Experience Benefits and Firm Organization

A principal requires a manager for production. He can use an internal manager, or contracts with an external manger. In each case, the manager obtains experience benefits from production. When the principal uses an internal manager, both parties share cost information. When the principal contracts with an external manager, only the external manager acquires cost information. The internal manager has limited access to the credit market; he has a minimum income constraint. The external manager has adequate access and has no minimum income constraint. The principal faces a tradeoff. Hiring an internal manager eliminates asymmetric information, but extracting experience rent is more difficult due to the minimum income constraint. Hiring an external manager means giving up information rent, but extracting experience rent is feasible. Whether the principal uses an internal or an external manager depends on the tightness of the minimum income constraint and the magnitude of the experience benefit. The principal’s optimal choice may not be socially efficient.