This research was sponsored by the MIT Center for Coordination
Science. I would like to thank Oliver Hart, Tom Malone, Birger
Wernerfelt, an anonymous associate editor and referees, and seminar
participants at the ORSA/TIMS Joint National Meeting (1992), the
Coordination Science Seminar Series and the Third Workshop on
Information Systems and Economics for helpful comments and insights.
Although there is good reason to expect that the growth of information
work and information technology will significantly affect the
trade-offs inherent in different structures for organizing work,
the theoretical basis for these changes remains poorly understood.
This paper seeks to address this gap by analyzing the incentive
effects of different ownership arrangement in the spirit of the
Grossman-Hart-Moore (GHM) incomplete contracts theory of the firm.
A key departure from earlier approaches is the inclusion of a
role for an "information asset", analogous to the
GHM treatment of property. This approach highlights the organizational
significance of information ownership and information technology.
For instance, using this framework, one can determine when 1)
informed workers are more likely to be owners than employees of
firms, 2) increased flexibility of assets will facilitate decentralization,
and 3) the need for centralized coordination will lead to centralized
ownership. The framework developed sheds light on some of the
empirical findings regarding the relationship between information
technology and firm size and clarifies the relationship between
coordination mechanisms and the optimal distribution of asset
ownership. While many implications are still unexplored and untested,
building on the incomplete contracts approach appears to be a
promising avenue for the careful, methodical analysis of human
organizations and the impact of new technologies.
2. Information and asset ownership
3.2 What is the impact of making information alienable or contractible?
3.3 Do smaller firms provide better incentives for exploiting information?
3.4 Are flexible assets more appropriate for informed agents?
3.5 How does "coordination information" affect the distribution and ownership of production assets?
4.2 Comparison with empirical evidence
4.3 Comparison with related literature
Information technology has the potential to significantly affect
the structure of organizations. However, the nature of these changes
is still being debated. While the heuristics and intuition that
managers have applied for years provide some guidance, the changes
enabled by information technology are potentially so radical that
past experience may not prove a trustworthy guide. Meanwhile,
researchers using field studies examining the link between investments
in information technology and changes in organizational structure
have come to diverse and often contradictory conclusions (see
Crowston & Malone (1988) for a review). Econometric work has
been able to generalize some of the findings of the case studies,
but can only claim to have found correlations, not causal links
(Brynjolfsson, Malone, Gurbaxani, et al., 1991a). Managers and
researchers each suffer from the lack of robust theoretical models
that provide sharp, testable predictions.
The interdisciplinary field of coordination science has emerged in part to help address this gap. For instance, Malone and colleagues (Malone & Smith, 1988; Malone, Yates & Benjamin, 1987), have modeled different structures, such as firms and markets, for coordinating intelligent agents. This has enabled specific predictions of the effects of changes in information technology on the flexibility, production and coordination costs of these structures. However, many important issues concerning information technology and the boundaries of the firm are beyond the scope of these models. In this paper, I pursue a new approach to address the following questions:
1) How does the location of information affect incentives and ownership structure?
2) What is the impact of making information alienable or contractible?
3) Do smaller firms provide better incentives for exploiting information?
4) Are flexible assets more appropriate for informed agents?
5) How does "coordination information" affect the optimal
distribution and ownership of production assets?
While many of these questions fall under the traditional purview
of economics, progress has been hampered by the lack of an adequate
economic theory of the firm. Ironically, despite the central role
of the firm in economics, neoclassical economics traditionally
treats the firm as little more than a black box "production
function". Developments in principal-agency theory have
given some insight into the incentive mechanisms used inside
firms, and by extension, the role of information and information
technology. However, because the same models apply equally well
to contracts between firms, agency theory by itself cannot
explain the boundaries of firms or the relative advantages of
different institutional or ownership structures (Hart, 1989) .
Transaction cost economics (Williamson, 1985) directly addresses
the question of what determines firm boundaries. The insights
of this approach have been useful in describing the impact of
information technology on firm boundaries (Brynjolfsson, Malone
& Gurbaxani, 1988; Malone, Yates & Benjamin, 1987). However,
while it is difficult to develop a theory of IT's impact
on firm boundaries using agency theory, it is almost too easy
using transaction cost economics. As Fischer (1977, n. 5) put
it: "There is a suspicion that almost anything can be rationalized
by invoking suitably specified transaction costs."
More recently, an economic theory of the firm has emerged that
combines the insights of transaction cost economics regarding
the importance of bounded rationality and contracting costs with
the rigor of agency theory. The new theory focuses on the way
different structures assign property rights to resolve the issues
that arise when contracts are incomplete. This provides a basis
for defining different organizational structures by the ownership
and control of key assets. Grossman, Hart and Moore (Grossman
& Hart, 1986; Hart & Moore, 1990) pioneered this approach
and its relationship to earlier approaches has been lucidly documented
by Hart (1989).[1]
In this paper, I build on the insights of the property rights
approach to the theory of the firm to clarify the mechanisms by
which information technology can be expected to affect the organization
of economic activity. Although I change some of the assumptions
and come to new conclusions, this paper can perhaps best be viewed
as an application of the Hart-Moore framework which focuses on
information, whether embodied in humans or artifacts. In particular,
I will consider the incentive effects of various allocations of
"information assets" as well as physical assets. This
approach is particularly appropriate given the increasing importance
of information in the economy. In addition, by considering the
role of incentives, it is possible to answer some long-standing
questions regarding the link between stylized coordination mechanisms
and real-world institutions like firms and markets. For instance,
this approach facilitates the analysis of cases that illuminate
each of the five questions posed above.
The remainder of the paper is organized as follows. Section two
describes the basic assumptions behind the property rights approach
and sets up the framework. Section three uses this framework to
explicitly treat information as an asset. This facilitates the
investigation of a variety of different organizational forms under
different distributions of information, levels of asset specificity
and coordination mechanisms. In section four, I summarize the
conclusions of the paper and compare and contrast it to related
literature.
2. Information and asset ownership
2.1 Asset Ownership and Incentives
Before examining specific models of information technology and
information work, it is worth sketching the basic tenets of the
property rights framework.
Begin by considering one of the simplest sorts of organization,
an arrangement between a principal and an agent hired to accomplish
some task. As principal-agent theory has long argued, appropriate
incentives must be provided for the agent. In general, because
the principal cannot directly measure the effort level of the
agent, incentives need to be provided by making the agent's
pay partially contingent on performance. An example is the commission
that a sales agent often receives. A basic conclusion of the theory
is that agency problems can be mitigated, and sometimes even solved,
by promising the agent a sufficient share of the output produced.
However, problems arise when it is not possible to specify clear
performance measures in advance. For instance, the owner of the
firm may have insufficient information to prespecify the decision-making
activities of the firm's managers (after all, that's presumably
what they were hired to do). Simply linking management
pay to sales or even profits would encourage managers to inappropriately
shift resources away from R&D and maintenance. The solution
prescribed by agency theory calls for a comprehensive contract
that considers the marginal value of all possible activities of
the agents and the marginal cost to the agents in all possible
states of the world, and the ability of the principal to commit
to pay the appropriate compensation for each outcome (Hart &
Holmstrom, 1987). Lacking such a comprehensive contract, incentives,
and therefore production, will be suboptimal.
