Get access

The boundaries of firms as information barriers

Authors


  • I am indebted to David Levine for his continuous guidance. The article benefits from insightful discussions with Kong-Pin Chen, Stephen Chiu, Yuk-fai Fong, Shingo Ishiguro, Domenico Menicucci, Hideo Owan, John Riley, and participants of various seminars and conferences. Comments from the editor and two referees helped improve the article substantially. Part of the research is done during my service at the Chinese University of Hong Kong. Financial support from the University Grants Council of Hong Kong (Ref. No. CUHK4265/03H) and the Chinese University of Hong Kong (direct grand 2002-03) are gratefully acknowledged. All errors are mine.

Abstract

When contracts are incomplete, the property-rights theory of firms suggests that ownership of physical assets provides better outside options, which in turn strengthen the owner's incentives to invest in the enterprise. This approach is less suitable for human capital firms such as management consulting that lack physical assets. This article develops an alternative theory for integration that sheds light on the boundaries of human capital firms. In particular, when a relationship between parties includes large potential externalities, reducing the outside option of each party will be beneficial. Integration provides this reduction by blurring the contribution of individual parties within the firm, and thus lowering their independent market valuation. Unlike some results in the property-rights literature, the results here are robust to variations in ex post bargaining solution.

Ancillary