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Resource Allocation and Firm Scope


  • Friebel, Guido
  • Raith, Michael


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.

Suggested Citation

  • Friebel, Guido & Raith, Michael, 2006. "Resource Allocation and Firm Scope," CEPR Discussion Papers 5763, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:5763

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    References listed on IDEAS

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    Cited by:

    1. Roman Inderst & Manuel Klein, 2007. "Innovation, endogenous overinvestment, and incentive pay," RAND Journal of Economics, RAND Corporation, vol. 38(4), pages 881-904, December.
    2. Otto H. Swank & Bauke Visser, 2009. "Decision Making and Learning in a Globalizing World," Economics Working Papers ECO2009/20, European University Institute.
    3. Ricardo Alonso & Wouter Dessein & Niko Matouschek, 2008. "When Does Coordination Require Centralization?," American Economic Review, American Economic Association, vol. 98(1), pages 145-179, March.
    4. Maria Guadalupe & Julie M. Wulf, 2008. "The Flattening Firm and Product Market Competition: The Effect of Trade Liberalization," Harvard Business School Working Papers 09-067, Harvard Business School.
    5. Choe Chongwoo & Park In-Uck, 2011. "Information, Authority, and Corporate Hierarchies," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 11(1), pages 1-39, February.
    6. Alonso, Ricardo, 2009. "Strategic control and strategic communication," LSE Research Online Documents on Economics 58682, London School of Economics and Political Science, LSE Library.
    7. Alonso, Ricardo & Dessein, Wouter & Matouschek, Niko, 2008. "When does coordination require centralization?," LSE Research Online Documents on Economics 58664, London School of Economics and Political Science, LSE Library.
    8. Van den Steen, Eric, 2007. "The Limits of Authority: Motivation versus Coordination," Working papers 37305, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    9. Bakonyi, Zoltán, 2015. "Centralizáció - utolsó mentsvár vagy a bukás előszele?. A tervezés általános természetéről
      [Centralization: last chance or a foreshadowing of collapse?. On the general nature of planning]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(3), pages 305-328.

    More about this item


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

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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