DP1777 Power in a Theory of the Firm

Author(s): Raghuram G Rajan, Luigi Zingales
Publication Date: January 1998
Keyword(s): Incomplete Contracts, Theory of the Firm, Vertical Integration
JEL(s): D2, G3, L2
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1777

Transactions take place in the firm rather than in the market because the firm offers agents who make specific investments power. Past literature emphasizes the allocation of ownership as the primary mechanism by which the firm does this. Within the contractibility assumptions of this literature, we identify a potentially superior mechanism, the regulation of access to critical resources. Access can be better than ownership because: i) the power agents get from access is more contingent on them making the right investment; ii) ownership has adverse effects on the incentive to specialize. The theory explains the importance of internal organization and third-party ownership.