A Theory of Firm Scope

I recently presented a new working paper co-written with Bengt Holmstrom at the Law, Economics and Organizations workshop entitled A Theory of Firm Scope.

In the standard property rights model, parties write contracts that are ex ante incomplete but that can be completed ex post; the ability to exercise residual control rights improves the ex post bargaining position of an asset owner and thereby increases her incentive, and the incentive of those who enjoy significant gains from trade with her, to make relationship-specific investments, and as a consequence, it is optimal to assign asset ownership to those who have the most important relationship-specific investments or who have indispensable human capital. Although the property rights approach provides a clear explanation of the costs and benefits of integration, the theory seems to describe owner-managed firms better than large companies.

The purpose of the current paper is to modify the property rights approach so that it can be applied to a broader set of organizational issues, including the organization of large firms. We develop a model in which: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm’s profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. Under these conditions, firm boundaries matter.

Under non-integration, bosses maximize the right thing (profits plus private benefits) but are parochial (they do not take into account their effect on the other unit), while under integration, they maximize the wrong thing but are broad. In our basic model, where the only issue is whether the units coordinate, we show that non-integration and integration make the opposite kind of mistake. Non-integration leads to too little coordination. This happens if the benefits from coordination are unevenly divided across the units. One unit may then veto coordination even though it is collectively beneficial. In contrast, under a weak assumption–specifically, that coordination represents a reduction in “independence” and therefore causes a fall in private benefits–integration leads to too much coordination. We also extend our analysis to understand the role of delegation.

The full paper is available for download here.