A Theory of Firm Scope

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 large companies. In this paper we attempt to broaden the scope of the property rights approach by developing a simpler model with three key ingredients: (a) decisions are non-contractible, but transferable through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm's profit. With these assumptions, 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 trade-off first in a basic model that focuses on the difficulties companies face in cooperating through the market if benefits are unevenly distributed; therefore they may sometimes end up merging. We then extend the analysis to study industrial structure in a model with intermediate production. This analysis sheds light on industry consolidation in times of excess capacity.