Author: Birger Wernerfelt
Date: February 2014
We look at the economic functions of firms, markets, and contracts, and characterize the optimal scope of the firm. Governance structures appear as equilibria and are compared in terms of production costs - determined by a tradeoff between standardization and adaptation, - and bargaining costs – sometimes incurred when new prices have to be agreed upon. Under natural conditions, employment, markets, or sequential contracting weakly dominate all other equilibria. As firms become larger, gains from standardizing come at the cost of increasingly poor adaptation, ultimately bounding their scope. The model rests on standard assumptions, is consistent with the managerial literature on the scope of the firm, and makes predictions based on factors that do not play a role in contemporary theories of the firm.