Contract Theory
What Makes A Firm?

What is a firm? Although the activities of firms are central to the operation of a decentralized economy, conventional economic theory often takes for granted the existence and structure of firms. Relatively little work considers the determinants of how vertically or laterally integrated the firm's activities are. In Discussion Paper No. 70, Sanford Grossman and CEPR Research Fellow Oliver Hart explore these questions, building on the ideas of Coase and Williamson. Their theories of the firm emphasize the benefits of 'control' in situations where there are difficulties in writing or enforcing complete contracts.

Hart and Grossman define a firm to consist of those assets (e.g. machines, inventories) which it owns or over which it has control. They do not distinguish between ownership and control and define ownership as the power to exercise control. Of course, control or ownership is never absolute; for example, a firm which owns a machine may not be able to sell it without the permission of the lenders for whom the machine serves as collateral; more generally, a firm may give another firm specific authority over its machines. But, ownership does give all rights to use the machine which are not voluntarily surrendered or which some other party (like the government) has not taken by force.
Hart and Grossman discuss the organisation of the firm when contracts are costly to write or to enforce. They note that contractual rights can be of two kinds: specific rights and residual rights. When it is too costly for one party to specify a long list of the particular rights it desires over another party's assets, it may be optimal to purchase all the rights except those specifically mentioned in the contract. Ownership is the purchase of these residual rights of control. Hart and Grossman show that certain allocations of residual rights can have harmful effects. For example a firm which purchases its supplier, thereby removing residual rights of control from the manager of the supplying company, can distort the manager's incentives sufficiently to make common ownership harmful.

Hart and Grossman base their theory of the firm and of integration upon the attempt of parties to write a contract which allocates efficiently the residual rights of control between themselves. It may be extremely costly to write a contract which specifies unambiguously the payments and actions of all parties in every observable state of nature. The authors assume that integration by itself does not change the cost of writing down a particular contractual provision. It does change who has control over those provisions not specifically included in the contract. Consider, for example, a contract between a publisher and a printer for a particular number of copies of a book. Suppose the contract has no provision for an additional print run, but the publisher receives some new information which suggests another run will be profitable. It is obvious that the right to decide whether or not to do it belongs to the owner of the printing press. This is a simple example of Hart and Grossman's approach - that the benefit of ownership lies in the residual right of control, i.e. the right to control all actions that have not been explicitly given away by contract.

Hart and Grossman emphasize that since ownership provides residual rights of control, the usual argument that integration merely enlarges the range of actions open to the firm is incorrect. If firm 1 buys firm 2, the owner of firm 1 will have the power to intervene in firm 2 in a variety of ways, some of which may be very undesirable and lead to large efficiency losses. The point is that the owner cannot commit himself to intervene only selectively in his subsidiary's operations since by their very definition residual rights refer to powers that cannot be specified in advance (at least in the detail required to make them part of an enforceable contract). It follows immediately that integration can impose costs as well as benefits.


The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration
S Grossman and O Hart

Discussion Paper No. 70, July 1985 (ATE)