Endogenous Outside Options, Incomplete Contracts and the Theory of the Firm
University of Siena, Economics Working Paper No. 250
28 Pages Posted: 29 Nov 1999
Date Written: April 1999
The paper asserts that introducing endogenous outside options in the standard incomplete contract framework might reverse some of the main conclusions on incomplete contracts enforcement and on the nature of the firm drawn by the New Institutional Economists. In particular, the explanations of the firm provided by the New Property Rights school (the GHM model) are based on the assumption that agents outside options are not affected by human capital investments. When outside options are endogenous, in order to maximise contractual power in a transactional exchange and/or to increase market share, agents will then be induced to invest a greater amount of economic resources than the neo-classical ideal-type requires. Bilateral enforcement mechanisms are thus affected by the actions selected by agents in order to deter a competitor's entry, and viceversa, competition strategies are affected by the economic incentives promoted by parties for the enforcement of contractual obligations. We label such a complex institutional context cross competition. Such a framework provides an alternative explanation of the firm which helps to understand the diversity of institutional arrangements observed in different economic systems, and suggests that the co-existence of alternative governance structures of the firm could represent a second best response to the market failures which arise in a "cross competition" context.
JEL Classification: K00, J41, L21, L22, L23
Suggested Citation: Suggested Citation