Working Paper Department of Economics Property Rights and the Nature of the Firm

The paper provides a framework for addressing the question of when transactions should be carried out within the firm and when through the market. Following Grossman and Hart (1986), we identify a firm with the assets which its owners control: ownership confers the right to decide how the assets are to be used in events unspecified in an initial contract. We study how changes in ownership affect non-owners of assets, such as employees. We show that a party 1 will put more weight on a party 2's objectives if 1 is an employee of 2 (i.e. 1 works with assets that 2 owns), than if 1 is an employee of some other party 3, or if 1 is an independent contractor providing 2 with a service. We use these ideas to give a partial characterization of an optimal control structure. Our framework is broad enough to encompass more general control structures than simple ownership: for example, partnerships, and worker and consumer cooperatives, all emerge as special cases. Our principal findings are, first, that assets should be owned or controlled together if they are (strongly) complementary; second, that ownership should be given to agents who are indispensable even though they may not have important (uncontractible) actions; third, that concentration of ownership through integration improves the incentives of the acquiring firm's employees, but has an ambiguous effect on employees in the acquired firm; and fourth, that when an asset is crucial to several firms, it may be optimal for the firms to share control of the asset via majority rule.