Envy, Comparison Costs, and the Economic Theory of the Firm

Abstract

An economic theory of the firm must explain both when firms supplant markets and when markets supplant firms. While theories of when markets fail are well developed, the extant literature provides a less than adequate explanation of why and when hierarchies fail. In this paper, we seek to develop a more complete theory of the firm by theorizing about organizational failure. Assuming that market failures provide an impetus to move activities inside the boundaries of the firm, we develop a theory that provides an explanation for both "managerial" diseconomies of scale and scope - an argument that is independent from traditional measurement, rent seeking, and competency arguments. In our theory, hierarchies fail as they expand in scale because social comparison costs imposed on firms escalate and hinder the capacity of managers to optimally structure incentives and production. Further, hierarchy fails as a firm expands in scope for the simple reason that while the need for differentially structured compensation is rising, the costs of differentially structuring compensation within firm are also rising. Thus, we argue that the high cost of organization and limits to its size and scope derive from social comparison costs triggered by envy.

Keywords: theory of the firm, envy, social comparison, compensation, vertical integration

JEL Classification: D23, L22, L23, M52, J41