Firm Scope v 32-2.wpd “A Theory of Firm Scope” - web.mit.edu.pdf

Firm Scope v 32-2.wpd “A Theory of Firm Scope” by Oliver Hart (Harvard University and NBER) and Bengt Holmstrom (MIT and NBER) November 4, 2002* *An earlier version of this paper circulated as “Vision and Firm Scope.” The material presented here formed part of the first author’s Munich Lectures (University of Munich, November 2001) and Arrow Lectures (Stanford University, May 2002). We are especially grateful to Andrei Shleifer for insightful comments. We would also like to thank Philippe Aghion, George Baker, Lucian Bebchuk, Pablo Casas-Arce, Mathias Dewatripont, Robert Gibbons, Meg Meyer, Chris Snyder, Jeremy Stein, Lars Stole, Eric van den Steen and seminar audiences at CESifo, University of Munich, Harvard University, London School of Economics, George Washington University, Stanford University, the Summer 2002 Economic Theory Workshop at Gerzensee, Switzerland and the University of Zurich for helpful discussions. Research support from the National Science Foundation is gratefully acknowledged. 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 large companies. In this paper we attempt to broaden the scope of the property rights approach by developing a simpler model with three key ingredients: (a) decisions are non-contractible, but transferable through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable,