Corporate Finance, Incomplete Contracts, and Corporate Control

This essay in celebration of Grossman and Hart (1986) (GH) discusses how the introduction of incomplete contracts has fundamentally changed economists' perspectives on corporate finance and control. Before GH, the dominant theory in corporate finance was the tradeoff theory pitting the tax advantages of debt (relative to equity) against bankruptcy costs. After GH, this theory has been enriched by the introduction of control considerations and investor protection issues. This essay assesses how our understanding of corporate finance has been improved as a result and where the incomplete contracts perspective has not yet been successfully applied.