Abstract
This paper provides a framework for addressing the question of when transactions should be carried out within a firm and when through the market. Following Grossman and Hart, we identify a firm with the assets that its owners control. We argue that the crucial difference for party 1 between owning a firm (integration) and contracting for a service from another party 2 who owns this firm (nonintegration) is that, under integration, party 1 can selectively fire the workers of the firm (including party 2), whereas under nonintegration he can "fire" (i.e., stop dealing with) only the entire firm: the combination of party 2, the workers, and the firm's assets. We use this idea to study how changes in ownership affect the incentives of employees as well as those of owner-managers. Our framework is broad enough to encompass more general control structures than simple ownership: for example, partnerships and worker and consumer cooperatives all emerge as speical cases.
Highlights
JOURNAL OF POLITICAL ECONOMYWhat is a firm? How do transactions within a firm differ from those between firms? These questions, first raised by Coase (1937) over 50 years ago, have been the subject of much discussion by economists, but general answers at the level of formal modeling still have to be provided
We argue that the crucial difference for party 1 between owning a firm and contracting for a service from another party 2 who owns this firm is that, under integration, party 1 can selectively fire the workers of the firm if he dislikes their performance, whereas under nonintegration he can "fire" only the entire firm: the combination of party 2, the workers, and the firm's assets. We use this idea in a multiasset, multiindividual economy to study how changes in ownership affect the incentives of nonowners of assets as well as the incentives of owner-managers
Transferring ownership of an asset from party 2 to party 1 increases 1's freedom of action to use the asset as he or she sees fit and increases 1's share of ex post surplus and ex ante incentive to invest in the relationship; but 2's share of ex post surplus and incentive to invest falls
Summary
JOURNAL OF POLITICAL ECONOMYWhat is a firm? How do transactions within a firm differ from those between firms? These questions, first raised by Coase (1937) over 50 years ago, have been the subject of much discussion by economists, but general answers at the level of formal modeling still have to be provided. We argue that the crucial difference for party 1 between owning a firm (integration) and contracting for a service from another party 2 who owns this firm (nonintegration) is that, under integration, party 1 can selectively fire the workers of the firm (including party 2) if he dislikes their performance, whereas under nonintegration he can "fire" (i.e., stop dealing with) only the entire firm: the combination of party 2, the workers, and the firm's assets We use this idea in a multiasset, multiindividual economy to study how changes in ownership affect the incentives of nonowners of assets (employees) as well as the incentives of owner-managers. Concentrating ownership in 1's hands will be good to the extent that l's investment decision is important relative to 2's, but will be bad if the opposite is the case In this way, the costs and benefits of integration can be understood as two sides of the same coin
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