Assessing the Property Rights and Transaction-Cost Theories of Firm Scope

Abstract

In his path-breaking 1937 article, Ronald Coase first identified the determinants of a firm's scope as an important research question. Although Coase's question initially attracted little attention, it has emerged over the last 25 years as a central issue in industrial organization. Much of the literature on firm scope since Coase uses the transaction-cost economics approach (henceforth, the TCE) pioneered by Oliver Williamson (1975, 1979, 1985) and Benjamin Klein et al. (1978). The TCE starts with the assumption that market transactions are plagued by incomplete contracts and the development of lock-in among trading partners. Lock-in leads the value of the relationship to exceed the value of the trading partners' outside alternatives creating what Klein et al. called quasi-rents. Contractual incompleteness gives contracting parties the ability to engage in opportunistic behavior to increase their share of these quasi-rents, leading to efficiency losses in market transactions. Internal procurement, on the other hand, involves its own inefficiencies, most notably the costs of bureaucracy and lowpowered incentives. According to the TCE, the optimal organizational form is found by comparing the efficiencies of these distinct transactional modes. Its primary prediction is that, as market transactions become characterized by increasing levels of quasi-rents and incompleteness in contracts, the likelihood of integration should increase. More recently, a great deal of attention has focused on an alternative theory of firm scope, the property-rights theory (henceforth, the PRT), pioneered by Sanford Grossman and Oliver Hart (1986) and Hart and John Moore (1990) (see also Hart, 1995). Like the TCE, the PRT starts with the assumption that contracts are incomplete and that lock-in often develops among trading partners. It then focuses on how ownership of physical assets, which confers residual rights of control over the assets, alters the efficiency of trading relations. In the process of doing so, the PRT produces a theory that differs from the TCE in three ways. The first is methodological rather than substantive: the PRT is substantially more formal than the (largely verbal) TCE. Second, the PRT focuses on distortions in ex ante investments, in contrast to the ex post haggling costs that are a major focus of the TCE.1 Third, the PRT assumes that efficiency losses are of the same nature in all ownership structures. That is, ownership of physical assets affects the parties' abilities to engage in opportunistic behavior not only in market transactions, but also within the firm. A very large empirical literature exists lending support to the TCE (for one survey, see Howard A. Shelanski and Peter G. Klein [1995]). In a typical study, some measure of lock-in, such as the specificity of the product procured or investments made, is related to the choice of whether to integrate. The strong association that this literature has found between specificity and integration has made the TCE