Coordination, Specialization and Incentives: An Equilibrium Model of Firm Boundaries

This paper derives firm boundaries as the outcome of an equilibrium coordination mechanism. The analysis is premised on the notion that efficient production and distribution are achieved through a mechanism that coordinates three basic activities: i) input acquisition, ii) production, iii) identification of customers/distribution of output to customers. In a perfectly competitive setting, this coordination activity is accomplished via a price mechanism that coordinates the decisions of individual input suppliers with individual input demanders and the decisions of individual output producers with individual output demanders. In worlds in which there are trading frictions, asymmetric information or small numbers of agents, other mechanisms are required to achieve efficient coordination. We seek to explain the observation of firms and other contractual arrangements as efficient coordination mechanisms, arising in response to these environmental elements. In particular, we seek to identify conditions on trading technologies, information and numbers of agents that generate various coordination mechanisms -- firms, contracts or markets -- as efficient responses to the particular environment. Since efficiency may involve specialization of tasks, efficient coordination must take into account the need of the mechanism to provide incentives for multiple agents to undertake efficient levels of the separate activities. The ability of various mechanisms to provide incentives and the way that this ability is affected by information and agent numbers will determine both which mechanism arises in a given environment and how much specialization takes place. This latter point is important. One insight that we provide is that the degree of specialization is not just limited by the extent of the market -- Stigler's perspective -- but also by the ability of the coordination mechanism to provide incentives for efficient activity levels as specialization occurs