Are Profitable Firms Always Founded?

18 November 2006 at 6:45 am Nicolai Foss Leave a comment

| Nicolai Foss |

No, says Matthias Kräkel. Here is the abstract of his recent neat paper, “On the ‘Adverse Selection’ of Organizations“:

According to New Institutional Economics, two or more individuals will found an organization, if it leads to a benefit compared to market allocation. A natural consequence will then be internal rent seeking. We discuss the interrelation between profits, rent seeking and the foundation of organizations. Typically, we expect that highly profitable firms are always founded but it is not clear whether the same is true for firms with less optimistic prospects. We will show that internal rent seeking may lead to a completely reversed result. The impact of internal rent seeking on overall investment and the implications of firm size and competition on the foundation of organizations are also addressed.

Admittedly, Kräkel’s stark result, that highly profitable firms may not be founded because of the prospect of heavy internal rent seeking, only holds for the situation where technology is exogeneosly given (he does relax this assumption and obtains other interesting results, however) and begs the question why exactly it is that rational cooperating individuals cannot constrain internal rent-seeking. However, there is a wider message in his paper, particularly for the resource-based approach in strategic management which — with the exception of the work of Russ Coff (see his 1999 Org Science paper and his 1997 AMR paper), Lippman and Rumelt (their 2003 SMJ paper on bargaining), and more recently Joe Mahoney (check Joe’s work on stakeholder theory) — has neglected internal bargaining processes in firms, including rent-seeking. Thus Kräkel’s work suggests that even if a projected venture controls resources that are strategic in the RBV sense, the venture may not materialize because of fear of rent-seeking in the second stage of the game (after the firm is actually founded).