Just for fun: the theory of the firm 2

Having tried to outline aspects of some of the new thinking on the theory of the firm in the posting Just for fun: the theory of the firm, I want, in this post, to look, briefly, at some of the problems with the 'reference point' approach to the firm and some extensions of this work. First lets note one advantage of the reference point approach. It gets round some foundational weaknesses of the standard incomplete contracts theory. In particular a benefit of this approach is that we are able to avoid (and with luck go beyond) the 'Maskin-Tirole' foundational critique of models of incomplete contracts (see Maskin and Tirole (1999)).

However, to do so it is necessary to introduce a number of somewhat ad hoc features. Let us take a quick look at some of the behavioural assumptions that could - and should - be refined and relaxed. The 'reference point' model has a number of "black box" behavioural features. The behavioural assumptions on which the analysis is based are undoubtedly strong, and although they are broadly consistent with a number of ideas in the behavioural economics literature, there is no single model or experiment that appeal can be made to that supports precisely what is done. These strong and ad hoc assumptions have to do with entitlements, self-serving biases, and shading behaviour. The important point here is that these have not been derived from first principles. Opening up the behavioural black box and showing that these assumptions are consistent with utility-maximizing behaviour is a must for future research.

The reference point approach - here I'm thinking in particular of Hart (2009) - helps understand the advantages of vertical integration. The model, where costly hold-up typically occurs with positive probability under uncertainty, seems relevant for understanding the costs of nonintegration and why vertical integration - interpreted here as a transfer of assets - can help. But it is less clear that Hart's model can be applied directly to understand the costs of integration.

Another issue that needs additional research is the internal make-up of the firm and why authority is used to resolve disagreement rather than, say, bargaining between the parties. The literature on the theory of the firm based around incomplete contracts and firm boundaries (not discussed here) has supposed that ex post efficiency is achieved through bargaining. Obviously in many cases this is not the case and problems such as hold-ups and other disagreements are often resolved by parties exercising their rights to make decisions, that is, by authority.

There is a recent paper, Hart and Holmstrom (2009), in which a model is developed, based on contracts as reference points and aggrievement, in which authority has a central role. The paper considers two units that have a horizontal or lateral relationship. The units take decisions that affect each other; for example, they may be deciding on whether to adopt a common standard. Each decision is ex ante non-contractible but ex post contractible. The 'boss' has the right to make the decision; however, aggrieved parties may shade. Each unit generates two kinds of benefit: monetary profit, which is transferable with ownership, and private benefits of managers and workers, which are non-transferable. Hart and Holmstrom show that non-integrated 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 private benefits. They also show that the aggrievement assumption introduces a friction that permits an analysis of delegation.

References:

• Hart, Oliver D. (2009). 'Hold-up, Asset Ownership, and Reference Points', Quarterly Journal of Economics, 124(1) February: 267-300.
• Hart, Oliver D. and Bengt Holmstrom (2009). 'A Theory of Firm Scope', Working Paper, July 13.
• Maskin, Eric and Jean Tirole (1999). 'Unforeseen Contingencies and Incomplete Contracts,' Review of Economic Studies, 66: 83–114.