Commitment, Exchange Autonomy, and the Boundary of the Hierarchical Firm

In this article, I present a theory of the boundary of the firm that accounts for some important characteristics of real-world multidivisional firms: operative decisions are in the hands of middle managers who are rewarded based on the performance of their units, managers' decisions are subject to approval and intervention by the top management of the firm, and managers are better informed regarding the affairs of their divisions. In this setup, the integration of an intermediate input supplier and its buyer as separate divisions within a single firm is desirable, as long as the choice of trading partners can be credibly delegated to the divisions' managers. I show that this is satisfied not only under the assumption of full commitment by the general office of the firm but also, remarkably, if it has no commitment power whatsoever. An explanation of the boundary of the firm emerges only if the general office retains some limited commitment power. I show that the general office mandates internal trades in more instances than would have been optimal with full commitment, adversely affecting the levels of investment undertaken by the divisions' managers. In such cases, it can be optimal to have the trade conducted between nonintegrated parties. The Author 2007. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.