among the firms.[10] Accordingly,
although reaching agreement on the sharing formula can involve long and costly
negotiations, if the property rights take this form they will reduce ex post enforcement
costs.

If, however, the property-rights formula does not allocate costs and production shares in
the same manner, then conflicts will emerge. The parties will have differential incentives
for development depending on the nature of their individual benefits and costs, since
they no longer are allocated in the same way. Certain lease owners will advocate actions
that would skew development in the direction of those expenditures (such as injection
wells) in which they would bear lower costs, but higher returns, even if that is
inconsistent with maximizing the overall value of the unit. With costs and revenues
portioned differently, every production and investment decision will involve individual
calculations among the lease owners as to how the proposed activity would affect them.
Dissension, delays, and even violation of the unit agreement, all with corresponding rent
dissipation, are likely. Hence the need to distribute benefits and costs among the parties
according to the same formula.
Because property rights within unit agreements must take this specific form in order to be
effective, negotiations become even more difficult. They can be plagued by hold-outs
seeking to gain larger revenue shares or by honest disagreements over measurement or
equity. The latter occurs owing to disputes over the value of individual leases, which is
the basis for assigning shares. To resolve such disputes, some parties (typically those
with the largest leases and the most to lose) may devise side payments that restore
consensus among the parties and allow the unit to proceed. For example, some parties
may be granted a larger revenue share than their cost share. But as we have argued,
this arrangement will not align incentives over the long term. New disputes and conflicts
will emerge with the need for additional side payments, but these will only further distort
the property-rights structure. The efficiency losses inflicted on the unit from disagreement
and non-optimal production practices may be irreversible owing to resulting changes in
reservoir dynamics. Accordingly, ex post efforts to align interests via side payments are
not apt to be as effective as the ex ante proportionate assignment of costs and
production shares to each party through the property-rights rule. This example illustrates
how demanding the initial allocation of property rights can be and why it might take so
long to reach agreement.

If the leases are homogeneous, then equity and measurement disputes during share
negotiations are unlikely to be serious obstacles. Libecap and Smith's (1999) empirical
investigation of sixty units in the United States and Canada reveals those with relatively
simple and homogeneous geologic structures (no clustering of oil and gas in separate
parts of the reservoir) and only one production phase (no secondary recovery) have no
[11]
history of conflict. These units have sharing or property rules that assign costs and
revenues in an equal manner to each party and hence, align incentives for optimal unit-
wide production. These conditions describe 78 percent (forty-seven of sixty) of the units,
underscoring the importance all parties place on reaching effective agreement to
maximize the value of the reservoir over the life of the contract; 22 percent of the units,
however, do not have the requisite property-rights arrangement. These are more
complex units with multiple production phases and/or separate concentrations of oil and
gas, and the leases are much more heterogeneous. Because of complicated geological
conditions and associated uncertainty over lease values, negotiating conditions are more
complicated for these units, and such conditions affect the ability of the parties to reach
agreement on an incentive-compatible property-sharing formula. Especially in formations
where oil and gas are in separate pockets (gas caps), incomplete agreements exist, and
conflicts and rent dissipation follow, as illustrated by the case of the Prudhoe Bay Unit.

In these cases, negotiating over unit shares amounts fundamentally to the trading of
disparate assets among the parties. Because the reservoir has distinct physical
properties that are not uniformly distributed, some leases have large amounts of gas and
little oil, while others have more oil and less gas. Converting both into common values is
necessary to determine lease values and unit shares. But measurement of the relative
amounts of oil and gas and their value conversion from gas to oil are sources of dispute.
Similarly, certain parties may hold leases that provide natural sites for production wells
(for example, high on the formation) during primary production, while others may hold
leases that are better candidates for water or gas injection (for example, low on the
formation) during secondary production. Again, it will be necessary for the parties to
adopt terms of trade based on the lease locations and the potential for enhanced
recovery efforts to supplement the natural reservoir drive.

Through repeated negotiations, the parties typically are capable of translating differences
in quantity of resources into ownership shares in the unit. However, differences in kind
are more problematic. The basis for placing relative values on the oil and gas assets
often is not obvious to the bargaining parties. Gas ownership presents a particular
problem. The valuation of gas in the reservoir depends on whether it is assumed to be
marketed, as opposed to being re-injected in support of enhanced oil recovery efforts.
Gas values are more volatile than are those for oil and they do not always track one
another, making valuation and exchange of gas and oil properties difficult. Further, owing
to limited transportability in some cases, the existence of any external market for the gas
may be doubtful, especially in remote locations. To the extent that the imputed value of
gas is speculative, the parties find it difficult to adopt any conversion factor for gas to oil,
and hence will be unable to agree on any particular distribution of equity in the unit as a
whole.

In response to these conditions, the firms may elect to partition the unit in a way that
isolates differences among tracts and permits them to be negotiated separately. When
the reservoir is partitioned along any dimension, however, a boundary is created that
may incite competition for resources and for value. The existence of such partitions may
render the unit incomplete and hence, create conflicts of interest that dissipate reservoir
rents.

Other complexities that lead to measurement and sharing disputes, raising the
transactions costs of negotiation, include differences among the leases in terms of their
structural advantage on the formation. Owners of leases that have a natural structural
advantage will want to retain the value of this advantage in the unitization formula. Such
individuals are unlikely to agree to a unitization contract that does not give them at least
as much oil or gas, as they would have received by not unitizing. Even if the increase in
ultimate recovery from unitization is so great that these parties will receive more from
unit operations than from individual development, they have a much stronger bargaining
position in negotiations than less-favored tract owners. They can hold out for the most
favorable property-rights allocation, secure in the knowledge that the regional migration
of oil will continue toward their tracts during any delay in negotiations. Indeed, holding
out may increase the value of a structurally advantageous location. If the other firms form
a sub-unit without the participation of the owners of better-located tracts, the pressure
maintenance operations of the unit may increase the amount of oil migration toward the
unsigned parties. The hold-outs then benefit from the unit without incurring any costs of
the pressure maintenance activity.

These equity disputes require measurement of individual claims. Valuation is hindered
by incomplete and/or asymmetric information about current lease values and the effects
of unit-wide production, such as secondary and enhanced recovery, which are risky
technologically and economically. Such actions change the time pattern of oil and gas
production, perhaps lowering short-term payments to firms, while increasing payments
over the long term. Production patterns, however, are estimated only imperfectly so that
there may be disagreement as to the present value of individual leases and proposed
unit shares. Some parties may refuse to join the unit because they have different
information and assess the risks and rewards differently than do the proponents of the
unit.

