Interpersonal Authority in a Theory of the Firm [ This paper is currently being revised ]

This paper develops a theory of the firm in which a firm’s centralized asset ownership and low-powered incentives give a manager, as an equilibrium outcome, “interpersonal authority” over employees (in a setting with differing priors). The role of low-powered incentives is both to minimize the employees’ temptation to disobey and to co-locate income and control. The role of the manager controlling the assets is to affect the level of the outside options in a way that makes the employee obey the manager’s orders. The paper thus provides micro-foundations for the idea that bringing a project inside the firm gives the manager control over that project, while – in the process – explaining concentrated asset ownership, low-powered incentives, and centralized authority as typical characteristics of firms. The paper also leads to new perspectives on the firm as a legal entity and on the relationship between the Knightian and Coasian views of the firm. With respect to the latter, the paper shows that there may be less, rather than more, firm integration when actions become non-contractible (in this world with open disagreement). JEL Codes: L22, D23, D81