A Theory of the Firm based on Partner Displacement
We develop a new theory of the firm where asset owners sometimes want to change partners ex-post. The model identifies a fundamental trade-off between (i) a "displacement externality" under non-integration, where a partner leaves a relationship even though the benefit is worth less than the loss to the displaced partner, and (ii), a "retention externality" under integration, where a partner inefficiently retains the other. Renegotiation cannot eliminate these inefficiencies when agents are wealth constrained. When there is more asset specificity, displacement externalities matter more and retention externality less, so that integration becomes more attractive. Our model also predicts that integration always provides stronger incentives for specific investments, and that wealthy owners actually want to commit to ex-post wealth constraints. Our analysis differs from the received theories of the firm because of our emphasis on dynamic partner changes.
We would like to thank Philippe Aghion, Florian Ederer, Bob Gibbons, Trond Olsen, Birger Wernerfelt, Ralph Winter, seminar participants at the University of British Columbia and the University of Toronto, and participants of the European Meeting of the Econometric Society (ESEM) in Malaga, and the Annual Meeting of the European Association for Research in Industrial Economics (EARIE) in Rome for valuable comments and suggestions. Funding support from SSHRC is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.