In negotiations, the level of information available to the contracting parties for
determining lease values depends upon the stage of production in which contracting
occurs. In exploration, little is known regarding the location of hydrocarbons and
commercial extraction possibilities. At that time, all properties are relatively
homogeneous, and unitization agreements can be comparatively easy to reach with low
transactions costs, using simple allocation formulas to assign property rights, often
based on surface acreage. Since no party knows whether the formula is to its particular
advantage or disadvantage, negotiators can focus on the aggregate gains from
unitization.

Information problems and distributional concerns, however, arise with development, as
oil and gas reserves are proved and expanded. With the initial discovery well and the
drilling of subsequent wells, lease heterogeneities emerge. Because reservoirs are not
uniform, the information released from a well is descriptive of only the immediate vicinity.
Hence, through drilling on their individual leases, firms gain knowledge of their portion of
the reservoir. The full extent of the deposit and the productive potential of other areas of
the reservoir will be revealed only through the drilling activities of other firms. Other
parties will not hold this asymmetric information so that verifying claims based on it will
be difficult.

Some of information is public, objectively measured, and non-controversial, such as the
number of wells on the lease, its surface acreage, and the record of current and past
production. Other data are more private, more difficult to measure, more subjective, and
hence, more likely to be disputed, such as the amount of oil below lease lines, remaining
reserves, net oil migration, and bottom hole pressure. As a result of disagreements over
the measurement and interpretation of sub-surface parameters, unit negotiations often
must focus on a small set of objectively measurable variables, such as cumulative output
or wells per acre. These objective measures, however, may be poor indicators of lease
value.

Conflicts over lease values and unit shares will continue until late in the life of a reservoir.
With the accumulation of information released through development and production,
public and private lease value estimates converge as primary production (production
based on natural sub-surface pressure) approaches zero. At that point, a consensus on
shares and the formation of the unit is possible. This suggests that unit agreements are
more likely to be reached late in the life of the reservoir. Unfortunately, by that time most
of the open-access losses have been inflicted.

[6]
Libecap and Wiggins (1984) cite industry trade journals for predictions that unitization would
raise oil recovery by 130 million barrels on the Fairway field in Texas.

[7]
Joe Bain (1947, p. 29) commented on the problem of fragmented lease holdings in the
United States for unitization. He stated: "It is difficult to understand why in the United States,
even admitting all obstacles of law and tradition, not more than a dozen pools are 100 percent
unitized (out of some 3,000) and only 185 have even partial unitization." Similarly, Libecap
and Wiggins (1985) reported that as late as 1975, only 38 percent of Oklahoma production
and 20 percent of Texas production came from reservoir-wide units.

[8]
Wiggins and Libecap (1985) and Smith (1987) examine some of the bargaining issues faced
by unit negotiators. See discussion in Libecap (2001).

[9]
For example, after unsuccessful efforts to completely unitize the 71,000 acre Slaughter field
in West Texas, ultimately 28 sub-units were established, ranging from 80 to 4,918 acres. To
prevent migration of oil across sub-unit boundaries, some 427 offsetting water injection wells
were sunk along each sub-unit boundary, adding capital costs of $156 million (Libecap 1989a,
p. 106).

[10]
As described by Klein and Murphy (1997, p. 417), "the self-enforcing range measures the
extent to which market conditions can change, thereby altering the gains to one or the other
party from nonperformance, without precipitating nonperformance." (See Libecap and Smith
1999.)

[11]
The empirical investigation uses sixty unit-operating agreements from oil and gas
reservoirs in Alaska, Alberta, Illinois, Louisiana, Oklahoma, New Mexico, Texas, and
Wyoming.
Notes
1. The material here draws on my chapter in Anderson and McChesney
(2001).
2. Yoram Barzel (1989) emphasizes transactions costs and measurement
problems in implementing property rights regimes.
3. The problem of the common pool was outlined early by Gordon (1954)
and the notion of rent dissipation clearly described by Cheung (1970).
4. Of course, if the rights structure already is incomplete, such that there
are divergences between the net private and social returns of resource
use (externalities), then regulations on resource use can be socially
beneficial.
5. These problems may be less critical in small-group settings where there
is a history of interaction, relative homogeneity of the bargainers, and
strong social norms (Rose 2000).
6. Libecap and Wiggins (1984) cite industry trade journals for predictions
that unitization would raise oil recovery by 130 million barrels on the
Fairway field in Texas.
7. Joe Bain (1947, p. 29) commented on the problem of fragmented lease
holdings in the United States for unitization. He stated: "It is difficult to
understand why in the United States, even admitting all obstacles of law
and tradition, not more than a dozen pools are 100 percent unitized (out
of some 3,000) and only 185 have even partial unitization." Similarly,
Libecap and Wiggins (1985) reported that as late as 1975, only 38
percent of Oklahoma production and 20 percent of Texas production
came from reservoir-wide units.
8. Wiggins and Libecap (1985) and Smith (1987) examine some of the
bargaining issues faced by unit negotiators. See discussion in Libecap
(2001).
9. For example, after unsuccessful efforts to completely unitize the 71,000
acre Slaughter field in West Texas, ultimately 28 sub-units were
established, ranging from 80 to 4,918 acres. To prevent migration of oil
across sub-unit boundaries, some 427 offsetting water injection wells
were sunk along each sub-unit boundary, adding capital costs of $156
million (Libecap 1989a, p. 106).
10. As described by Klein and Murphy (1997, p. 417), "the self-enforcing
range measures the extent to which market conditions can change,
thereby altering the gains to one or the other party from nonperformance,
without precipitating nonperformance." (See Libecap and Smith 1999.)
11. The empirical investigation uses sixty unit-operating agreements from oil
and gas reservoirs in Alaska, Alberta, Illinois, Louisiana, Oklahoma, New
Mexico, Texas, and Wyoming.
Theoretical Developments”Where do we
Part IV:

Stand?
Chapter 10: Transaction Costs and Incentive Theory
Chapter 11: Norms and The Theory of the Firm
Chapter 12: Allocating Decision Rights Under Liquidity Constraints
Chapter 13: Complexity and Contract
Chapter 14: Authority, as Flexibility, is at the core of Labor Contracts
Chapter 15: Positive Agency Theory”Place and Contributions
Transaction Costs and Incentive
Chapter 10:

