A Theory of Firm Scope

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.