A key tenet of the GHM approach is that unlike the contracts typically
analyzed by agency theory, real world contracts are almost always
"incomplete", in the sense that there are inevitably
some circumstances or contingencies that are left out of the contract,
because they were either unforeseen or simply too expensive to
enumerate in sufficient detail. For instance, the level of intangible
"quality" of a manufactured good, the level of "care"
used in maintaining a piece of equipment, or the thought process
used in generating a creative insight are all aspects of a contract
that are often too costly, if not impossible, to include in a
contract. This is a natural consequence of the bounded rationality
of the parties. Each of the parties will have certain rights under
the contract, but its incompleteness means that there will remain
some "residual rights" that are not specified in the
contract. When these rights pertain to the use of an asset, the
institution which allocates these residual rights of control is
property ownership. All rights to the asset not expressly assigned
in the contract accrue to the person called the "owner"
of the asset. [2]For example, if a machine rental contract says nothing
about its maintenance protocol, then it is the machine's
owner who retains the right to decide.
The allocation of the residual rights of control will have an
important effect on the bargaining position of the parties to
the contract after they have made investments in their relationship.
In the absence of comprehensive contracts, property rights largely
determine which ex post bargaining positions will prevail. In
particular, a party that owns at least some of the essential assets
will be in a position to reap at least some of benefits from the
relationship which were not explicitly allocated in the contract,
by threatening to withhold the assets otherwise. A party who does
not control any assets, and whose cooperation is unnecessary to
the harvesting of value, must rely on the letter of the contract
or the goodwill of the assets' owner to share in the output. As
a result, an agent who controls no essential assets risks going
unpaid for work which is not specifically described in an explicit
contract. In contrast, the agent who controls assets that are
essential to the relationship can "veto" any allocation
of the residual rewards which is not considered sufficiently favorable.
Thus, the ownership of assets that are essential to production
and the receipt of the residual income stream go hand in hand.
According to this view, the dilemma of providing incentives to
agents when comprehensive contracts are infeasible can be mitigated
if those agents are assured a significant share of the output
they produce by providing them with the ex post bargaining power
inherent in asset ownership. Based on this principle, Grossman,
Hart and Moore have derived a theory of vertical and lateral integration
with implications for industry structure and the optimal size
of firms.
The distinction between "markets" and "hierarchies"
emphasizes that production can be organized within one firm or
among several firms, depending on whether the principal means
of production are controlled by a single person (or group), or
distributed among several. Hart and Moore (1990) develop a useful
framework and notation for examining how changes in the distribution
of asset ownership affects the incentives of the individuals who
work, directly or indirectly, with those assets and they establish
a number of propositions regarding the optimality of different
ownership structures. I will use a variant of this framework to
capture the essential properties of the relationship between information
and ownership and to provide a useful tool for more broadly examining
the organizational implications of different distributions of
information among individuals.
Application of the framework requires a number of assumptions,
which are reproduced formally in the appendix. Because ownership
is only important to the extent that actions are uncontractible,
all actions in the model are assumed to be uncontractible, with
incentives influenced only by asset ownership. 
and the marginal value generated
by i's actions when he is in a coalition with a subset S of other
agents is denoted vi(S,A(S)|x), where A(S) is the set of all assets
owned by the coalition and x is the vector of actions taken by
the coalition's members. To decide how the total value generated
by a group of agents working together will be apportioned, Hart
and Moore suggest the use of the Shapley value.[3]
This amounts to paying each agent an amount equal to his contribution
to each potential coalition multiplied by the probability that
he will be in any given coalition. Although the Shapley value
is traditionally used to analyze cooperative bargaining (Shapley,
1953), Gul (1989) provides a detailed non-cooperative bargaining
justification for this assumption. In any event, the exact rule
for division of the surplus will generally have no qualitative
effect on the results as long as each agent's share of output
is positively correlated with his access to essential assets.
2.3 Information as an "Asset"
But what are "assets"? Assets are relevant in Hart and
Moore insofar as they affect marginal product; the marginal value
of an agent's actions are greater when he has access to more assets:
They specifically limit the interpretation of the term "asset"
to non-human assets like machines, factories or customer lists
because they are alienable, and thus can change "ownership".
Similarly, much of economic theory and practice has focused on
the role of physical capital and tangible assets to the detriment
of human capital and intangibles like information, knowledge and
skills.
In contrast, Simon has long argued for a greater emphasis on these
intangible assets:
My central theme has been that the main productive resource in an economy are programs -- skills, if you prefer -- that in the past have been partly frozen into the design of machines, but largely stored in the minds of men.(Simon, 1982)
Given the continuing information explosion, the role of "intellectual
capital" is becoming more significant. As Drucker (1992)
recently put it:
In this society, knowledge is the primary resource for
individuals and for the economy overall. Land, labor and capital
-- the economist's traditional factors of production -- do not
disappear, but they become secondary.
Quantifying the importance of intellectual capital is difficult,
given its intangible nature. But as Wriston points out, that does
not make it any less important:
To enter a business, the entrepreneur in the information age often
needs access to knowledge more than he or she needs large sums
of money. To write a software program that might make its author
millions of dollars may require only a relatively trivial investment
[in physical capital], compared to the investment needed to enter,
say, a manufacturing business producing a comparable stream of
income. It is the knowledge capital accumulated in the software
writer's head or in the documentation or on the disks that makes
possible the new program. This capital is substantial and very
real. And it does not show up with any clarity in the numbers
economists customarily quote about capital formation. (Wriston,
1992, p.102)
The dilemma of assessing the value of intellectual capital can
be addressed by focusing on the income it produces, rather than
the traditional approach of estimating the investments made. Using
this procedure, Jorgenson and Fraumeni (1992) recently concluded
that the stock of human capital is ten times greater than previous
estimates, dwarfing other kinds of investment.
Just as Jorgenson and Fraumeni empirically define human capital
by the income that this "asset" produces, we can adapt
Hart and Moore's (1990) framework to include human capital as
an asset that affects agents' marginal products when they have
access to it. This requires us to depart from their assumption
that only tradable commodities can be "assets". However,
it facilitates a number of insights into organizational form.
Given the qualitative and quantitative importance of information,
knowledge and skills in the modern economy, I will focus on the
application of the incomplete contracting paradigm to this type
of "asset". I will argue that the information that an
agent knows can be critical to his productivity and incentives,
suggesting that human capital can be treated on a par with physical
capital. Accordingly, in the examples that follow, I will treat
the information that the agent knows as an "asset" that
he "owns". This approach enables the analysis of how
the inalienability of some assets, such as knowledge, affects
the optimal allocation of other assets, such as physical capital.