Theory
Eric Malin, David Martimort
1 Introduction
Over the last twenty-five years, incentive theory has been used as a powerful tool to
describe how resources can be allocated in a world of decentralized information. The key
achievement of incentive theory is that it provides a full characterization of the set of
implementable allocations when resources within an organization must be allocated
under informational constraints. The basic tool to obtain such a characterization is the
Revelation Principle which has been demonstrated independently by several authors.[1]
The Revelation Principle stipulates that any contractual outcome achieved by an
organization where information is decentralized among its members can equivalently be
implemented with a simple direct mechanism where privately informed agents send
messages on their own piece of information to a mediator who, in turn, recommends
plans of actions to those agents. Moreover, the agents' messages are truthful in
equilibrium, i.e. the mechanism must satisfy a number of incentive compatibility
constraints. If the mechanism must be voluntarily accepted by the agents, some
participation constraints must also be satisfied. These two sets of constraints completely
characterize the set of feasible allocations under asymmetric information.

Once this first step of the analysis is completed, one can stipulate an objective function
for the organization and proceed to further optimization. This optimization leads to an
interesting trade-off between the achievement of allocative efficiency as Coasian
bargaining would permit under complete information and the cost of insuring incentive
compatibility. Under asymmetric information, conceding informational rents to privately
informed agents must be done at the minimal cost and this has allocative consequences.
The distribution of payoffs in the organization and the overall size of the cake to be
shared among its members are determined simultaneously.

This two-step procedure has led to an enormous amount of work which is very much
normative by nature and which, over the last twenty-five years, has changed our view of
economics. Progress owing to incentive theory has spanned as many different fields as
[2] [3]
labor economics, the theory of the firm, regulation and procurement, public good
[4] [5] [6]
provision, optimal taxation, and, more recently international trade. Roughly and to
simplify, any field in economics benefitted from being reconsidered through the lens of
the rent“efficiency trade-off.

Interestingly, the optimal direct mechanism which is found following this two-step
procedure may be implemented in many different ways by real-world institutions, i.e. by
some sort of indirect mechanism. For instance, in the procurement context we analyze
below, the optimal output produced by a privately informed seller (the agent) for an
uninformed buyer (the principal) can equivalently be implemented by letting the agent
report his information to the principal and having the latter choose the particular output
target and compensation or by letting the principal offer a non-linear price and letting the
agent choose within this menu his most preferred choice. In the first case, the agent has
no freedom of actions except on his report to the principal who exerts formal and real
authority. In the second case, the agent exerts some form of real authority within the
constrained set of decisions proposed by the principal. As a consequence, the optimal
scheme cannot explain the allocation of authority within the firm. Moreover, whether the
agent works in the buyer's firm or owns his own productive unit has no consequence for
the overall allocation of resources. Firms' boundaries are irrelevant in this context.
This indetermination in the implementation procedure has fascinating consequences
since it amounts basically to an Irrelevance Theorem. One of the most striking
applications of this Irrelevance Theorem is that ownership may have no impact on the
optimal allocation of resources in the economy. For instance, Sappington and Stiglitz
(1987) have shown that a publicly owned firm and a regulated privately owned one can
both be induced to produce the same socially optimal output at the same incentive cost
by a clever design of the procedure for auctioning the right to produce to the private
sector. In this case, privatization has no impact on how resources are allocated between
the public and the private sectors of the economy.
At first glance, this Irrelevance Theorem bears a strong resemblance to the traditional
Coase Theorem which states that decentralized bargaining is enough to achieve
allocative efficiency and that this outcome is independent of the allocation of property
rights. First, note that this latter theorem presupposes that there is no asymmetric
information and no transaction costs of any sort. For a given form of decentralized
bargaining, asymmetric information introduces allocative inefficiency.[7] However, these
inefficiencies depend on the allocation of property rights through the role that those rights
play in determining the status quo payoffs of agents in the bargaining.[8] The Irrelevance
Theorem differs from the Coase Theorem along several lines. First, it assumes a world
of asymmetric information. Second, for a given set of property rights, it assumes that
decentralized bargaining is replaced by a centralized design of the procedure for
allocating resources in the organization. This is the implementation of this centralized
design which is somewhat indetermined, since it can be realized in many different ways
which have different observational consequences in terms of the distribution of authority
in the organization (see our procurement example above). Third, if the procedure for
allocating resources also includes the possibility of allocating ownership through ex ante
auctioning, clever design makes the allocation of ownership irrelevant.

As a consequence, this Irrelevance Theorem has often been interpreted as implying that
incentive theory has nothing to say about such things as the distribution of authority
within an organization, the limits of the firm, the separation between the public and the
private spheres of the economy, and, more generally, nothing to say about
organizational forms and designs.
In our view, this criticism is clearly valid. However, we think that scholars who advocate
this "criticism approach" fail also to give enough justice to what incentive theory is really.
Those opponents of incentive theory have been too eager "to throw away the baby with
the bath water." Indeed, the commonly held view of incentive theory provides us only
with an ideal benchmark: it describes a world which is frictionless, a world in which
transaction costs are absent or at least negligible. In other words, the Revelation
Principle is a natural extension of the Arrow“Debreu world to asymmetric information
settings. As it is almost nonsensical to explain market conduct and firm's performance
within an Arrow“Debreu world, it becomes almost useless to discuss organizational
forms with the Revelation Principle as the only tool at hand.
This chapter argues that simple and tractable extensions of standard incentive theory
can nevertheless take into account various forms of transaction costs and that those
forms of transaction costs lead to various contract incompletenesses which can be easily
described. Indeed, those forms of incompletenesses are shown to preserve the great
advantage of incentive theory, i.e. its ability to describe feasible allocations. To do this
the standard Revelation Principle must be conveniently amended by introducing some
transactional constraints which altogether with incentive and participation constraints
again completely describe feasible allocations. This characterization, in turn, leads to
interesting third-best optimizations which describe a world in which the Irrelevance
Theorem does not any longer hold. Within this third-best approach, various
organizational forms can thus be compared and, we believe, interestingly distinguished.
Section 2 presents the standard rent“efficiency trade-off to which we will refer
throughout the chapter. It also solves for the second-best optimal contract in a
transaction cost-free world. Section 3 discusses the assumptions underlying the
applicability of the Revelation Principle and shows how various transaction costs
correspond to relaxation of some of these assumptions and that the corresponding grand
contract becomes then somewhat incomplete. Section 4 shows that those
incompletenesses are in fact associated with contractual externalities which affect the
third-best outcome. We show also that there exist quite general reduced-form formula
describing the impact of these transactional constraints.

