A-Theory-of-Firm-Scope.pdf
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A-Theory-of-Firm-Scope.pdf
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“ATheoryofFirmScope”*byOliverHart(HarvardUniversityandNBER)andBengtHolmstrom(MITandNBER)December18,2008*Thisisanextensivelyrevisedversionoftwoearlierpapersthatcirculatedas“ATheoryofFirmScope”and“VisionandFirmScope.”SomeofthematerialpresentedhereformedpartofthefirstauthorsMunichLectures(UniversityofMunich,November2001),ArrowLectures(StanfordUniversity,May2002),KarlBorchLecture(Bergen,May2003),andMattioliLectures(Milan,November2003).WeareespeciallygratefultoAndreiShleiferforinsightfulcomments.WewouldalsoliketothankPhilippeAghion,GeorgeBaker,LucianBebchuk,PabloCasas-Arce,MathiasDewatripont,RobertGibbons,LouisKaplow,MegMeyer,DavidScharfstein,ChrisSnyder,JeremyStein,LarsStole,EricvandenSteen,andseminaraudiencesatCESifo,UniversityofMunich,HarvardUniversity,LondonSchoolofEconomics,GeorgeWashingtonUniversity,StanfordUniversity,theSummer2002EconomicTheoryWorkshopatGerzensee,Switzerland,andtheUniversityofZurichforhelpfuldiscussions.ResearchsupportfromtheNationalScienceFoundationisgratefullyacknowledged.AbstractTheexistingliteratureonfirms,basedonincompletecontractsandpropertyrights,emphasizesthattheownershipofassets-andtherebyfirmboundaries-isdeterminedinsuchawayastoencouragerelationship-specificinvestmentsbytheappropriateparties.Itisgenerallyacceptedthatthisapproachappliestoowner-managedfirmsbetterthantolargecompanies.Inthispaper,weattempttobroadenthescopeofthepropertyrightsapproachbydevelopingasimplemodelwiththreekeyingredients:
(a)decisionrightscanbetransferredexantethroughownership,(b)managers(andpossiblyworkers)enjoyprivatebenefitsthatarenon-transferable,and(c)ownerscandivertafirmsprofit.Inourbasicmodeldecisionsareexpostnon-contractible;inanextensionweusetheideathatcontractsarereferencepointstorelaxthisassumption.Weshowthatfirmboundariesmatter.Nonintegratedfirmsfailtoaccountfortheexternaleffectsthattheirdecisionshaveonotherfirms.Anintegratedfirmcaninternalizesuchexternalities,butitdoesnotputenoughweightontheprivatebenefitsofmanagersandworkers.Weexplorethistradeoffinamodelthatfocusesonthedifficultiescompaniesfaceincooperatingthroughthemarketifthebenefitsfromcooperationareunevenlydivided;therefore,theymaysometimesendupmerging.Weshowthattheassumptionthatcontractsarereferencepointsintroducesafrictionthatpermitsananalysisofdelegation.11.IntroductionInthelasttwentyyearsorso,atheoreticalliteraturehasdevelopedthatarguesthattheboundariesoffirms-andallocationofassetownership-canbeunderstoodintermsofincompletecontractsandpropertyrights.Thebasicideabehindtheliteratureisthatfirmboundariesdefinetheallocationofresidualcontrolrightsand,inaworldofincompletecontracts,thesematter.Inthestandardpropertyrightsmodel,partieswritecontractsthatareexanteincompletebutthatcanbecompletedexpost;theabilitytoexerciseresidualcontrolrightsimprovestheexpostbargainingpositionofanassetownerandtherebyincreasesherincentive,andtheincentiveofthosewhoenjoysignificantgainsfromtradewithher,tomakerelationship-specificinvestments,andasaconsequence,itisoptimaltoassignassetownershiptothosewhohavethemostimportantrelationship-specificinvestmentsorwhohaveindispensablehumancapital.1Althoughthepropertyrightsapproachprovidesaclearexplanationofthecostsandbenefitsofintegration,asanumberofpeoplehaveargued,thetheoryseemstodescribeowner-managedfirmsbetterthanlargecompanies.2Thereareseveralwaystoseethis.First,accordingtothetheory,themajorimpactofachangeinownershipisonthosewhogainorloseownershiprights;however,inamergerbetweentwolargecompanies,itisoftenthecasethatthekeydecision-makers(theCEOs,forexample)donothavesubstantialownershiprightsbeforeorafterthemerger.Second,therelationship-specificinvestmentsanalyzedaremadebyindividualsratherthanbyfirms;thisagainresonatesmorewiththecaseofsmallfirmsthanthatoflargecompanies.Third,andperhapsmostimportant,theapproachenvisionsasituationof“autarky,”inwhichalltherelevantpartiesmeetandbargainexpostoverthegainsfromtradeandtheonly1SeeGrossmanandHart(1986),HartandMoore(1990),andHart(1995).ThisliteraturebuildsontheearliertransactioncostliteratureofWilliamson(1975,1985)andKleinetal.(1978).Extensionsofthemodelshowthatitissometimesoptimaltotakeassetsawayfromsomeonetoimprovetheirincentivestomakerelationship-specificinvestments(e.g.,todiscouragerent-seekingbehavior).Onthis,seeBakeretal.