Hart and Holmström on Firm Scope

12 January 2009 at 12:36 am Peter G. Klein Leave a comment

| Peter Klein |

One drawback of the Grossman-Hart-Moore “property rights approach” to the firm is that it isn’t really a theory of the firm per se, but a theory of which individuals should own which assets. Key organizational issues such as firm scope, delegation, monitoring, information sharing, and other coordination problems do not figure prominently in this approach (though there are plenty of formal theory papers dealing with internal organization by people like Radner, Tirole, Gibbons, Garicano, and Hart himself).

A new paper by Hart and Bengt Holmström extends the GHM model by incorporating intra-firm coordination. In this approach the value of the firm depends not only on the allocation of residual rights of control, but also on operating decisions of the firm’s subunits, decisions that may or may not be in synch. The central office of an integrated firm can internalize these externalities, but at the cost of reducing division managers’ private benefits. Here’s the abstract:

The existing literature on firms, based on incomplete contracts and property rights, emphasizes that the ownership of assets — and thereby firm boundaries — is determined in such a way as to encourage relationship-specific investments by the appropriate parties. It is generally accepted that this approach applies to owner-managed firms better than to large companies. In this paper, we attempt to broaden the scope of the property rights approach by developing a simple model with three key ingredients: (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. We show that 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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