[1]
See Green and Laffont (1977); Dasgupta, Hammond and Maskin (1979); Harris and Raviv
(1979); and Myerson (1979).
[2]
See Hart and Holmström (1987b) for survey of these two fields.

[3]
See Laffont and Tirole (1993).

[4]
See Laffont and Maskin (1982).

[5]
See Mirrlees (1971) for his seminal and pathbreaking paper.

[6]
See Brainard and Martimort (1997), for instance.

[7]
See Fudenberg and Tirole(1991, chapter 7). Moreover, Myerson and Satterthwaite (1983)
have shown that the Pareto-efficient bargaining procedures under informational constraints
require some allocative inefficiency.

[8]
See Cramton, Gibbons and Klemperer (1987), on this point.
2 The rent-efficiency trade-off: a procurement example
As an example of the two-step procedure underlying the use of the Revelation Principle,
let us consider the following procurement setting. A principal, the buyer, delegates
production of an output to an agent, the seller. The principal gets a benefit S (q) (with S
> 0, S < 0) from consuming q units of the procured good. The agent incurs a cost q
from producing q units. The marginal cost is privately known by the agent. It is drawn
in a common knowledge distribution having for support { , } (we denote = the
spread of the uncertainty) with respective probabilities and 1 .
Of course, first-best efficiency obtained under complete information requires that
production qFB( ) is set such that marginal cost equals marginal benefit, i.e.:

for both values of .

This contractual outcome can be easily implemented by allowing the principal to make a
take-it-or-leave-it offer to the agent. For a given output target recommended to the agent,
the principal compensates the latter with a lump-sum transfer so that the agent is just
indifferent between producing or not for the principal.
This first-best solution can no longer be implemented under asymmetric information.
Indeed, as can be easily shown, the efficient agent would like to claim that he is
inefficient to produce the smaller output qFB( ) recommended by the principal to the
FB
inefficient agent. By doing so, he can save on the production cost an amount q ( )>
0.
In what follows, we denote by GC ={(q, U); (q, U)} the grand contract offered by the
principal to the agent. From the Revelation Principle, this is a direct mechanism which
induces production and allocates informational rents (q, U) when the firm claims to be
efficient and (q, U) when, on the contrary, it claims to be inefficient.
To induce information revelation from the efficient agent, the principal has to leave an
informational rent U to the efficient agent which satisfies the following incentive
compatibility constraint:


Similarly, the principal has to induce participation from the least efficient agent. The
following participation constraint has thus to be satisfied:


It is standard to show that the optimal contract solves the following reduced-form
problem[9]:



In the last maximand, one can recognize on left the expected efficiency which would be
maximized under complete information and on the right the expected cost of the
informational rent which is now incurred by the principal under asymmetric information.
Optimization leads to the following second-best outputs:


and



Comparing second-best and first-best outputs,


i.e. there is no allocative distortion for the most efficient agent; and
i.e. there is a downward distortion of the output requested from the least efficient seller.

Therefore, (6) clearly highlights the rent-efficiency trade-off discussed earlier. By
reducing output requested from an inefficient agent, the principal reduces the costly
informational rent of an efficient one. The distribution of informational rents within the
organization and the allocative efficiency cannot be disentangled under asymmetric
information.

[9]
Here, we have omitted the incentive compatibility constraint of the inefficient firm and the
participation constraint of the inefficient one which both turn out to be strictly satisfied at the
optimum.
3 The ideal world of the Revelation Principle
That the Revelation Principle describes an ideal world can be easily understood by
coming back to the assumptions underlying its applicability. Doing this is important first to
understand the real domain of applicability of this Principle and second to define
explicitly what should be a good definition of transaction costs from the point of view of
incentive theory:
Definition of transaction costs for incentive theory: In our view,
transaction costs should be understood as all sorts of impediments to the
applicability of the Revelation Principle.
Our definition is more precise than that given by Coase (1937) and Williamson
(1985, 1996) who argue that transaction costs are all sort of costs incurred both
the ex ante (negotiation or writing costs) and ex post (renegotiation, arbitration
costs). Concerning ex ante transaction costs, this definition is somewhat
imprecise since it puts under the same hat costs of different nature: costs owing
to asymmetric information (negotiation) and costs owing to some limited ability
to foresee contingencies or to think about their consequences. Concerning ex
post transaction costs, again the definition is unclear. Indeed, renegotiation
costs are the consequences of some form of limited commitment which can be
explained only by introducing loopholes of the judiciary system, and thus other
transaction costs Arbitration points instead to enforcement problems which
are again linked to limits of the judiciary system in case of unforeseen
contingencies. In other words, the actual definition of transaction costs à la
Coase-Williamson is somewhat self-referencing.
Our definition being stated, we can discuss all the different assumptions
underlying the Revelation Principle and trace out the corresponding transaction
costs which limit its applicability.
Assumption 1: full rationality and complexity This is a rather simple
observation to make but it deserves to be made. Implicitly, behind the
Revelation Principle is the assumption that the mediator (or principal) is
able to perfectly reconstruct the strategies of privately informed agents and
to include their plans of actions into his recommendations about how the
direct mechanism he proposes should be played.

As recognized by Williamson (1975), bounded rationality is one of the possible
transaction costs which impedes contractual efficiency. This point is well taken,
but neoclassical economics is still having difficulties dealing with this problem
and the honest course is to recognize that transaction-cost economics (TCE)
has not provided us with a powerful analytical treatment of this issue as well. As
such, this obviously does not point to a weakness of incentive theory and we will
have almost nothing to say on this issue in this chapter.[10]
Assumption 2: perfect communication Once communication channels
between the mediator and his agents have been opened, information flows
up and recommendations flow down costlessly within the organization. This
is of course an extreme assumption but little is known on contracting under
[11]
communication constraints. The methodological problem here is
extremely close to that faced when one wants to deal with bounded
rationality. It is quite easy to describe what happens with perfect
communication (as with perfect rationality), it is much less easy to introduce
convincing restrictions on communication (like convincing restrictions on
the ability of agents to perform correct computations). The modeler here
necessarily falls in the realm of adhocity.

