Rent and Quasi-Rent

20 December 2007 at 3:22 pm 3 comments

| Steve Phelan |

In a recent paper in the Journal of Business Venturing, Sharon Alvarez attempts to construct a theory of entrepreneurship and the firm. The central question is why new resource combinations are sometimes carried out by entrepreneurs starting new ventures rather than within established firms.

According to Alvarez:

Entrepreneurial rents are created when economic actors combine resources in new and different ways, and when the value of these resource combinations is not known, ex ante

and:

Quasi-rents are created when parties to an exchange make transaction specific investments, and when the value created by those investments is either known with certainty or known probabilistically.

and:

It is the uncertainty about whether or not these new resource combinations will yield greater rents than applying these resources in alternative uses that distinguish entrepreneurial rents from quasi-rents. Once the value of specific investments is known — even if only probabilistically — any value created by those investments takes the form of quasi-rents.

Alvarez then makes two extraordinary claims:

The reason that managerial fiat works to control the threat of opportunism in the allocation of quasi-rents is that the manager in these firms has the ability to understand and value the input of parties to an exchange that create quasi-rents. Armed with this knowledge, this manager can monitor and control behavior, perhaps even exercising the ultimate hierarchical discipline of firing a party to an exchange that refuses to behave in ways consistent with the value maximizing interests of the organization.

and:

Traditional transactions cost theory suggests that firms exist when managerial fiat is exercised. This argument suggests that managerial fiat cannot be exercised under uncertainty, when entrepreneurial rents are being created. Thus, traditional transactions cost theory suggests that firms cannot exist when entrepreneurial rents are being created.

These constructs are then used to develop a theory of the firm as “institutional placeholder”:

One possible solution to this problem is to think of an entrepreneurial firm as an institutional placeholder through which the identity of the most appropriate holders of residual rights of control can be identified over time. Thus, as parties to an exchange learn more about the value of that exchange for themselves and each other, renegotiation can occur within the firm until the most efficient form of governance is obtained. In other words in conditions of uncertainty, parties initially hold the residual control rights in common. Over time, as uncertainty evolves — through the acquisition of information about the project — into risk, the identity of the individuals who should actually have those rights is revealed, and contracts in the firm can be renegotiated appropriately.

So basically, because rents are uncertain the firm must be held in common until the rental streams can be identified/resolved with more certainty and then the residual income rights can be effectively allocated (i.e. the various resource holders can appropriate the rental stream).

I think the question being asked is a very good one — why do some resource re-allocations occur within the boundaries of existing firms and others trigger the creation of new firms? However, I think the institutional placeholder argument relies on a fundamental misreading of the transaction cost and incomplete contracts literature. Why should the entrepreneur cede or renegotiate any residual rights after the rents become realized? Why do managers have an incentive to fairly allocate rental streams?

Does anyone else have a better theory to explain the central question of why new firms are created? My own explanation would tend to rely on dynamic transaction costs, the path dependency of knowledge, and the need for entrepreneurs to back their judgments of future value (that others cannot evaluate) by risking their own assets.

Entry filed under: Entrepreneurship, Former Guest Bloggers, Management Theory, Papers. Tags: .

EU Research Productivity A False Dichotomy?

3 Comments Add your own

  • 1. Paolo Mariti  |  21 December 2007 at 4:32 am

    I researched in the area of new firm birth in the early 90’s building a nation wide data bank based on administrative informations disclosed by new entrepreneurs when applying to local authorities. After a three year period from birth a questionnaire was circulated to a casual sample of new firms. In spite of the great effort, results were mixed, to say the least. No single factor dominated the scene. Rougly 30% of firms had disappeared after three years.

  • 2. sakshi  |  4 March 2010 at 10:18 am

    very useful for business law

  • 3. azeem qurashi  |  9 September 2012 at 1:49 am

    i think defination is gud

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