This allocation will, in turn, determine firm boundaries and organizational
structure.
In addition, treating information as an asset allows us to treat
endogenously the question of whether it should be created in an
alienable or inalienable form. After all, in many cases, information,
knowledge and skills can be embodied either in humans or in tradable
commodities like software or databases. What are the costs and
benefits of alternative strategies and the implications for organizational
structure? What is the value of making information alienable?
Finally, by assuming that the synergies between agents occur only
through the assets (which now include information) that they have
access to, we can simplify the notation by suppressing the explicit
reference to the coalition of other agents. In addition, to simplify
notation, we also suppress the vector of actions, x:
Note that in this framework, actions x do not directly create
or change the value of assets, but access to assets can affect
the value of actions.
3. Information and organizational structure
Explicitly treating information as an asset, the framework can
now be applied to a number of questions regarding the relationship
among information, technology and organizations.
3.1 How does the location of information affect incentives and ownership structure?
In the first case I examine, consider an entrepreneur who has
some expertise needed to run a firm. For simplicity, assume that
the only relevant assets are the information in the entrepreneur's
head, labeled 
, and the physical assets
of the firm, 
. No value can be created without
access to both of these assets. In addition, assume that the assets
are complementary in that the information is of no value without
access to the firm, and that firm is of no value without access
to the entrepreneur's expertise. [4]If no comprehensive contract
can be written regarding the disposition of the firm in each possible
future contingency, should the entrepreneur or some other agent
own the firm? The framework can be readily applied to answer this
question.
First, consider the case in which someone other than the entrepreneur
owns the firm, . In this case, if the entrepreneur
makes an investment of effort and creates some potential value,
he can be subjected to a hold-up by the other party, since he
needs access to in order to realize that
value. [5]By assumption, no contract for the use of
exists, so the parties must bargain for the division of the surplus.
Under Nash bargaining, each party can expect to get 1/2 of the
additional value created (this is their Shapley value). Similarly,
if the other party creates some value, the entrepreneur can bargain
for 1/2 of the value created by threatening to withhold his expertise,
otherwise. Each agent will exert effort
until the marginal benefit he can expect to receive is just equal
to the marginal cost of the action he takes. Since each party
will bear the full costs of their efforts but can only expect
to receive 1/2 of the incremental value created, they will both
underinvest in this ownership arrangement.
Formally, the first order conditions are given by the following
equations where the entrepreneur and the other party are indexed
by {1,2}, respectively.
Because the information and physical assets of the firm are productive
only when used together, then the second term in both equation
4a and equation 4b is equal to zero, so each party will only invest
in effort to the point at which marginal costs are equal to 1/2
of marginal value.
Alternatively, consider giving the entrepreneur ownership of the
firm, (as well as "ownership"
of his expertise, ). In this case, the other
party cannot hold up the entrepreneur, since the entrepreneur
already controls all the assets needed. While the entrepreneur's
incentives are improved, the other party's incentives are unaffected,
since as before, the entrepreneur can bargain for 1/2 of the value
created by other party's investments in the relationship.[7]
Net benefits will be maximized by providing the strongest [8] incentives
for effort on the part of each agent. The organizational problem
can thus be viewed as a matter of choosing among the feasible
allocations of asset ownership one that maximizes the share of
value that each party can expect to receive. Thus, incentive considerations
prescribe that it is optimal to give the entrepreneur ownership
of the physical assets of the firm as long as he has information
that is essential to its productivity anyway. Other considerations,
such as wealth constraints and credit constraints may limit the
feasibility of such an allocation. Nevertheless, from an incentive
standpoint, the informed agent should be given ownership of the
assets necessary to his work.
It is worth interpreting this result in terms of Hart and Moore
(1990). In one sense, it could be considered an application of
their proposition 6, that an agent who is "indispensable"
to an asset should own that asset. Because the agent in the preceding
example has information essential to the productivity of the physical
asset, he is effectively "indispensable" by their definition.
Given our treatment of information as an asset that is necessary
to the productivity of the physical assets, they can appropriately
be thought of as complementary assets. This suggests that Hart
and Moore's proposition 8 is even more germane: complementary
assets should be owned by the same agent when complete contracts
are infeasible.
If the entrepreneur's information is not completely essential
to the productivity of the physical assets, then giving him ownership
of them will reduce the incentives of the other agent[9]. Whether
this is outweighed by the improved incentives to the informed
agent will be a function of how necessary that agent's information
is to the productivity of the firm and how important it is to
maximize his incentives relative to those of the other agent.
An analysis of the first order conditions under alternative ownership
structures show that the more important it is to provide incentives
to the informed agent, the more likely it is that it will be optimal
to give him ownership. Furthermore, to the extent that it is particularly
difficult to prespecify the outputs for "information work",
it is likely that informed agents will have significant, uncontractible
actions.
Hart and Moore also present an argument suggesting that the ownership
of assets essential to production is likely to give the owner
"authority" over other agents that need access to those
assets. Without reproducing their argument, this suggests that
a corollary to the proposition that informed agents should own
the essential assets is that they are also likely to gain authority
over uninformed agents.
The above analysis helps explain why an entrepreneur, with information
essential to the success of the firm, is more likely to own the
firm than are other people who work inside or outside the firm.
Similarly, if a key individual, such as a research scientist or
a star salesperson is critical to the success of a new venture,
the venture capitalist is likely to insist that that individual
be given an ownership stake in the firm. This will tend to improve
the key individual's incentives without reducing those of other
parties proportionately.
The analysis also suggests an important exception to this principle:
when a key individual's actions are entirely contractible, incentives
can be provided via a contract and ownership of the firm is not
needed. For instance, when there is a well-defined product, market
and distribution channel, the incentives of a star salesperson
may be adequately provided by a commission-based sales contract.
Likewise, a patent may be sufficiently complete that additional
incentives for an inventor are not needed. Management contracts
in which top executives have no ownership stake in the firm are
particularly unlikely to be sufficient in the early stages of
a venture, but pose less of a problem for mature firms. One explanation
for the boom in management buy-outs in the 1980s is that the turbulent
business environment provided new opportunities for managers to
profitably apply knowledge in unforeseen ways. Given incomplete
contracts, the incentives are much greater for an individual who
owns a newly spun-off company than they are when the same individual
is a head of an equivalent division owned by others.
A second implication of the above analysis is that ownership of
the physical assets of the firm, aF, may be
of little value when complementary information assets, aI,
are not also controlled. By definition, the purchaser of a firm
only gets control of the alienable assets owned by the firm, in
this case, aF. Therefore, for a "knowledge-based"
firm, such as a consulting firm, or a research firm dependent
on a few research scientists, ownership of the physical assets
of the firm may have little value. The purchaser may still have
to share profits with the key individuals who remain in control
of the essential information assets. Thus, an empirically-testable
prediction of the framework is that, a potential purchaser will
pay much less for a knowledge-based firm than a traditional firm
with a comparable earnings record. Ironically, a knowledgeable
entrepreneur may be unable to "cash out" unless a way
is found to make the firm independent of the inalienable expertise
of the key individuals.
