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Resource Allocation and Firm Scope

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  • Friebel, Guido
  • Raith, Michael

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 non-integration. 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 e±ciently, 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 incentive-based argument for the prevalence of hierarchically structured firms in which higher-level managers coordinate the actions of lower-level managers.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5763.

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Date of creation: Jul 2006
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Handle: RePEc:cpr:ceprdp:5763

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Keywords: authority; coordination; incentives; strategic information transmission; theory of the firm;

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References

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  1. Luis Garicano, 2000. "Hierarchies and the Organization of Knowledge in Production," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 874-904, October.
  2. Crawford, Vincent P & Sobel, Joel, 1982. "Strategic Information Transmission," Econometrica, Econometric Society, vol. 50(6), pages 1431-51, November.
  3. John Geanakoplos & Paul R. Milgrom, 1988. "A Theory of Hierarchies Based on Limited Managerial Attention," Cowles Foundation Discussion Papers 775R, Cowles Foundation for Research in Economics, Yale University.
  4. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  5. Jacques Cremer, 1980. "A Partial Theory of the Optimal Organization of a Bureaucracy," Bell Journal of Economics, The RAND Corporation, vol. 11(2), pages 683-693, Autumn.
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  7. Gibbons, Robert, 2005. "Four forma(lizable) theories of the firm?," Journal of Economic Behavior & Organization, Elsevier, vol. 58(2), pages 200-245, October.
  8. Povel, Paul, 1999. "Optimal "Soft" or "Tough" Bankruptcy Procedures," Journal of Law, Economics and Organization, Oxford University Press, vol. 15(3), pages 659-84, October.
  9. Paul Milgrom and John Roberts., 1987. "Bargaining and Influence Costs and the Organization of Economic Activity," Economics Working Papers 8731, University of California at Berkeley.
  10. Robert H. Gertner & David S. Scharfstein & Jeremy C. Stein, 1994. "Internal versus External Capital Markets," NBER Working Papers 4776, National Bureau of Economic Research, Inc.
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Cited by:
  1. Ricardo Alonso & Wouter Dessein & Niko Matouschek, 2008. "When Does Coordination Require Centralization?," American Economic Review, American Economic Association, vol. 98(1), pages 145-79, March.
  2. Maria Guadalupe & Julie Wulf, 2008. "The Flattening Firm and Product Market Competition: The Effect of Trade Liberalization," NBER Working Papers 14491, National Bureau of Economic Research, Inc.
  3. Choe, Chongwoo & In-Uck, Park, 2010. "Information, Authority, and Corporate Hierarchies," MPRA Paper 21865, University Library of Munich, Germany.
  4. Van den Steen, Eric, 2007. "The Limits of Authority: Motivation versus Coordination," Working papers 37305, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  5. Otto H. Swank & Bauke Visser, 2009. "Decision Making and Learning in a Globalizing World," Economics Working Papers ECO2009/20, European University Institute.

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