We argue that long-term debt has a role in controlling management's ability to finance future investments. Companies with high (widely held) debt will find it hard to raise capital, since new security-holders will have low priority relative to existing creditors; conversely for companies with low debt. We show that there is an optimal debt--equity ratio and mix of senior and junior debt if management undertakes unprofitable as well as profitable investments. We derive conditions under which equity and a single class of senior long-term debt work as well as more complex contracts for controlling investment behavior.

Oliver Hart delivered his Prize Lecture on 8 December 2016 at the Aula Magna, Stockholm University.

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This paper considers a firm whose marginal (revenue) product of labor is a random variable. We derive the form of an optimal long-term contract between workers and the firm under the assumption that labor's marginal product is observed by the firm but not by the workers. We show that the existence of asymmetric information causes unemployment to be greater than in a situation where information about labor's marginal product is public, or where employment is determined in spot markets. In particular, unemployment can occur when the marginal product of labor exceeds the reservation wage.

Hart and John Moore (2008) introduce new behavioral assumptions that can explain long-term contracts and the employment relation. We examine experimentally their idea that contracts serve as reference points. The evidence confirms the prediction that there is a trade-off between rigidity and flexibility. Flexible contracts—which would dominate rigid contracts under standard assumptions—cause significant shading in ex post performance, while under rigid contracts much less shading occurs. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.