A Theory of Firm Scope

37 Pages Posted: 15 Jan 2009 Last revised: 29 Jan 2009

See all articles by Oliver Hart

Oliver Hart

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Bengt R. Holmström

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2008

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.

Suggested Citation

Hart, Oliver D. and Holmström, Bengt R., A Theory of Firm Scope (December 2008). NBER Working Paper No. w14613, Available at SSRN: https://ssrn.com/abstract=1327235

Oliver D. Hart (Contact Author)

Harvard University - Department of Economics ( email )

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Bengt R. Holmström

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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