This explanation for why knowledge goes hand in hand with ownership
is distinct from, but complementary to, that of Rabin (1993) ,
which also models the relationship between information, ownership,
and authority. Instead of examining the incentives of the informed
agent to maximize uncontractible effort as is done above (a moral
hazard problem), Rabin showed that the adverse selection problem
could also be sufficiently severe that, in certain equilibria,
an informed agent could only "prove" the value of his
information by taking control of the firm and its residual income
stream. This leads to the informed agent getting authority over
the uninformed agent. Both these considerations may be relevant
in some situations. For instance, venture capitalists often insist
that an informed entrepreneur hold a significant stake in a new
venture, both as a signal of his own faith in the project (self
selection) and as a motivator to get him to work hard (moral hazard).
3.2 What is the impact of making information alienable or contractible?
Explicitly treating information as an asset as modeled above,
not only makes it possible to consider whether an informed party
(agent 1) should own the firm instead of another party (agent
2), it also makes it natural to consider a third alternative:
giving the other party "ownership" of both the physical
assets and the information. Of course, this requires that the
information can be made "alienable" for instance in
the form of an expert system, a procedures manual or some other
artifact. In certain circumstances, it may be more efficient to
move the information than to shift ownership of all the physical
assets to the informed agent.
Given agent 2 ownership of both the information, aI, and the other assets of the firm, aF, yields the following first order conditions:
 | [10] |
Now the incentives of agent 2 are maximized at the expense of
agent 1. This will provide incentives that are superior to those
under agent 1's ownership if the actions of agent 2 are relatively
important.
However, there are a number of reasons that it may be difficult
to transfer the information "asset" to agent 2 (Brynjolfsson,
1990a). Most notably, the reason for hiring an agent in the first
place is often to reduce some of the information processing load
on the principal. Furthermore, the relevant information may be
generated by the hired agent in the course of his activities,
as in learning-by-doing, or simply by what Hayek (1945) calls
the "knowledge of the particular circumstances of time and
place". This information may be costly to convey to the agent
2, not only because of difficulties in codifying and transmitting
it, but also because of adverse selection problems. It is notably
difficult to consummate transactions when the parties have differential
information because of the "fundamental paradox" of
information: "its value for the purchaser is not known until
he has the information, but then he has in effect acquired it
without cost" (Arrow, 1971, p. 152).
When, for whatever reason, the information asset cannot be owned
by agent 2, yet it is necessary to the productivity of the physical
assets, the incentive considerations featured in the preceding
analysis suggest that the next best solution will generally be
to give ownership of the physical assets to the informed agent.
In the absence of contractibility, complementary assets should
be owned by the same party, and in this case, this requires moving
control of the alienable physical assets to the owner of the inalienable
information asset. Thus, the control of information can determine
the equilibrium ownership of other assets as well, and therefore
organizational structure and authority.
In addition, this framework also suggests a method of quantifying
the potential improvement in incentives, and therefore increase
in value, enabled by making information alienable. Compare the
output created under the best possible ownership structure when
information is alienable (the unconstrained allocation) to the
output created under the best possible ownership structure when
information must be "owned" by a particular party (the
constrained allocation). In above case, this would amount to comparing
the maximum value created when choosing an organizational arrangement
described by equations 4, 5 or 6, with the maximum attainable
when the choice is limited to equations 4 or 5. Obviously, the
ownership of even the alienable assets may be shifted by adding
the inalienability constraint to some assets. The difference between
the values created under these alternatives could be called the
"value of alienability". In some circumstances,
it can be quite large, suggesting that merely embodying information
in a tradable form can "create" a great deal of value
even without increasing the stock of knowledge.
The above analysis suggests that the definition of which assets
are alienable, and which are not, can be made endogenous. Incentives
for advancing technology in ways which make information alienable
will be strongest if the value of alienability is high. For instance,
to the extent that value is enhanced by embodying and delivering
expertise in the form of a knowledge-based expert system, such
knowledge engineering efforts are likely to be undertaken. Procedures
manuals, how-to books, lectures and other vehicles for purchasing
know-how have existed even longer.
A natural extension of this approach would be to empirically examine
the organizational effects of making expertise alienable through
software in areas like tax law or medicine, or through on-line
databases in a rapidly growing number of domains. More generally,
the reduction in information transmission costs enabled by information
technology is already leading to significant new approaches to
the related organizational problem of co-locating information
and decision rights (Brynjolfsson & Mendelson, 1993) .
When knowledge can be articulated, it is often straightforward
to embody it in an alienable artifact. However, this is may be
impossible for tacit knowledge (Williamson, 1979) , although some
knowledge may be transferred through tacit shared understandings
of collectives. [11] For instance, it might be fruitful to interpret
the organizational value of corporate cultures as a "technology"
which allowed information to be transferred at relatively low
cost, but only among parties which share the same culture. Languages
and even education could also be interpreted in this vein, simply
by considering the organizational value of enabling "semi-constrained"
allocations in which knowledge was alienable, but only among a
finite subset of agents.
In the past decade, the digital revolution has led to the creation
of numerous alienable information assets. The model predicts that
the primary financial beneficiaries will be those who own the
information assets but who formerly could not benefit from them
without being personally involved. Indeed, the relative incomes
of high-skill "superstars" in several fields may be
a reflection of this phenomena (Levy & Murnane, 1992). The
embodied information need not be limited to "knowledge"
in the traditional sense. Consider the relative incomes of popular
musicians and other artists today who are able to embody their
work in various recording media.
The analysis above and in section 3.1 shows that incentives are
improved by having the control of both information assets and
complementary physical assets vested in the same party. Separating
control leads to potential hold up problems. However, relaxing
the underlying assumption that no comprehensive contract can be
written changes this conclusion. As Williamson (1985) has argued,
complementary assets will only lead to integration when there
is "market failure", that is the breakdown of arm's
length contracting. Above, it was argued that this will make it
difficult to contractually transfer information from party to
another. It will also make it difficult to specify its application
even if it is not transferred. In fact, Teece (1980) argued that
the existence of "knowhow" is a key determinant of integration
because "a knowhow agreement ...will be highly incomplete,
and the failure to reach a comprehensive agreement may give rise
to dissatisfaction during execution." However, some information
is fairly contractible, such as the control algorithms of an robotic
assembly line. Trends in technology, and in intellectual property
law suggest that more information may fall into this category.
What are the organizational and efficiency implications of making
information contractible?
If information is fully contractible, then there are no "residual
rights" so the ownership of it is irrelevant. The same party
who owns physical assets does not need to control the complementary
information because there is no longer a holdup problem. Thus,
even more ownership arrangements become feasible. For instance,
as operating system software became more standardized in the late
1960s, IBM stopped bundling it with their mainframes. More recently,
the trend toward information system outsourcing is consistent
with an improved ability to define outputs and inputs contractually.
