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A Theory of Firm Scope

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  • Oliver Hart
  • Bengt Holmstrom

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 to large companies. In this paper, we attempt to broaden the scope of the property rights approach by developing a simple model with three key ingredients: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm's profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. We show that 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 tradeoff in a model that focuses on the difficulties companies face in cooperating through the market if the benefits from cooperation are unevenly divided; therefore, they may sometimes end up merging. We show that the assumption that contracts are reference points introduces a friction that permits an analysis of delegation.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14613.

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Date of creation: Dec 2008
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Publication status: published as Oliver Hart & Bengt Holmstrom, 2010. "A Theory of Firm Scope," The Quarterly Journal of Economics, MIT Press, vol. 125(2), pages 483-513, May.
Handle: RePEc:nbr:nberwo:14613

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Cited by:
  1. Conconi, Paola & Legros, Patrick & Newman, Andrew, 2008. "Trade Liberalization and Organizational Change," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7028, C.E.P.R. Discussion Papers.
  2. Thorsten V. Braun & Sebastian Krispin & Erik E. Lehmann, 2009. "Entrepreneurial Human Capital, Complementary Assets, and Takeover Probability," Discussion Paper Series, Universitaet Augsburg, Institute for Economics 307, Universitaet Augsburg, Institute for Economics.
  3. Serfes, Konstantinos, 2013. "A Price Theory of Vertical and Lateral Integration under Two-Sided Productivity Heterogeneity," School of Economics Working Paper Series, LeBow College of Business, Drexel University 2013-6, LeBow College of Business, Drexel University, revised 06 Mar 2014.
  4. Dass, Nishant & Nanda, Vikram & Wang, Qinghai, 2013. "Allocation of decision rights and the investment strategy of mutual funds," Journal of Financial Economics, Elsevier, Elsevier, vol. 110(1), pages 254-277.
  5. Patrick Legros & Andrew Newman, 2013. "A Price Theory of Vertical and Lateral Integration," ULB Institutional Repository 2013/141436, ULB -- Universite Libre de Bruxelles.
  6. Oliver Hart, 2013. "Noncontractible Investments and Reference Points," Games, MDPI, Open Access Journal, MDPI, Open Access Journal, vol. 4(3), pages 437-456, August.
  7. Giorgio Zanarone, 2012. "Coase (1937) revisited: Endogenous fiat in firms and markets," International Review of Economics, Springer, Springer, vol. 59(2), pages 201-221, July.
  8. Altomonte, Carlo & Rungi, Armando, 2013. "Business groups as hierarchies of firms: determinants of vertical integration and performance," Working Paper Series, European Central Bank 1554, European Central Bank.
  9. Bruce Owen, 2011. "Antitrust and Vertical Integration in “New Economy” Industries with Application to Broadband Access," Review of Industrial Organization, Springer, Springer, vol. 38(4), pages 363-386, June.
  10. Wallis, John Joseph, 2011. "Institutions, organizations, impersonality, and interests: The dynamics of institutions," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 79(1-2), pages 48-64, June.
  11. Simone Moriconi, 2012. "Taxation and Incomplete Contracts," CREA Discussion Paper Series 12-08, Center for Research in Economic Analysis, University of Luxembourg.
  12. Hoppe, Eva I. & Schmitz, Patrick W., 2009. "Can Contracts Solve the Hold-Up Problem? Experimental Evidence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7205, C.E.P.R. Discussion Papers.
  13. Bohdan Kukharskyy, 2012. "Global Sourcing if Contracts are Reference Points," Working Papers, Bavarian Graduate Program in Economics (BGPE) 129, Bavarian Graduate Program in Economics (BGPE).

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