Chapter 2: The Boundaries of the Firm Revisited

Chapter 2: The Boundaries of the Firm Revisited

Bengt Holmström John Roberts


Why do firms exist? What is their function, and what determines their scope? These remain the central questions in the economics of organization. They are also central questions for business executives and corporate strategists. The worldwide volume of corporate mergers and acquisitions exceeded $1.6 trillion in 1997. It is hard to imagine that so much time, effort, and investment bankers' fees would be spent on adjusting firm boundaries unless there was some underlying economic gain. Indeed, the exceptional levels of merger and acquisition activity over the past two decades are a strong indication that economically significant forces do determine organizational boundaries.

The study of firm boundaries originated with the famous essay by Coase (1937), who raised the question of why we observe so much economic activity inside formal organizations if, as economists commonly argue, markets are such powerful and effective mechanisms for allocating scarce resources. Coase's answer was in terms of the costs of transacting in a world of imperfect information. When the transaction costs of market exchange are high, it may be less costly to coordinate production through a formal organization than through a market.

In large part thanks to the work of Williamson (1975, 1985), recent decades have seen a resurgence of interest in Coase's fundamental insight that firm boundaries can be explained by efficiency considerations. Our understanding of firm boundaries has been sharpened by identifying more precisely the nature and sources of transaction costs in different circumstances. In the process, the focus of attention has shifted away from the coordination problems originally emphasized by Coase and toward the role of firm boundaries in providing incentives. In particular, the most influential work during the last two decades on why firms exist, and what determines their boundaries, has been centered on what has come to be known as the "holdup problem".

The classic version of the hold-up story is told by Klein, Crawford, and Alchian (1978); its essence is modeled in Grout (1984). One party must make an investment to transact with another. This investment is relation-specific; that is, its value is appreciably lower (perhaps zero) in any use other than supporting the transaction between the two parties.[1] Moreover, it is impossible to draw up a complete contract that covers all the possible issues that might arise in carrying out the transaction and could affect the sharing of the returns from the investment. The classic example, cited by Klein, Crawford, and Alchian (1978), involves the dies used to shape steel into the specific forms needed for sections of the body of a particular car model (say, the hood or a quarter panel). These dies are expensive—they can cost tens of millions of dollars. Further, they are next-to-worthless if not used to make the part in question. Suppose the dies are paid for and owned by an outside part supplier. Then the supplier will be vulnerable to hold-up. Because any original contract is incomplete, situations are very likely to arise after the investment has been made that require the two parties to negotiate over the nature and terms of their future interactions. Such ex post bargaining[2] may allow the automobile manufacturer to take advantage of the fact that the dies cannot be used elsewhere to force a price reduction that grabs some of the returns to the investment that the supplier had hoped to enjoy. The supplier may then be unwilling to invest in the specific assets, or it may expend resources to protect itself against the threat of holdup. In either case, inefficiency results: Either the market does not bring about optimal investment, or resources are expended on socially wasteful defensive measures. Having the auto company own the dies solves the problem.

If the supply relationship faces more extensive hold-up problems, the best solution may be vertical integration, with all the parts of the body being procured internally rather than outside. The organization and governance structure of a firm are thus viewed as a mechanism for dealing with hold-up problems.

The next section of the paper will review the two strains of work that have dominated the research on the boundaries of the firm: transaction cost economics and property rights theory. Both theories, while quite different in their empirical implications, focus on the role of ownership in supporting relationship-specific investments in a world of incomplete contracting and potential hold-ups. There is much to be learned from this work.

In this essay, however, we argue for taking a much broader view of the firm and the determination of its boundaries. Firms are complex mechanisms for coordinating and motivating individuals' activities. They have to deal with a much richer variety of problems than simply the provision of investment incentives and the resolution of hold-ups. Ownership patterns are not determined solely by the need to provide investment incentives, and incentives for investment are provided by a variety of means, of which ownership is but one. Thus, approaches that focus on one incentive problem that is solved by the use of a single instrument give much too limited a view of the nature of the firm, and one that is potentially misleading.

We support our position first by pointing to situations where relationship-specific investments appear quite high and contracting is incomplete, yet the patterns of ownership are hard to explain either with transaction cost theory or property rights models. The comparison of traditional procurement and subcontracting practices across the U.S. and Japanese automobile industries is the best and most detailed example of this sort that we discuss. Another set of examples illustrates settings in which hold-up problems seem to be small, and therefore boundary choices must be driven by other considerations. Our examples suggest that ownership patterns are responsive to, among other things, agency problems, concerns for common assets, difficulties in transferring knowledge, and the benefits of market monitoring. These suggestions are tentative, and we confess that they are mostly without a good theoretical foundation. They are offered in the hope of inspiring new theoretical research.

We emphasize that this paper is not a survey. We make no claim to having been complete in either our exposition or our citations. Indeed, we are aware of many excellent papers that bear on our arguments or that relate to our examples but that we could not cite because of space considerations. We hope those whose work we have slighted will understand and forgive.

[1]Thus, once the investment has been sunk, it generates quasi-rents—amounts in excess of the return necessary to keep the invested assets in their current use. There could, but need not be pure rents— returns in excess of those needed to cause the investment to be made in the first place.

[2]The terms ex ante and ex post—"before the fact" and "after the fact"—are widely used in this literature. In the hold-up story, the investment must be made ex ante, before a binding agreement is reached, while the renegotiation is ex post, after the investment. More generally, the literature refers to negotiations that occur after some irreversible act, including the establishing of the relationship, as ex post bargaining.