Making information alienable improved incentives by making new
ownership patterns feasible, but it still fell short of the first
best since any party not getting control of the information asset
was potentially subject to being held up. In contrast, making
information fully contractible could potentially give every party
the optimal incentives, at least with regard to this asset. In
principle, access to the information asset can be allocated to
each individual based on the appropriate contingencies that will
maximize their incentives. As with alienability, one can compare
the value created when information is contractible with the value
created when information is not. It is likely that in many cases
this will indicate that the "value of contractibility"
can be extremely high. I will not venture to speculate whether
America's growing legal profession is helping in this regard,
but moves towards greater standardization and better defined intellectual
property rights do seem to fall into this category.
3.3 Do smaller firms provide better incentives for exploiting information?
The analysis above considered just one "information"
asset and showed that the physical assets should be owned by the
same person who has the information necessary to the productivity
of those assets.
The possibilities become more interesting when there are multiple,
informed agents. Consider the case of n agents (i = 1...n), each
of whom has some information (ai, i = 1 ...n) which requires access
to a physical asset (the "firm": ),
to be productive. Assume that the information of one agent does
not affect the information of other agents.
If any one agent, j, is given ownership of the physical asset,
his first order condition is:
Regardless of which agent owns the physical asset, all
the other agents in the firm will have insufficient incentives
to exert effort. To the extent that these insufficient incentives
will lead them to underutilize their information, overall productivity
would be enhanced if the same agent could own all the information
and the physical asset of the firm. This is consistent with the
notion of providing all the necessary information to the running
of the firm to an owner/manager. The owner/manager has the information
and the first-best incentives, while the other agents simply carry
out his instructions, with little information or physical asset
ownership of their own. Because their uncontractible actions
are kept to a minimum, there is little need to provide them incentives
through ownership. This is in many ways consistent with the Taylorist
prescription that enables the creation of large, successful hierarchical
firms.
An interesting alternative to single agent ownership is to have
a partnership, as many professional firms do, in which control
of the physical assets is allocated on the basis of majority rule.
In this case, the agent will effectively control the firm whenever
he is in the majority coalition, so assuming random coalitions
on any given issue, his first order condition (for n odd) is:
This system will more evenly allocate the incentives of all the
agents. However, they will still have insufficient incentives
to invest compared to the first-best, especially as n becomes
large.
The problem of insufficient incentives for the informed agents
cannot be solved by any combination of voting patterns because
there is simply not enough residual income to go around. The first
best incentives require that on the margin, each agent receive
100% of his contribution, but this is not possible if only total
output is observed and budget balance is to be maintained (Alchian
& Demsetz, 1972). This brings us back to the assumption made
at the beginning of this section that all actions were not contractible.
There is clearly a strong benefit to setting up production so
that actions are contractible. That way, ownership does not have
to bear the (impossible) burden of providing incentives for all
the agents. Firms obviously do try to regiment production in ways
that facilitate this, sometimes at the expense of creative freedom
(Holmstrom, 1989).
One can see that small firms are likely to have an advantage in
providing incentives, not only because it is likely to be easier
to separate out and contractually reward the individual contributions,
but also because agents in smaller firms will have stronger incentives
to make the uncontractible contributions as well. [12] For instance,
equation (8) indicates that small partnerships will provide stronger
incentives than large ones; proprietorships provide the best incentives
of all. When it is important to provide incentives for the application
of information in ways that cannot be easily foreseen and incorporated
into a contract, small firms will have a relative advantage over
large firms.
One example is that partnerships such as law firms have traditionally
been fairly small compared to corporations. It is interesting
to note that in the 1980s some law firms grew to over 200 partners
(Labaton, 1990), which would seem to be beyond the size consistent
with equation 8. One explanation is that these firms can more
accurately apportion revenues and costs through explicit
contracts by using computers to track billing and asset use on
an individual basis. In this sense, the uncontractible "community
property" is minimized and the partnership functions more
like a conglomerate of individual entrepreneurs, each with his
or her own "turf". The growing numbers of non-equity
"partners" (Aoki, 1990) is also consistent with the
idea that control of non-human assets is no longer of such central
importance in large law firms because uncontractible contingencies
have been reduced.
3.4 Are flexible assets more appropriate for informed agents?
The inefficiencies inherent in having multiple informed agents
working in the same firm, whether the firm is owned by one of
the agents or a partnership, can be alleviated if each of the
agents could have uncontested ownership of, and therefore access
to, the physical assets of the firm.
If the physical assets of the firm are not unique, and if there
are no economies of scale in their use, then the first best incentives
for all of the informed agents can be costlessly achieved by giving
each of them his or her own firm (that is, an
asset for each agent with an ai asset, as in equation 7).
Alternatively, the assets of the firm may be divisible to some
extent. In this case, agent i may not need access to all of the
physical assets that comprise the firm, but only some subset,
i. Then there will be
a trade-off between distributing the assets of the firm to its
agents or keeping the assets together. To the extent that the
firm's assets are complementary, dividing ownership of the assets
will reduce their productivity in those coalitions in which they
were separated. On the other hand, if each agent's information,
ai, were particularly synergistic with only the subset i,
then there are advantages to giving that agent ownership, so that
they would always be together.
As an example, consider the case of three agents and three physical
assets of the firm, where synergies exist among the firm's assets,
and between each agent's information and the firm's assets.
When agent i owns the subset of physical assets i,
(and of course his private information, ai,)
the first order condition for agent 1 is:[13]
Alternatively, if all the assets of the firm are owned by another
agent, agent 1's first order condition is:
The first order conditions for each of the other agents will be
symmetrical.
The ownership structure that provides the greatest incentives
to an agent can be determined by comparing the left hand sides
of the two equations. If the assets are highly or strictly complementary,
then the second, third and fourth terms of the first equation
will be low or zero. In this case, dividing the assets will provide
lower incentives than keeping them together, even for an agent
who is not the owner of the united assets. On the other hand,
if the information 1 applies mainly to the
physical asset aF1, and they are fairly productive
even when separated from 2 and 3,
then the first equation shows that separate ownership provides
close to the first best incentives for the agent.[14]
The fact that there are several agents, each of whom has an important
information asset, ai, that requires access to the physical assets
of the firm to be productive means that first-best efficiency
cannot be achieved by organizing as a single firm, as shown in
equation 10. Therefore, where information technology results in
a decentralizing of information, it opens the door to a parallel
effect of decentralization of asset ownership, that is in an increased
use of markets to coordinate economic activity.
Moreover, the preceding discussion also highlights the importance
of the asset specificity of the physical assets in the integration/non-integration
trade-off. If information technology makes assets more flexible,
so that they are not as locked-in to other particular assets,
then it will facilitate the decentralization of asset ownership.
This is essentially the argument of Malone and colleagues (Malone,
Yates & Benjamin, 1987; Brynjolfsson, Malone & Gurbaxani,
1988), among others. On the other hand, when the technology increases
lock-in, for instance because of network externalities, proprietary
standards or idiosyncratic hardware and software protocols, it
will make decentralization more costly.
