Friday, January 23, 2009

A theory of firm scope

Oliver Hart and Bengt Holmstrom have a new paper (also see here) recently which extends the standard property rights model by incorporating coordination activities inside the firm so that a theory of firm scope can be further explored. A large drawback of the standard GHM model and the property rights approach to the theory of the firm, as pointed out by Holmstrom (1999) among others, is that there is no real "firm" per se in the model, only "representative entrepreneurs". Hence it can only explain why individuals own assets, not why firms own assets. Although this approach provides a clear explanation of the costs and benefits of integration, it seems to describe owner-managed firms better than large scale companies.

In order to understand key organizational issues (particularly in large scale organizations), e.g., firm scope, authority, hierarchy and power delegation, we have to examine more closely to "what it (the organization) does and what is done within it". Therefore, questions like how activities are coordinated within the organization and which factors lead to the way of organization and coordination become extremely important.

The purpose of this paper is to modify the property rights approach so that it can be applied to better serve the need. We develop a model in which: (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. Under these conditions, 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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