Firm-Specific Human Capital and Theories of the Firm

Abstract:     
This paper focuses on contracting problems in firms caused by asset specificity and investment incentives, particularly the problems that arise when employees make investments in "firm specific human capital." In such cases, employee investments will also be seriously at risk in the enterprise.

Under the nexus of contracts theory of corporations, corporation law is viewed as providing a standardized solution to a central contracting problem, namely the agency problem between shareholders (who are assumed to be the "owners" of the firm) and their hired managers. All other relationships are seen as governed by ordinary, negotiated contracts. But where employees make important specific investments, it is no longer appropriate to assume that shareholders are, and should be, the hiring party, or the "owners." A broader view of what a firm is, and what corporation law accomplishes, is needed, one that permits exploration of why one set of participants in the firm might end up with certain control rights rather than some other set. For a firm in which such firm-specific employee investments are important, one would expect, for example, to find institutional arrangements that are central to the nature of the firm and that encourage continuity in the relationships between employees and the firm, as well as give employees the means to protect their stakes. Such institutions might include unions, severance pay, and social norms of lifetime employment, together with internal job ladders, career paths, seniority rules, and direct and formal control rights. The paper then reviews several new theories that view the firm alternately as a system of incentives, or as a nexus of specific investments. In other words, they conceptualize the firm as a mechanism for governing the relationships among all the participants (those who contribute labor as well as those who contribute capital), not just the relationship between shareholders and managers.

JEL Classifications: G34, J24

Accepted Paper Series