Clearly, incentive theory has not yet offered a satisfactory treatment of imperfect
rationality and imperfect communication. But again, incentive theory is waiting
for more fundamental developments of theory which would help the modeler to
cope efficiently with those issues and which would benefit other fields of
economic theory as well.
Assumption 3: full control of communication channels between agents
The mediator used in the Revelation Principle has full control of the
communication channels he opens with the privately informed agents. This
means that he can prevent at no cost bilateral communication among
agents of the organization.
Assumption 4: full control of communication channels between agents
and other mediators The mediator used in the Revelation Principle can
also prevent at no cost the communication of any of these agents with
outsiders or external mediators who do not further communicate with the
initial mediator and do not share his objectives.

To understand the consequences of relaxing assumptions 3 and 4, assume now that
there exist some unmodeled transaction costs which make the mediator unable to
control all possible communications that an agent of his organization can open.

The first limit on the ability of the principal to control communication channels among
agents raises the issue of collusion and clique formation among workers or between
agents and their supervisors. These collusions have been shown to impact quite
significantly on the efficiency of an organization, as we have learned from industrial
sociologists in the field of the theory of the firm[12] and from political scientists in the field
[13]
of organization of government.
The second limit on the ability of the principal to control communication channels
between agents and outside mediators points to the fact that there is nothing like a single
principal ruling all the activities of the economy. The norm instead is that agents report to
several principals who may have conflicting interests. This is clearly the case of the
management of the firm who is involved in several bilateral contracts with customers,
[14]
shareholders, creditors, regulators, and so on But multiprincipal structures also
[15]
abound within governments.
Both contractual limits above can be dealt within an incentive theory framework. In both
cases, the Revelation Principle must nevertheless be amended. When collusion among
agents matters, the set of implementable allocations is conveniently described by
appending to the initial individual incentive and participation constraints that must be
satisfied by a direct mechanism, the coalition incentive compatibility constraints which
guarantee that the possible coalitions which can form do not gain from collectively
manipulating informational reports to the principal. This last step of the analysis was first
performed in the early 1970s[16] but it received its most convincing treatment only with
Tirole (1986, 1992) for collusion under symmetric information and Laffont and Martimort
(1997, 2000) for collusion under asymmetric information. In that latter case, bilateral
collusion is itself impeded by asymmetric information among colluding agents. Still, the
set of implementable allocations can be easily described and the optimization within this
set leads generally to a constrained optimum when collusion is a binding concern of the
organization.
When communication with other principals matters, the set of equilibrium allocations of
the game among non-cooperating multiprincipals is hard to describe by simple direct
[17]
mechanisms. However, as was initially suggested in Martimort (1992) and formally
proved independently in Martimort and Stole (1999a, 1999b) and Peters (1999), the set
of equilibria can be described with a Taxation Principle. This Taxation Principle stipulates
that any equilibrium outcome of a game with competing mediators can be replicated
when mediators offer non-cooperatively indirect mechanisms which leave to the common
agents the choices of actions within those initially suggested by these mediators. In other
words, when one moves from the one-principal setting to a multiprincipal setting, direct
mechanisms becomes useless to describe equilibrium allocations. Instead, agents must
now keep most decisionmaking and their information to themselves instead of sending it
to their competing principals who would otherwise enter into infinite gaming to induce
report manipulations into the mechanisms offered by their respective rivals.

Note that in both cases above, the existence of transaction costs which make a principal
unable to control all communication channels within his organization does not make
impossible a clear characterization of the set of implementable allocations. Incentive
theory can still describe how transaction costs which make the control of all
communication difficult or impossible for the principal to affect the set of feasible
allocations.
Assumption 5: full commitment An important assumption behind the use of
the Revelation Principle is the fact that the mediator can commit to the
mechanism he proposes to the agents. Commitment is the right benchmark
for complete contracts. If parties to the contract find it beneficial to commit
ex ante, they should be able to do so just by committing to pay large
penalties in case of renegotiation. However, commitment is hard to justify if
it is not sequentially optimal. Indeed, in the course of actions, information
which would make beneficial a Pareto-improving recontracting may become
available.[18] This issue naturally arises in the case of long-term contracting
where the agent's choice of action in the first period reveals information to
the principal before the second-period contract is implemented.[19] Also, it
arises even within a single period of contracting when the principal uses a
direct mechanism and learns the agent's report on his type before sending
[20]
him a recommendation or when the principal contracts ex ante with the
agent (i.e. before the latter learns his information) and the agent's action is
chosen after his own learning of the information. In the first case, the
mechanism may be subject to ex post renegotiation taking place before the
second-period contract is executed. In the second case, the mechanism
may be threatened by interim renegotiation taking place just before its
execution itself.
However, in both cases, the principal can perfectly anticipate the issue of the
renegotiation and include this issue into his initial offer. By doing so, the principal
ensures that the initial renegotiation-proof contract he offers will come unchanged as an
equilibrium outcome of the game of initial contractual offer cum renegotiation. The
Renegotiation-Proofness Principle is a natural extension of the Revelation Principle to
this limited commitment environment. Incentive theory can again describe all equilibrium
allocations by adding to standard incentive and participation constraints a set of
renegotiation-proofness constraints.

