Working Paper: NBER ID: w14613
Authors: Oliver Hart; Bengt Holmstrom
Abstract: The existing literature on firms, based on incomplete contracts and property rights, emphasizes that the ownership of assets - and thereby firm boundaries - is determined in such a way as to encourage relationship-specific investments by the appropriate parties. It is generally accepted that this approach applies to owner-managed firms better than to large companies. In this paper, we attempt to broaden the scope of the property rights approach by developing a simple model with three key ingredients: (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. We show that firm boundaries matter. Nonintegrated firms fail to account for the external effects that their decisions have on other firms. An integrated firm can internalize such externalities, but it does not put enough weight on the private benefits of managers and workers. We explore this tradeoff in a model that focuses on the difficulties companies face in cooperating through the market if the benefits from cooperation are unevenly divided; therefore, they may sometimes end up merging. We show that the assumption that contracts are reference points introduces a friction that permits an analysis of delegation.
Keywords: No keywords provided
JEL Codes: D23; L23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ownership of assets (G32) | firm boundaries (F23) |
| firm boundaries (F23) | relationship-specific investments (D14) |
| ownership (H13) | investment incentives (O31) |
| firm structure (L10) | ability to manage externalities (D62) |
| contracts as reference points (K12) | frictions in decision-making authority (D73) |
| ownership structure (G32) | decision-making outcomes (D70) |
| organizational form (L22) | externalities considered in decision-making (D62) |
| integration vs. non-integration (F02) | decision-making calculus of managers (D79) |
| distribution of benefits (D39) | coordination decisions (D70) |
| unevenly distributed benefits (D30) | veto power over coordination decisions (D70) |