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THE QUARTERLY JOURNAL OF ECONOMICS Vol. CXXV May 2010 Issue 2 A THEORY OF FIRM SCOPE∗ OLIVER HART AND BENGT HOLMSTROM The formal literature on firm boundaries has assumed that ex post conflicts are resolved through bargaining. In reality, parties often simply exercise their decision rights. We develop a model, based on shading, in which the use of authority has a central role. We consider two firms deciding whether to adopt a common standard. Nonintegrated firms may fail to coordinate if one firm loses. An integrated firm can internalize the externality, but puts insufficient weight on employee benefits. We use our approach to understand why Cisco acquired StrataCom, a provider of new transmission technology. We also analyze delegation. I. INTRODUCTION In the last twenty years or so, a theoretical literature has developed that argues that the boundaries of firms—and the allocation of asset ownership—can be understood in terms of incomplete contracts and property rights. The basic idea behind the literature is that firm boundaries define the allocation of residual control rights, and these matter in a world of incomplete contracts. In the ∗ This is an extensively revised version of two earlier papers that circulated as “A Theory of Firm Scope” and “Vision and Firm Scope.” Some of the material presented here formed part of the first author’s Munich Lectures (University of Munich, November 2001), Arrow Lectures (Stanford University, May 2002), Karl Borch Lecture (Bergen, May 2003), and Mattioli Lectures (Milan, November 2003). We are especially grateful to Andrei Shleifer for insightful comments. We would also like to thank Philippe Aghion, George Baker, Lucian Bebchuk, Patrick Bolton, Pablo Casas-Arce, Mathias Dewatripont, Douglas Diamond, Aaron Edlin, Florian Englmaier, Robert Gibbons, Richard Holden, Bob Inman, Louis Kaplow, Bentley MacLeod, Meg Meyer, Enrico Perotti, David Scharfstein, Chris Snyder, Jeremy Stein, Lars Stole, Eric van den Steen, and seminar audiences at CESifo, University of Munich, Harvard University, London School of Economics, George Washington University, Stanford University, the Summer 2002 Economic Theory Workshop at Gerzensee, Switzerland, and the University of Zurich for helpful discussions. Finally, we have benefited from the very constructive suggestions of the editor and three referees. Research support from the National Science Foundation is gratefully acknowledged. C 2010 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, May 2010 483 484 QUARTERLY JOURNAL OF ECONOMICS standard property rights model, parties write contracts that are ex ante incomplete but can be completed ex post. The ability to exercise residual control rights improves the ex post bargaining position of an asset owner and thereby increases his or her incentive to make relationship-specific investments. As a consequence, it is optimal to assign asset ownership to those who have the most important relationship-specific investments.1 Although the property rights approach provides a clear explanation of the costs and benefits of integration, the theory has a number of features that have limited its applicability.2 One that we focus on here is the assumption that ex post conflicts are resolved through bargaining with side payments. Although direct empirical evidence on this topic is not readily available, casual inspection suggests that bargaining with unrestricted side payments is not ubiquitous. Many decisions made in a firm will be carried out without consultation or negotiation with other firms even when these decisions impact the other firms in a major way. It is rare, for instance, for a firm to go to a competitor with the intention of extracting side payments for avoiding aggressive mov