Here, the impossibility of intertemporal commitments finds itself its origins in various
loopholes of the judiciary system, if one is interested in private contracting, or of the
Constitution if one is instead interested in public contracting. Transaction costs make
those commitments difficult or impossible. Nevertheless, incentive theory can still
describe the set of feasible allocations and can still allow us to optimize within this set.
Assumption 6: mediator's benevolence The mediator of the Revelation
Principle is assumed to be a benevolent agent taking the objectives of the
organization as his own. In reality, there is a substantial amount of
delegation to those mediators. These may be political decision-makers to
whom power has been given in elections or these may be CEOs to whom
shareholders have delegated the control of the firm. Those principals have
both private information on how the organization should be run and also
private agendas that they may pursue.[21]
The delegation of decision-making to those non-benevolent mediators is thus
itself plagued with transaction costs. Again, incentive theory can perfectly
describe the contractual imperfections associated with these transaction costs
by simply adding the necessary incentive constraints characterizing the behavior
of these biased mediators.
Assumption 7: costless enforcement Within the realm of the Revelation
Principle, the contract between the mediator and the agents is supposed to
be perfectly enforceable. Contract enforcement is not an issue. In other
words, the judiciary system is perfect and uncorruptible. Several problems
arise when the judge enters into the picture. First, the set of verifiable
variables which can be part of a contract is somewhat endogenous. It
depends on the limited amount of attention and time that the judge is ready
to spend on the particular contractual issue which is at stake. This is a
moral-hazard problem. Second, the contract may specify outcomes for
some contingencies which have to be clearly assessed by the judge. This
raises the issue of collusion between the judge and one of the contracting
parties.
The judiciary system is thus very much the source of various contractual
inefficiencies which can be modeled only by making the judge be an actual
player of the game with his own incentives and rewards. In a sense, the costly
enforcement framework which is called for at this point is badly defined since
introducing the judge as an actual player would call for another layer of
enforcement device. One can think of reputations and more general repeated
relationships as the potential glue to provide the right incentives to the judiciary
system. However, if one believes in this last argument, costly enforcement of an
imperfect judiciary system can only be a theoretical issue in the short run and
this does not seem to be the case.

In this chapter, we will have little to say on this enforcement issue since little or, more
precisely, nothing, is so far known about the role the judge in the design of incentive
schemes.

[10]
In the property-rights literature, the debate between Maskin and Tirole (1999b) and Tirole
(1999) and Grossman and Hart (1986) and Hart and Moore (1999a) also shows that the
perfect ability to describe contingencies and the corresponding payoffs and to perform
backward induction, in other words, unlimited rationality, is enough to recover efficiency even
when no ex ante contract can be written as long as renegotiation of the revelation games
used to implement this outcome is not an issue.

[11]
See nevertheless Green and Laffont (1986).

[12]
See Dalton (1959), Gouldner (1961), and Crozier (1963), among others.

[13]
See Moe (1984), for instance.

[14]
See Williamson (1985, chapter 11) for a clear overview of these bilateral deals and the
corresponding contractual externalities.

[15]
See Wilson (1989), Martimort (1996b), and Dixit (1996), who all argue or formalize that the
difference between public and private bureaucracies comes from the fact that bureaucrats are
controlled by multiple principals in the former case.

[16]
See Green and Laffont (1977), and various contributions therein.

[17]
See Epstein and Peters (1996) for a definition of the set of relevant types to which the
Revelation Principle should apply. This set includes both physical types and market-like
information (the contracts of other principals).

[18]
Moreover, the French Code des Contrats, for instance, allows contractual partners to write
a new contract if they wish so.

[19]
See Dewatripont (1988, 1989), Hart and Tirole (1988), and Laffont and Tirole (1993,
chapter 9).

[20]
See Beaudry and Poitevin (1993).

[21]
In both examples above, the loss of control is particularly acute since there is a multiplicity
of "principals of the principal" (voters and shareholders) who may fail to coordinate in exerting
perfect control of the latter.
4 Contractual externalities and transaction costs
To summarize section 3, the Revelation Principle presupposes a set of assumptions
which describes an ideal world which is free of any transaction cost. Relaxing these
assumptions amounts to introducing various transaction costs which impede the
achievement of the second-best rent“efficiency trade-off obtained in the frictionless
world. However, except for the case of bounded rationality and perfect communication,
incentive theory still provides a useful description of the constrained feasible set. Once
this first step of the analysis is completed it becomes easy to find the constrained optimal
contract subject to incentive, participation, and some newly defined transaction-costs
constraints.
Importantly, relaxing any of assumptions 3“6 amounts to introducing the possibility that
the initial grand contract offered by the mediator to his agents is perturbed by further
contractings. This may be collusive side contracting between agents of the organization
(assumption 3), this may be external contracting with other mediators (assumption 4) or,
finally, this may be explicit or implicit recontracting with the principal himself
(assumptions 5 and 6). These further contractings introduce various contractual
externalities which affect grand contracting.
Transaction costs thus imply some form of incomplete grand contracting and some kinds
of contractual externalities associated with that incompleteness.
It is useful to classify contractual externalities with respect to their respective impact on
the rent“efficiency trade-off discussed in section 3.
We will say that an externality is negative (resp. positive) if the rent“efficiency trade-off is
tilted towards excessive rent extraction (resp. excessive efficiency). In this case, there is
too much (resp. not enough) rent extraction in the organization with respect to the case
without further contracting.
Coming back to our procurement example, it is easy to write a priori an ad hoc formula
describing the optimal output choice of the organization when the optimal second-best
trade-off between rent extraction and efficiency is achieved.

Since only the inefficient seller's output is affected by contracting under asymmetric
information, let us write the third-best output of this agent when both incentive and
transactional constraints are taken into account as:

is a parameter which is positive (resp. negative) in the case of a positive (resp.
negative) externality.
Still in our procurement example, we now discuss how the various transaction costs
previously discussed affect the value of .

4.1 Vertical collusion

Let us now assume that the buyer vertically integrates the production stage. To further
control the production process, the owner“buyer sets up a monitoring system: a
supervisor is used to report any informative signal that he may have learned on the
[22]
seller's cost parameter.
Let us further assume that these signals are hard information.[23] With conditional
probability the supervisor learns that the seller is efficient. Otherwise, she learns
nothing.

The fact that both the supervisor and the seller know some piece of information unknown
to the principal leaves them the possibility of reaching a collusive side deal to manipulate
this information and to share the gain of this manipulation.
In this case, the general expression for is the following:

where k [0, 1] is a parameter representing the efficiency of side contracting. k
decreases when the collusive side contract suffers from greater transaction costs.
Here, the overall contractual externality is positive. Setting up a monitoring system
improves incentives within the integrated firm and this definitively tilts the rent“efficiency
trade-off towards efficiency. However and this last point illustrates Williamson's view of
the large integrated firm as a bureaucratic structure,[24] that setting up a monitoring
system also creates the scope for collusion between the supervisor and the seller unit.
This last force is in fact a positive contractual externality. With respect to the case of no-
collusion (k = 0), output should be reduced more as collusion becomes more efficient (k
increases). Since the collusive stake is proportional to output, the cost of the binding
collusion-proofness constraint necessary to induce information revelation from the
supervisor is reduced with these downward distortions of output. The optimal contract
moves towards a more bureaucratic rule leaving little discretion to the privately informed
supervisor.
Several theories are now available to describe the behavior of these vertical collusions,
i.e. to give foundations to the parameter k:
Exogenous k : hidden transfers Tirole (1992b) argues that, side
transfers being implicit, enforced by a word of honor or by cultural norms
within the organization, members of a collusive deal must incur some
transaction costs of side contracting so that necessarily k < 1.

