Resource Allocation and Firm Scope
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 efficiently, 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.
|Date of creation:||Aug 2006|
|Date of revision:|
|Publication status:||published in: American Economic Journal: Microeconomics, 2010, 2 (2), 1-33|
|Contact details of provider:|| Postal: |
Phone: +49 228 3894 223
Fax: +49 228 3894 180
Web page: http://www.iza.org
|Order Information:|| Postal: IZA, Margard Ody, P.O. Box 7240, D-53072 Bonn, Germany|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Geanakoplos, John & Milgrom, Paul, 1991.
"A theory of hierarchies based on limited managerial attention,"
Journal of the Japanese and International Economies,
Elsevier, vol. 5(3), pages 205-225, September.
- 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.
- Bengt Holmstrom, 1982.
"Moral Hazard in Teams,"
Bell Journal of Economics,
The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
- Itoh, Hideshi, 1991. "Incentives to Help in Multi-agent Situations," Econometrica, Econometric Society, vol. 59(3), pages 611-36, May.
- 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.
- V. Crawford & J. Sobel, 2010.
"Strategic Information Transmission,"
Levine's Working Paper Archive
544, David K. Levine.
- Gertner, Robert H & Scharfstein, David S & Stein, Jeremy C, 1994.
"Internal versus External Capital Markets,"
The Quarterly Journal of Economics,
MIT Press, vol. 109(4), pages 1211-30, November.
- 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.
- 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.
- Milgrom, Paul & Roberts, John, 1987. "Bargaining and Influence Costs and the Organization of Economic Activity," Department of Economics, Working Paper Series qt32s7d4jv, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 473-94, July.
- Gibbons, Robert, 2005. "Four forma(lizable) theories of the firm?," Journal of Economic Behavior & Organization, Elsevier, vol. 58(2), pages 200-245, October.
- 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.
- Harris, Milton & Raviv, Artur, 1996. " The Capital Budgeting Process: Incentives and Information," Journal of Finance, American Finance Association, vol. 51(4), pages 1139-74, September.
When requesting a correction, please mention this item's handle: RePEc:iza:izadps:dp2249. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mark Fallak)
If references are entirely missing, you can add them using this form.