Thus, technology will affect the organizational choices of the
firm both through its impact on the distribution of information
and by changing the nature of the non-human assets. These effects
interact with each other and feedback on themselves. The best
incentives can be achieved either 1) through the centralization
of information and asset ownership in one party, in which case
there is no cost to high asset specificity, or 2) through decentralization
of information and assets, which requires low asset specificity.
Thus, one would expect to see trends affecting the distribution
of information influence the types of physical assets used in
production, and vice versa.
One dramatic example is the way the rise of the personal computer
enabled thousands of small high technology startups to compete
successfully with bigger companies. In turn, the desires of knowledge
workers drove the shift from centralized computing to personal
workstations, even within large companies. The rise of automated,
knowledge-intensive steel mini-mills is another example of complementarities
between the distribution of information and the flexibility of
technology.
3.5 How does "coordination information" affect the distribution and ownership of production assets?
Up until now, we have only considered complementarities among
the physical assets or between information and physical assets,
not among the information assets themselves. Obviously, when there
are multiple informed agents working closely together, each of
them may need access to the information possessed by some other
agent at any given time. Such interactions can become exceedingly
complex, leading to combinatorial explosion and making explicit
contracts unworkable (Mailath & Postlewaite, 1989; Rosen,
1988). What's worse, if every agent truly depends on information
known only to other agents, then no rearrangement of the physical
assets alone can eliminate this interdependency. There will always
be insufficient incentives comparable to those of when complementary
physical assets are owned by separate agents (e.g. equation 9).
However, one way to reduce the number of necessary links between
agents is to channel all interactions through a central "coordinator"
(Malone & Smith, 1988). In this way, instead of each n agents
having to communicate and coordinate with n-1 other agents (for
a total of n.(n-1) links), each agent only
has to send and receive information from one coordinator (for
a total of n links). Obviously, relying on a central coordinator
can be vastly cheaper, and when bandwidth or time available for
communication is limited, results in better coordination. Diverse
organizations such as factory production lines and military operations,
which require tight coordination among members in limited time,
are often structured so that coordination is based on centralized
instruction rather than negotiation among agents. While the costs
of delay and bandwidth can be intangible when the links refer
to communication, a similar principle applies to transportation,
where the costs are more explicit. For instance, the idea of using
a hub-and-spoke network is clearly a principle of efficiency that
enables Federal Express, and increasingly passenger airlines as
well, to economize on air routes.
When centralized coordination is required, it is often, but not
always, carried out within firms rather than among them. While
others have simply assumed that centralized coordination is synonymous
with firms, one can demonstrate that such an arrangement follows
from weaker assumptions about assets and incentives. Below, I
show that the existence of one agent who has essential coordination
information has interesting implications for the distribution
of physical assets. In particular, it can make centralized ownership
of all physical assets optimal if either 1) it is important to
provide incentives to the "coordinator" or 2) the physical
assets are even weakly complementary. Each of these cases is analyzed
below.
To analyze the first case, consider the following stylized model
of centralized coordination. Instead of each agent being able
to contact the other agents directly, assume that they can only
communicate with a central "coordinator".[15] Because of
his positioning, the central coordinator obtains information that
is essential to the productivity of the agents. [16]This set-up reduces
the total number of links that need to be maintained, but also
makes the agents very dependent on the central coordinator. Formally,
assume that the typical agent needs access to the coordination
information, ac, to be productive, but that
the information of any given agent is irrelevant to the coordinator
or the other agents directly. Assume further that the productivity
of any agent, i, is enhanced when he has access to certain physical
assets, i, but is independent
of other assets, j,
j
i .[17]
When each of the agents owns some physical assets (and his information,
ai), the first order condition for a typical agent is:[18]
When the central coordinator owns all the physical assets, then
agent i's first order condition is:
Because the agent needs access to the coordination information,
the second term in each equation is equal to zero, so the incentives
for a typical agent do not change under alternative ownership
structures. However, the incentives for the coordinator are unambiguously
improved by giving the coordinator ownership of all the physical
assets, even if they only increase his productivity marginally.
Thus, if it is important to provide incentives to the central
coordinator, centralized ownership is optimal.
The second case in which shifting ownership of non-human assets
from one agent to the coordinator is optimal is when the physical
assets are at least weakly complementary. Interestingly, in this
case giving the central coordinator all the assets is optimal
even when the effect on the coordinator's incentives is unimportant
or disregarded. The reason is that shifting such assets from any
agent i to the coordinator will enhance the incentives of the
other agents, (j i).
For tractability, consider the case of just two agents (i = 1,2)
and a coordinator (c) in which the two agents each own a physical
asset, i and each has
some valuable information, ai. Unlike the previous case, we now
assume that the physical assets 1
and 2 are weakly complementary
with each other. In this case, each agent's first order condition
is given by:
Alternatively, if both the physical assets of the firm are owned
by the central coordinator, each agent's first order condition
is:
Under the assumption that each agent needs access to the central
coordinator's information to be productive, the third and fourth
terms of equation (13) are zero, as is the second term of equation
(14). If the physical assets i
and j are even weakly
complementary, then the two remaining terms will sum to less than
1/2 vi(ai, i,j,
ac), but this is precisely the incentive that the agent would
get under centralized asset ownership (equation (14)).
Thus when there is a need for centralized coordination, all agents'
incentives are improved by having ownership of assets also centralized.
In other words, centralized coordination is more efficiently
carried out in firms than in markets. Conversely, if coordination
directly between the agents becomes feasible, then the need for
centralized coordination and centralized asset ownership is diminished.
The idea of thinking of the firm primarily in terms of its coordination
function has received much attention (Mailath & Postlewaite,
1989; Malone, 1987; Rosen, 1988) but it has been difficult to
derive the link between coordination structures and asset ownership.
Treating information, and particularly coordination information,
as an asset and employing the property rights approach may be
a beginning for such a theory, but clearly much work still needs
to be done to understand and formalize the concept of coordination
information as an "asset".
There have been significant changes in the way economic activity
has been organized since the inception of large scale investment
in information technologies like computers. Researchers have found
both empirical and theoretical support for a relationship between
these two phenomena. In this paper, I add to this research by
showing how the property-rights approach to the nature of the
firm can provide insight into the mechanisms by which information
technology influences organizational structure.
The models indicate that information technology will result in reduced integration and smaller firms to the extent that it:
1) leads to better informed workers, who need incentives,
2) enables more flexibility and less lock-in in the use of physical assets, and
3) allows direct coordination among agents, reducing the need
for centralized coordination.
On the other hand, the framework suggests that more integration will result from information technology where:
1) network externalities or informational economies of scale support the centralized ownership of assets and
2) it facilitates the monitoring, and thus contractibility, of
agent's actions.
More than one of these phenomena may be important in any given
case.
