Business Strategy, Human Capital, and Managerial Incentives, Second Version

Abstract:     
We posit that the value of a manager's human capital depends on the firm's business strategy. The resulting interaction between business strategy and managerial incentives affects the organization of business activities, both the internal organization of the firm and the determination of firm boundaries. We illustrate the impact of this interaction on firm boundaries in a dynamic agency model. There may be disadvantages in merging two firms even when such a merger allows the internalization of externalities between the two firms. Merging, by making unprofitable certain decisions, increases the cost of inducing managerial effort. This incentive cost is a natural consequence of the manager's business-strategy-specific
human capital.

Keywords: Human Capital, Managerial Incentives, Firm Boundaries, Firm Organization

JEL Classifications: D23, L14, M40, M46

Working Paper Series