A Theory of Inefficient Intrafirm Transactions

This paper presents a model in which goods market distortions lead firms to socially inefficient modes of internal organization. The model seeks to capture the aversion documented by Eccles and White (1988) of middle management aversion to inter-profit center transactions. I consider situations where reputational forces are able to support equilibria in which goods are of high quality. These forces can break down when the transactions take place within the firm. Integration may nonetheless be privately worthwhile if price exceeds marginal cost. •I wish to thank OhverHart, Jim Poterba, Jean Tirole and Garth Saloner for comments and the NSF and Sloan Foundations for research support A Theory of Inefficient Intrafirm Transactions Julio J. Rotemberg Sloan School of Management, Massachusetts Institute of Technology Unrelated individuals work together within firms. Firms have rules governing the relationships of these individuals. Some individuals within the firm have authority, they decide what others should do and how much to pay them. They also decide what activities the firms lets outsiders carry out under contract. At least since Coase (1937) economists have viewed these arrangements as adaptations which make profits higher than they would be otherwise. Obviously, this maximization of profits does not imply that the organization of firms maximizes the social good. The usual product market imperfections can lead firms to make money while providing a socially inefficient level of output. Authors concerned with the internal organization of the firm tend to ignore these imperfections. Perhaps for this reason the analysis of Coase (1937), Alchian and Demsetz (1972), Williamson (1985) and Grossman and Hart (1986) implies that the authority relations within firms are optimal from a social perspective. Williamson (1985) goes so far as to state: "This book advances the proposition that the economic institutions of capitalism have the main purpose of economizing on transactions costs." In this paper I show that this optimistic appraisal is due at least in part to the exclusion of market imperfections. The inefficiencies associated with product market power can distort not only the level of output but also the transactions which make this level of output