Resource Allocation and Firm Scope

50 Pages Posted: 5 Sep 2006

See all articles by Guido Friebel

Guido Friebel

Goethe University Frankfurt; Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Michael Raith

University of Rochester - Simon Business School

Multiple version iconThere are 3 versions of this paper

Date Written: August 2006

Abstract

We develop a theory of firm scope in which integrating two firms into one facilitates the allocation of resources, but leads to weaker incentives for effort, compared with nonintegration. Our theory makes minimal assumptions about the underlying agency problem. Moreover, the benefits and costs of integration originate from the same problem - to allocate resources efficiently, the integrated firm's top management must obtain information about the possible use of resources from division managers. The division managers' job is to create profitable investment projects. Giving the managers incentives to do so biases them endogenously towards their own divisions, and gives them a motive to overstate the quality of their projects in order to receive more resources. We show that paying managers based on firm performance in addition to individual performance can establish truthful upward communication, but creates a free-rider problem and raises the cost of inducing effort. This effect exists even though with perfect information, centralized resource allocation would improve the managers' incentives. The resulting tradeoff between a better use of resources and diminished incentives for effort determines whether integration or non-integration is optimal. Our theory thus provides a simple answer to Williamson's "selective-intervention" puzzle concerning the limits of firm size and scope. In addition, we provide an incentivebased argument for the prevalence of hierarchically structured firms in which higher-level managers coordinate the actions of lower-level managers.

Keywords: theory of the firm, coordination, authority, incentives, strategic information

JEL Classification: D23, D82, L22, M52

Suggested Citation

Friebel, Guido and Raith, Michael, Resource Allocation and Firm Scope (August 2006). IZA Discussion Paper No. 2249, Available at SSRN: https://ssrn.com/abstract=928379

Guido Friebel (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Michael Raith

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-8380 (Phone)
585-273-1140 (Fax)

HOME PAGE: http://works.bepress.com/michael_raith/

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