DP10432 Multifaceted Transactions, Incentives, and Organizational Form

Author(s): Michel Antoine Habib
Publication Date: February 2015
Keyword(s): contractability, general and specialized investment, low-powered incentives, organizational form, resource allocation, resource creation
JEL(s): L22, L24, L33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10432

When not every facet of a transaction can be contracted upon and transacting parties' payoffs are asymmetric, low-powered incentives for those facets of the transaction that can be contracted upon may be necessary to avoid too large a distortion in those facets that cannot be contracted upon (Barzel, 1982, 1997; Hansmann, 1996; Holmstrom and Milgrom, 1991). Distinguishing between different types of capital (financial, physical, intangible), different forms of incentives (performance pay, organizational form, ownership), and different transacting pairs (manager/shareholder, supplier/buyer, customer/firm), and using a model of investment developed by Falkinger (2014), we extend the preceding insight to explain partnerships, mutuals, cooperatives, government ownership, and vertical integration. Distinguishing between resource allocation and resource creation, we show that resource creation calls for higher powered incentives than does resource allocation. Allowing for diversification-induced economies of scale in the use of capital, we establish the result that larger, more diversified firms offer higher-powered incentives. Finally, allowing for the partial contractibility of investment and the use of capital, we show that the former decreases the power of incentives whereas the latter increases that power, thereby providing a combined explanation for the Nineteenth- and Twentieth-Century rise of large military and civilian bureaucracies and the more recent outsourcing of products and services previously sourced internally. Our results suggest that the recognition of the multiple facets of most transactions can help explain numerous institutional arrangements, as well as the apparent lack of disadvantage of low-powered-incentives organizations competing with their high-powered-incentives counterparts (Bohren and Josefsen, 2013; Hansmann and Thomsen, 2012).