Laffont and Martimort (1999) show that the design of the monitoring structures and in
particular the division of tasks[25] between supervisors helps to reduce the overall cost of
implementing a collusion-proof allocation. Laffont and Meleu (1997) argue informally that
the reciprocity of favors in an organization reduces these transaction costs of side
contracting.
Endogenous k : repeated collusive relationships Martimort (1999a)
endogenizes this parameter by explicitly modeling the repeated
relationship between a principal, his supervisor and his agent. Side
contracts are now enforced as self-enforcing collusive equilibria of a
repeated game.[26] More precisely, one has:


where r > 1 is greater if collusive agents have a shorter life in the organization.
More informative signals for the supervisor and greater future prospects of a
continuing collusive relationship increases the efficiency of side contracting and
tilts the optimal grand contract towards more rent extraction.
Endogenous k : delegated monitoring Faure-Grimaud, Laffont and
Martimort (1999a, 1999b) analyze hierarchical supervisory structures as
nexi of bilateral vertical contracts between first, a principal and an
informed supervisor, and, second, an informed supervisor and an even
more informed agent. The design of the delegated contract can be
viewed as the choice of a moral-hazard variable from the point of view of
the top principal. With risk aversion at the supervisory level, there is an
interesting trade-off between providing incentives to this supervisor to
choose the right contract with the agent from the point of view of the
overall organization and providing him insurance against shocks in the
agent's cost parameter.

In those nested information structures, formula (8) is still valid provided that:

Now the efficiency of side contracting is greater when the supervisor has more
informative signals on the agent ( greater), when he is harder to control (greater degree
of risk aversion ) and when collusive stakes are greater ( q greater).
Note that with endogenous k, becomes now a function of various organizational
parameters: information structures, preferences of the agents, technology, and
bargaining power of the supervisor at the side contracting stage. In this third-best world,
the exact design of the organization is no more neutral with respect to the rent“efficiency
tradeoff. The Irrelevance Theorem no longer holds in this context and there is scope for
such things as authority structures, limits of the firm, ownership, and limits between the
public and the private spheres[27] since these are all parameters which influence
significantly the transaction costs of side contracting.

4.2 Delegation
Suppose that the buyer cannot procure the good directly but must rely on an
intermediary to do the job. This intermediary acts thus as a principal for the seller, he
may have a productive task himself or not. The impossibility of a direct contract between
the final buyer and the seller creates a setting of sequential contractings between
different layers of the hierarchy. Here, the exact timing of contracts signing and the
information structure at the time of this signing is quite important to evaluate the true loss
(if any) of delegated contracting.
Baron and Besanko (1992), Mookherjee and Reichelstein (1995), and Laffont and
Martimort (1998) isolate conditions under which delegation per se does not affect the
rent“efficiency trade-off, i.e. = 0. In those settings characterized by risk-neutrality of the
intermediary and ex ante contracting, some form of the Irrelevance Theorem still applies
even if the intermediate principal may be privately informed. The exact design of the
organization does not really matter.

This is no longer true when there is some communication constraint and (or) some form
[28]
of interim contracting as in Laffont and Martimort (1998) and McAfee and McMillan
(1995) or some form of moral-hazard constraint (veto constraint) on the intermediate
principal as in Faure-Grimaud and Martimort (1999).[29]

In this case, summarizing various results in the literature, we have:


where ( , , q) [0, 1] and is equal to 0 in the case of a risk neutral intermediate
and 1 in the case of an infinitely risk averse one. Moreover, as shown in Faure-Grimaud
and Martimort (1999), ( , , q) is increasing in the stake q, capturing the fact that
delegation becomes more costly as the intermediate principal has more stake to control.
The contractual externality here is negative. Indeed, the contractual chain of contracts
induces distortions extremely close to the "double marginalization effect" of the industrial
organization literature.[30] The top principal does not internalize the fact that the
intermediate principal has already reached a balance between efficiency and rent
extraction at the time of contracting with the latter.

4.3 Multiprincipals

A multiprincipal setting is extremely close to a model of delegation. The main difference
is that there is no principal on top of the organization, i.e. sequential contracting has to
be replaced by simultaneous bilateral contractings between the common agents and
their non-cooperative principals.
Let us come back to our procurement example and assume that instead of one buying
unit, there are two buyers each with a surplus Si (qi) from consuming qi units of the
[31]
procured good. Each of these buyers contracts independently with the common seller.
Two cases must be distinguished.
4.3.1 The case of complements
Suppose that the seller is a Research and Development (R & D) venture which provides
to both upstream firms an indivisible innovation. This innovation is in fact a public good
from the point of view of both principals. In this case, we have[32]:


Since neither of the principals takes into account the fact that the other principal is also
paying the cost of information revelation, there is now excessive rent extraction and the
contractual externality is negative. Achieving the right trade-off between efficiency and
rent extraction becomes a public good and principals free ride in providing enough
incentives to their common agent.
4.3.2 The case of substitutes
Suppose now that the seller provides to both parents qi units from an essential input.
More generally, the production cost of the common agent can now be written as C(q1 +
q2) where q1 and q2 are perfect substitutes from the point of view of the agent's utility
[33]
function (with C < 0). Then, we have:


With perfect substitutes, the setting is very close to an auction between the principals.
The two competing principals are now bidding for the common agent's services. They do
this by conceding a large amount of rent to the agent. Since informational rent is
increasing with output, efficiency rises until the first-best output is achieved.

In both cases, substitutes and complements, allocative distortions depend on the set of
outputs which are under the control of both principals. This third-best world leads again
to failures of the Irrelevance Theorem. For instance, if ownership of an asset is
associated with the auditing rights on the streams of profit generated by this asset,
different ownership structures of a common venture yield different Nash equilibria
between the upstream firms of this common subsidiary and different trade-offs between
allocative efficiency and rent extraction. An optimal ownership structure should thus
minimize the cost incurred by the organization because of these contractual externalities.