4.2 Comparison with empirical evidence
There has only recently been large sample econometric analysis
showing that information technology is broadly correlated with
significant reductions in vertical integration and firm size (Brynjolfsson,
Malone, Gurbaxani et al., 1991a). While one can infer from this
that one or more of the first three mechanisms discussed above
is especially relevant empirically, the framework introduced in
this paper provides a basis for more specific hypothesis testing.
For instance, where the technology has lead to an increase in
the average skill level of employed workers by augmenting the
demand for workers with more education relative to those who do
routine jobs, the framework predicts a decline in firm size, ceteris
paribus. Because information technology has been found to be broadly
correlated with increased demand for more educated workers relative
to less educated workers, the framework suggests that this may
be a mechanism by which information technology leads to a general
decline in firm size.
At the same time, by highlighting the link between uncontractible
actions and the use of ownership to provide incentives, the framework
can also help explain cases in the other direction. The example
of law firms discussed in section 3.3 is one such example.
It should also be possible to examine other predictions of the
framework. For instance, the network externalities and economies
of scale inherent in ATM's and large databases, respectively,
should lead to increased integration in the banking industry.
Increased flexibility of physical assets, like robots, should
make it possible to decouple some manufacturing plants from one
another. Where technology reduces the need for centralized coordination,
it should also be associated with the more decentralized asset
ownership, as in value-adding partnerships and markets coordinated
through interorganizational information systems.
4.3 Comparison with related literature
The findings of this paper are broadly consistent with three related
strains of literature, but also build on their conclusions. Below,
I compare the results of this paper with previous applications
of 1) transaction costs literature, 2) coordination theory, and
3) the Grossman-Hart-Moore approach to property rights.
The transaction costs literature pioneered by Williamson (1985)
has been invoked to explain the recent shift from hierarchies
to markets (Malone, Yates & Benjamin, 1987; Brynjolfsson,
Malone & Gurbaxani, 1988). The basic result of this literature,
that as information technology reduces asset specificity it facilitates
de-integration, is supported and formalized in a model presented
in this paper. However, a second aspect of the Williamsonian credo
is not supported. The transaction cost approach posits that market
failure leads to increased integration and that markets break
down when it is difficult to write complete contracts (because
of bounded rationality combined with complexity and uncertainty,
according to Williamson). This suggests that the shift to markets
associated with the introduction of information technology is
a signal of an increased ability of firms to write complete, contingent
contracts with agents. [19] Unfortunately, field studies indicate that
top management in the most organizations of the 1980s have actually
been writing less detailed contracts with employees and
suppliers than in earlier eras (Kanter, 1989; Piore, 1989). The
increased knowledge and flexibility of agents and the increasingly
volatile environment has apparently outstripped any improvements
in management's bounded rationality.
Although one could argue that, even if this is true, transaction
costs are still reduced on balance because of the increased flexibility
of assets discussed above, the analysis presented in section 3.2
suggests an alternative explanation. The extent to which an agent's
actions are contractible does not by itself determine organizational
structure, rather it is the interaction of contractibility with
the need to provide incentives via asset ownership that defines
the costs and benefits of market coordination. In fact, it is
precisely the party whose actions are least contractible who is
most in need of asset ownership to provide, and make credible,
the right incentives. Thus, if information technology has led
to more decentralized asset ownership by affecting contractibility,
it has done so either by 1) reducing the contractibility of the
agent's actions, or 2) increasing the contractibility of the principal's
actions. Either of these effects would make it more important
to provide agents with asset ownership, which means using market
coordination. In contrast to the transaction cost approach, this
analysis indicates that a technology that leads to a general increase
in contractibility will not by itself lead to increased use of
markets. Indeed, if complete, contingent contracts could be written
for all actions, there would be no "residual" rights
and thus ownership and the concept of "firms" vs. "markets"
would be meaningless.
Malone (1987) has pioneered a theory of coordination that formally
distinguishes organizations by their costs of coordination, production,
and vulnerability. A basic result of this literature is that centralized
structures can economize on the costs of coordination, at the
expense of production and vulnerability costs. Malone and Smith
(1988) argue that many of the historical changes in the dominant
organizational structures of the economy can be explained by changes
in technology and the environment that increased the relative
importance of economizing on coordination costs. They also suggest
that less centralized coordination mechanisms will come to dominate
as information technology reduces coordination costs and speculate
that this will reverse the historical trend toward larger firms.
While their models show that centralized coordination can theoretically
take place either within firms or through "brokered"
markets, the model presented in section 3.5 provides a way of
distinguishing the circumstances under which each ownership structure
will dominate. Indeed, it suggests that in the presence of incomplete
contracts, most centralized coordination will optimally take place
within firms (that is, under centralized asset ownership). Only
when 1) the central coordinator's job is well-defined enough that
he can be provided with incentives through a relatively complete
contract, and 2) the goods and services being coordinated are
not too complementary, will markets (distributed asset ownership)
be optimal. These conditions seem likely to hold for financial
brokers and commodities trading, but are less descriptive of CEOs
or manufacturing activities. The approach taken in this paper
formally links centralized coordination in the latter sorts of
cases with firms, and is thus is a natural extension of earlier
work in coordination theory.[20]
4.3.3 The Grossman-Hart-Moore approach to property rights
Finally, the Grossman-Hart-Moore property rights approach to identifying
the determinants of integration and organizational structure has
enjoyed increasing success and recognition from theoreticians,
and was obviously central to the analysis presented in this paper.
This theory exposes the role of non-human assets in affecting
the incentives of agents, but does not presume to explain from
whence the need for incentives arises. While it shows the importance
of giving ownership of essential assets to the those agents that
have important non-contractible actions, the theory by itself
is not sufficient to enable predictions about whether information
technology would be expected to lead to greater use of firms or
markets. For instance, (Piore, 1989) considered applying the property
rights framework, and although he found it provided some valuable
insights, he concluded:
The ability of this model to assimilate the recent corporate changes
[is] more limited than it appears. The critical outcomes ultimately
depend in the model upon the location of the information required
to make decisions which are expensive to anticipate, and the model
itself does not tell you where that information is located. For
that one must ultimately turn to a production (or technologically)
based theory.
In a previous paper (Brynjolfsson, 1990a), I showed how information
technology can, and has, led to a broader distribution of information
in many organizations and how this has affected the need for incentives.
The analysis in this paper takes some additional steps towards
applying this prerequisite to applying the property rights based
approach. While there is no technological inevitability in these
models, it is hoped that they do address Piore's call by
clarifying the mechanisms by which the changes in technology can
lead to commensurate changes in the dominant organization forms
in the economy.
The property rights framework of Grossman, Hart and Moore highlights
the central role of non-human assets because they can be bought
and sold as well as "owned". In this paper, I have treated
human assets, specifically the productive knowledge or information
of the agents, on an equal footing. The more explicit modeling
of the "information asset" facilitates the analysis
of organizations in which control of information, not physical
assets, is determinative.