(2002),Chiu(1998),deMezaandLockwood(1998),andRajanandZingales(1998).2Foradiscussionofthisandrelatedpoints,seeHolmstromandRoberts(1998)andHolmstrom(1999).2issueiswhohastherighttowalkawaywithwhichassets;therearenootherdecisionsinthemodel.Asitstands,themodelhasnoroomfor“organizationalstructure,”“hierarchy”or“delegation”;inanimportantsense,themodelcontinuestodescribeapuremarketeconomy,althoughoneenrichedbytheideathatindividualscanbeempoweredthroughtheownershipofkeynonhumanassets.Thepurposeofthecurrentpaperistomodifythepropertyrightsapproachsothatitcanbeappliedtoabroadersetoforganizationalissues,includingtheorganizationoflargefirms.Wewilldevelopamodelinwhichcontractscannotbecompletedcostlesslyexpostandwherethereforethefinaloutcomedependsonwhohasdecision-makingauthority.Webeginbydescribingthekeyingredientsofourapproach.Wewillfocusontwounitsthathaveahorizontalorlateralrelationship.Wethinkofaunitasanirreduciblesetofactivitiesthatitwouldbemeaninglesstobreakupfurther.Wewillbeinterestedinthecasewhereeachunitmakesadecisionthataffectstheotherunit,i.e.,thereareexternalities.Forexample,theunitsmaybedecidingwhethertoadoptacommonstandardfortheirtechnologyorproduct.Ortheunitsmightrepresenttwodepartmentsorschoolsinauniversitythatmustchoosewhethertomaketheircurriculumrequirementscompatibleorsynchronizetheiracademiccalendars.LaterinthepaperwewillusethemodeltointerpretCiscosapproachtoplatformleadershipthroughacquisitions.Forsimplicitywefocusonthecasewhereeachunithasabinarydecision:
itcanchoose“Yes”or“No”.Moreover,wesimplifymattersfurtherbysupposingthatthereareonlytwoaggregateoutcomes,whichweterm“coordination”or“non-coordination”.CoordinationoccursifandonlyifbothunitschooseYes.Non-coordinationoccursifoneorbothunitschooseNo.Laterinthepaperwebrieflydiscussmoregeneraldecisions.Thedecisionineachunitisexantenon-contractible.Theownerofaunithastherighttomakethedecisioninthatunitexpost;thatis,theownerhasresidualcontrolrightsasinthepropertyrightsliterature.Wewillrefertotheownerastheboss.Inthesimplestversionofthemodeleach3unitsdecisionisalsoexpostnon-contractible.Wewillcomparetwoleadingorganizationalforms.Inthefirst,non-integration,theunitsareseparatefirms,andeachunitisownedbyitsmanager.Inthesecond,integration,theunitsarepartofasinglefirm,andaprofessionalmanageristheowner.Thesearenottheonlypossibilities.Forexample,onecouldconsideranotherformofintegrationwhereoneoftheunitmanagersistheowner.However,themaininsightsofouranalysiscanbeobtainedfromconsideringthetwoleadingforms.Fullintegrationwouldalwaysbeoptimalifallthebenefitsandcostsfromdecisionsweretransferablethroughcontractorownership.Toavoidthisuninterestingconclusion,weassumethateachunitgeneratestwokindsofbenefit:
monetaryprofitandprivate(nontransferable)benefitsintheformofjobsatisfactionforthoseworkingintheunit.Forthemostpart,wewillassumethatthemanageristheonlyworkerandhenceprivatebenefitsrefertoherjobsatisfaction.Weassumethatthebossofaunitcandivertalltheprofitfromthatunittoherself.Thissimplifiestheanalysisbyrulingoutprofit-sharingasawaytoinfluenceincentives.Profitsharingwouldalleviate,butnoteliminate,theeffectswedescribe.Toillustratehowfirmboundariesaffectdecisionmaking,considerthesimplestsetting,whereexpostdecisions,aswellexantedecisions,arenon-contractible.Denotethepairofprofitsandprivatebenefits(measuredinmoney)accruingtoeachunitby),(AAwvand),(BBwv,respectively.Then,iftheunitsarenonintegratedandmanagerAisthebossofunitAandmanagerBthebossofunitB,managerAwillmaximizeAAwv+sinceshedivertstheprofitfromunitAandcaresaboutherownprivatebenefits,andmanagerBwillmaximizeBBwv+forsimilarreasons.Incontrast,ifunitsAandBareintegrated,then,ifa(professional)outsideristheboss,shewillmaximizeBAvv+,sinceshedivertsalltheprofitanddoesnotcareaboutprivatebenefits.Asabenchmark,notethatsocialoptimalityisachievedbymaximizingtotalsurplus:
BABAwwvv+.4Theimportantpointhereisthatintegrationresultsinlessweightbeingplacedonprivatebenefitsthannon-integration.Undernon-integration,BAww,eachappearsinonebosssobjectivefunction.Incontrast,underintegration,thewsfailstoappearintheoverallobjectivefunction.However,thisdiminishedinfluenceofprivatebenefitsisoffsetbythefactthat,underintegration,totalprofits,ratherthanindividualunitprofits,aremaximized.Insummary,undernon-integration,bosseshavetherightbalancebetweenprivatebenefitsandprofits,butareparochial(theydonottakeintoaccounttheireffectontheotherunit),while,underintegration,theyhavetherightbala
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