4.4 Renegotiation

Renegotiation of a contract can by the agent be accepted only if he gets more
informational rent than without any limit on commitment, i.e., more rent than in the
optimal contract without renegotiation described in (6). Since informational rent is
increasing in output, allocative distortions implemented in a renegotiation-proof contract
must induce more production than the second-best outcome.
Indeed, again summarizing results in the literature, a whole range of values of
correspond to renegotiation-proof allocations and they can be written as:

where [0, 1].

The tension between reducing the informational rent for incentive reasons and increasing
the informational rent to make the allocation renegotiation-proof tilts the rent“efficiency
trade-off towards efficiency. The possibility of further recontracting between the principal
and the agent creates a positive externality on the initial grand contract.
Interestingly, this tension is the same whether one is interested in interim or in ex post
renegotiations and renegotiation-proof final allocations (i.e. allocations taking place just
after the renegotiation stage) can be expressed in the same way.
A priori, from the point of view of the execution of the last stage of contracting, there is
always some cost of committing to a renegotiation-proof allocation which is not the
[34]
second-best conditionally optimal outcome. However, these commitments may have
also some benefit in more complex environments.

First, such commitments make credible actions of the agent which may affect the
behavior of some third party who interacts with the principal, as has been shown by
Dewatripont (1988). For instance, by committing to excess efficiency with his seller, the
buyer commits also to put lots of output on the final product market and this may help
[35]
him to get a Stackelberg position on this market.

Second, in long-term relationships, such commitment also makes information revelation
easier in the first period. Since the efficient seller has a credible promise on the amount
of informational rent he will receive in the future, he does not fear to reveal (at least
partially) his type in the first periods of the relationship. It is this trade-off between first-
period and second-period incentives which has been studied by Dewatripont (1988), Hart
and Tirole (1988), and Laffont and Tirole (1993).

There have been very few works dealing with the organizational consequences of
renegotiation. However, one can still prove here also that the Irrelevance Theorem fails.
For instance, Poitevin (1995) argues that the distribution of information matters at the
renegotiation stage and that an organization should be chosen to minimize the burden of
renegotiation. Martimort (1999b) shows that combining renegotiation and multiprincipal
considerations provides a theory of optimal renegotiation design among competing
principals. The basic idea is that the positive externality of recontracting can be mitigated
by introducing the negative externality of common agency. In the firm's context, various
creditors should be given contracting rights on the firm's profit to harden renegotiation
and improve the firm's overall ability to commit. In the context of the organization of the
government, the separation of powers helps intertemporal commitment, as has been
very often argued by political scientists.[36]

4.5 Biased principals
Let us now consider public procurement and let us assume that delegation of public
decision-making is imperfect in the sense that social welfare is not maximized by elected
biased political principals. Let us take the following example. With probability 1/2, a
rightist government gets elected and takes a pro-industry stance, putting a weight ]0,
1[ on the seller's informational rent into his objective function. Here the motivation is that
rightist parties are financed by the defense industry and their policy choice reflects
somewhat the pressure of this industry. With probability 1/2, a leftist government gets
elected and, still because of reelection concerns, takes a stance against the industry
putting now a weight on the seller's informational rent into his objective function.
Hence, the political bias of the principal, i.e. his degree of non-benevolence, can be
viewed as a random variable ã.
Third-best output can still be described with (7) provided that satisfies:


Contractual externalities are now positive (resp. negative) with a rightist (resp. leftist)
party.

As shown in Laffont (1995), there are excessive fluctuations of the optimal policies
around the socially optimal outcome. In this framework also the Irrelevance Theorem
fails, organizational forms may still be designed to reduce those fluctuations and bring
the outcome closer, at least in expectations, to the second-best outcome.

For instance, Laffont (1995) shows that simple policy instruments may be preferred to
optimal contracts to reduce those fluctuations. Faure-Grimaud and Martimort (2000a,
2000b) and Gabillon and Martimort (1999) show, respectively, that independence of a
regulatory agency and of a central bank from the political sphere improves expected
social welfare and can be used strategically by the incumbent principal.

[22]
Note that the assumption of integration is important here, indeed under non-integration the
buyer may not have such a monitoring technology at his disposal (see Williamson 1985,
chapter 4) or even if he has this monitoring technology, he may not have the auditing rights to
use it.

[23]
See Tirole (1986) for a discussion of this kind of informative signals which can be
concealed but not manipulated by the supervisor.

[24]
See Williamson (1985, chapter 6).

[25]
These authors interpret this division of tasks as a separation of powers in their application
of this idea to a regulatory framework.

[26]
Martimort (1997) applies the same idea and techniques to an instance of horizontal
collusion between workers. This model also endogenizes the observation made in Laffont and
Meleu (1997) that reciprocal deals are easier to enforce.

[27]
On this last issue, see Martimort and Rochet (1999).
[28]
I.e. contracting with the intermediate principal once he has learned some information on the
seller.

[29]
These latter two authors explicitly model the possibility that the top principal and the
intermediate one may have conflicting preferences on the sub-set of agents who must
definitively produce. This adds a "no-shut-down" constraint which creates new agency costs.

[30]
See Spengler (1950).

[31]
The case of Type 1 externality (see Laffont and Martimort 1997 for a typology of these
externalities in a common agency framework) where Si (q1, q2) depends on both outputs is
fully analyzed by Martimort and Stole (1999b).

[32]
Martimort (1998) shows that there exist multiple equilibria in a two-type model with perfect
complementarity as above. We select thereafter the Paretodominant one. In the case where
is a continuous variable, Martimort (1992, 1996a) and Stole (1990) show also that there exist
multiple ranked symmetric equilibria for imperfect complementarity.

[33]
In the case of imperfect substitutes, there exists no pure strategy equilibrium in the two-
type model as shown in Martimort and Stole (1999b). Martimort (1992, 1996a) and Stole
(1990) show also that there exists a unique symmetric equilibrium in the case of substitutes
(perfect and imperfect) with being distributed continuously over an interval. In the case of a
continuous variable, we have ( ) [0, 1] with ( ) = 0 and defined over the whole interval
[ , ] and where is replaced by the hazard rate of the distribution with F( ) the
cumulative distribution of and F = f.

[34]
This is the expression coined by Laffont and Tirole (1993, chapter 10).

[35]
Of course, in such a setting, the objective function of the buyer can be written as S(q, qe)
where qe is the output put on the final market by his competitor.

[36]

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