The residual rights of control over who has access to the productive
information in an agent's brain may often be more important than
the residual rights associated with non-human assets which he
owns. For instance, the departure of key executives, deal-makers
or researcher (and their knowledge) may affect the other members
of the firm more than the loss of the lease to their building,
or even of their office equipment.[21] Consider the departure of Michael
Milken from Drexel, Burnham as a particularly disastrous example.
More colorfully, Reich (1990) has argued that Americans should
not be concerned that Bruce "Born-in-the-USA" Springsteen
now "works for the Japanese" (his record label has been
purchased by Sony). Applying the framework of section 3.1, indicates
that the essential asset of his trade, his human capital,
is still in American hands. It also validates Reich's contention
that investments in human capital play an especially important
role in determining the wealth of nations.
Instead of modeling only the alienable assets, I include inalienable
assets as well, but add the constraint that asset allocations
which separate inalienable [22]assets from their original "owners"
are not feasible. This approach may prove useful as the ranks
of knowledge workers and service workers grow, increasing the
need to model how incentives and organizational structure are
affected by the distribution of the residual rights associated
with both human and non-human assets. For instance, one immediate
implication of the inalienability of human assets is that, unlike
complementary physical assets, complementary human assets cannot
be centralized under the ownership of a single agent. This suggest
that incentive problems will be particularly severe in large,
knowledge-intensive enterprises.[23]
Happily, in most cases, the productivity of one agent's information
does not depend entirely on its synergies with the information
or physical assets controlled by other specific individuals. In
fact, when the information possessed by agents is not idiosyncratic,
an arrangement with close to optimum incentives can be achieved:
distributed, independently owned assets, giving each agent claim
to the non-contractible, residual income generated by his actions.
In this paper, I have shown that this explanation may be consistent
with the economy-wide growth of small firms and decline in vertical
integration. As information work has come to account for a dominant
share of labor costs, providing sufficient incentives for information
workers becomes increasingly important. In the absence of contractibility,
ownership may be the only way of providing such incentives.
At times, the recent restructuring of firms and industries appears
to have been as indiscriminate as it has been dramatic, underscoring
the need for better theory. Although models of how firms and markets
coordinate agents have progressed as much in the past ten years
as they did in the previous fifty, glaring gaps remain. Fortunately,
the opportunities for sharp, empirical tests enabled by the recent
changes in both the technology and superstructure of economic
organization give every reason to be optimistic about future advances
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[1] Holmstrom and Tirole (1989), and Hart and Holmstrom (1987) also present insightful models and discuss the organizational implications of incomplete contracts and the property rights approach.
[2] This is essentially equivalent to the legal definition of ownership. For example, Hart (1989) cites (Holmes, 1946) on this. Of course, law and custom may put some bounds on the use of an asset, even by its owner.
[3] Formally, the Shapley value is defined as:
For a helpful discussion of the Shapley value, see Myerson (1991, p. 436-444)
[4] Below, I consider weaker complementarity between the information asset and the firm.
[5] Klein, Crawford and Alchian (1978) were among the first to recognized some of the organizational implications of "appropriable quasi-rents" and the "hold up problem".
[6] The Shapley value for these cases can be worked out formally as follows. There are two coalitions that agent 1 can be a member of, {1,2} and {1}. Each of these coalitions occurs with probability p(s) = 1/2. When the assets are owned separately, agent 1 has access to both assets in the first coalition, and in the second coalition, he has access only to the physical assets of the firm. Thus his expected share the marginal product of his effort is: 1/2 vl(aF, aI) + 1/2 vl(aF), where vi(.) is the derivative of total value with respect to a change in agent i's actions. This is equated to the marginal cost of his actions, yielding the first order condition for agent 1. The derivation of the first order condition for agent 2 is analogous.
[8] Given the assumptions, there is no danger of the incentives being too strong. See proposition 1 in Hart and Moore (1990).
[9] That is, the FOC (5b) will lead to a lower equilibrium investment than the FOC (4b), becuase the second term of (4b) is not equal to zero.
[11] I thank an anonymous referee for pointing out this possibility.
[12] The stronger, output-based incentives for uncontractible actions in smaller firms will not only induce higher effort overall, but in multidimensional models, less effort on actions that do not enhance output. This supports the conjecture of Geanakoplos and Milgrom (1985): Actual diseconomies of scale in management are likely due to the political incentives of individuals and groups to divert common resources for their own purposes -- incentives which are notably smaller in smaller organizations.
[13] It might be worth explicitly deriving the Shapley value in the three agent case. Agent 1 can be in four coalitions: {1,2,3}, {1,2}, {1,3} and {1}. The probability p(S) of being in each is 1/3,1/6,1/6 and 1/3, respectively.
[14] In dynamic contexts, a third option may be optimal: sequential control over time, depending on which agent had the greatest need for the assets at an given time. This was the approach favored by the three mythological Graiae who rotated possession of a single eye and tooth, and may also be an apt model for the "ad-hocracies" and "cluster organizations" (Eccles, 1988; Mills, 1990) identified in more recent lore. Of course, the effectiveness of this approach is predicated on clear criteria for when different individuals or coalitions may take over control of the assets.
[15] Equivalently, suppose that direct communication is allowed but is prohibitively expensive because it would require that each of the n agents maintain a database of n-l addresses for the other agents, instead of just one address: the central coordinator's.
[16] Of course, the coordinator, in his role as entrepreneur may also have some prior information, skills or assets that his positioning merely serves to augment.
[17] As shown below, allowing other assets to affect agent i's incentives only strengthens the result.
[18] The marginal product of agent i is assumed to be unaffected by the physical or information assets specific to other agents, so we need only consider coalitions with and without the central coordinator.
[19] This hypothesis is consistent with the familiar conception that computers are best modeled as tools to slacken the constraints of bounded rationality.
[20] The theories of Malone and colleagues abstract from incentive considerations, in the spirit of team theory. Introducing incentives provides a mechanism through which asset ownership can affect coordination. However, incentives are not sufficient for this link. Rosen (1988), and Mailath and Postlewaite (1989) argue that coordination problems can make incentive contracts difficult to write among large numbers of agents and show that centralization will be often be cheaper, but they do not formally tie centralized coordination to centralized asset ownership (firms).
[21] Grossman and Hart (1986) recognize this possibility when they note that a subvector of residual rights may always remain under the control of manager j even after firm j is sold to someone else, but it plays no role in their subsequent analysis.
[22] Of course, as discussed in section 3.2, the definition of which assets are inalienable is changing with technological advances.
[23] If complete contracts cannot be written, possible organizational responses to mitigate opportunism include increased use of repetition and reputation to encourage the development of trust among agents, (see Kreps (1984) within the firm; Sabel, Kern & Herrigel (1989), among firms); hierarchical decomposition of responsibilities, to minimize interdependencies (e.g. re-engineering jobs to focus on customer outcomes, instead of tasks); and improved goal alignment, for instance by encouraging "company spirit", (e.g. some Japanese firms) or the development of anti-opportunistic ethics (e.g. the Hippocratic Oath).
