In this review, I describe how economists have moved beyond the firm as a black box to incorporate incentives, internal organization, and firm boundaries. I then turn to the way that the theory of the firm is treated in Daniel Spulber's book The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations. Spulber's goal is to explain why firms exist, how they are established, and what they contribute to the economy. To accomplish this, Spulber defines a firm to be a transaction institution whose objectives differ from those of its owners. For Spulber, this separation is the key difference between the firm and direct exchange between consumers. I raise questions about whether this is a useful basis for a theory of the firm.

This paper discusses how economists' views of firms' financial structure decisions have evolved from treating firms' profitability as given; to acknowledging that managerial actions affect profitability; to recognizing that firm value depends on the allocation of decision or control rights. The paper argues that the decision or control rights approach is useful, even though it is at an early stage of development, and that the approach has some empirical content: it can throw light on the structure of venture capital contracts and the reasons for the diversity of claims.

We study two parties who desire a smooth trading relationship under conditions of value and cost uncertainty. A contract fixing price works well in normal times because there is nothing to argue about. However, when value or cost is unusually high or low, one party will deviate from the contract and hold up the other party, causing deadweight losses as parties withhold cooperation. We show that allocating asset ownership and indexing contracts can reduce the incentives to engage in hold-up. In contrast to much of the literature, the driving force in our model is payoff uncertainty, rather than noncontractible investments.

A recent literature has shown that asymmetric information about a firm's profitability does not by itself explain strikes of substantial length if the firm and workers can bargain very frequently without commitment. In this paper we show that substantial strikes are possible if (a) there is a small (but not insignificant) delay between offers; and (b) a strike-bound firm may experience a decline in profitability after a certain point. A brief discussion of the ability of the theory to explain the data on strikes is included.

In Hart (1979), a model of monopolistic competition in a large economy with differentiated commodities was developed. In this model, firms had a choice whether to set up or not. One feature of the model was that free entry of firms was not assumed. Barriers to entry were captured by assuming that there was a large (generally, infinite) set of potential firms F. Corresponding to each f ∊ F, there was a firm (called “firm f”) with a production set Y(f). Each firm had a set-up cost associated with it. Only very weak conditions were placed on the set F and the production set mapping Y(·), so that in particular the case where different firms could produce a commodity on different terms was allowed for. The economy was made large by replicating the consumer sector, keeping the production sector, i.e. the set of potential firms F, fixed. The number of operating firms in equilibrium generally increased, however, since in view of the set-up costs there was “room” for more firms in a large economy. Unfortunately, it turns out that this procedure, while correct, does not capture quite what was intended. In particular, while in the resulting monopolistically competitive equlibrium, some firms will earn supernormal profits, it can be shown that, for any η > 0, the per capita number of firms earning profits in excess of η tends to zero as the size of the consumer sector tends to infinity (see Corollary 6 in the Appendix to Hart (1979)). In other words, in per capita terms, almost all firms earn approximately zero profits in a large economy. Thus while barriers to entry may be significant in absolute terms, in per capita terms they are negligible. The way round this difficulty is to drop the assumption that the set of potential firms is fixed. Instead substitute the assumption that the set of potential firms in the economy rE, where the consumer sector is replicated r times, is given by where F is as before. That is, one replicates the set of potential firms at the same time as the consumer sector. Then the theorems of Hart (1979) continue to hold. Corollary 6 in the Appendix must be modified as follows. Corollary 6′. There exists h > 0 such thatfor all f ∊ F. Corollary 6′ is proved below. Otherwise the proofs of Theorem 1 and Proposition 2 are unchanged (one no longer sets h = 1 after Corollary 6). As an example, F might consist of one firm with an efficient technology for producing some commodity and one firm with an inefficient technology. Then in the economy rE, there will be r potential firms with the efficient technology and r potential firms with the inefficient technology. It is easy to construct cases where both types of firms operate in the monopolistically competitive equilibrium in rE and the efficient firms earn supernormal profits which are bounded away from zero as r → ∞. Thus barriers to entry which are significant in per capita terms are now allowed for. A justification for replicating F along with the consumer sector can be given. In the above example, the efficient firms may owe their superior technology to the fact that they are situated on good land, say, of which there is a scarcity (thus the supernormal profits are just rents on the land). When one replicates the economy, it is natural to replicate the scarce land and hence the number of firms which are situated on it, so as to keep everything constant except for scale. Note finally that it may be possible to generalize the analysis to the case where the set of potential firms in the economy rE is given by rF, where 1F, 2F are exogenously specified sets and rF is not necessarily the r-fold union of some set F. We have not investigated this, however. Proof of Corollary 6′. Suppose not. Then for each h > 0, we can find f ∊ F with . By Lemma 5 (2), rπf > h for all r ≧ some r*. But in rE there are r firms identical to firm f and so each of these firms makes profit in excess of h in the monopolistically competitive equilibrium when r ≧ r*. Hence total per capita profits of all firms exceed h in equilibrium when r ≧ r*. It follows that, letting h → ∞, we can find a subsequence of the economies rE such that total per capita profits tend to infinity along the subsequence. However, applying Corollary 4 and an argument similar to that in (A.30)–(A.32), we see that ʃArp(a)drY1(a) is bounded. Hence so are per capita profits, ʃArp(a)drY1(a) + rY0. Contradiction. ||

In the last few years, a new area has emerged in economic theory, which goes under the heading of 'incomplete contracting'. However, almost since its inception, the theory has been under attack for its lack of rigorous foundations. In this paper we evaluate some of the criticisms that have been made of the theory, in particular, those in Maskin and Tirole (1998a). In doing so, we develop a model that provides a rigorous foundation for the idea that contracts are incomplete.

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This paper provides a framework for addressing the question of when transactions should be carried out within a firm and when through the market. Following Grossman and Hart, we identify a firm with the assets that its owners control. We argue that the crucial difference for party 1 between owning a firm (integration) and contracting for a service from another party 2 who owns this firm (nonintegration) is that, under integration, party 1 can selectively fire the workers of the firm (including party 2), whereas under nonintegration he can "fire" (i.e., stop dealing with) only the entire firm: the combination of party 2, the workers, and the firm's assets. We use this idea to study how changes in ownership affect the incentives of employees as well as those of owner-managers.

Our theory of costly contracts emphasizes that contractual rights can be of two types: specific rights and residual rights. When it is costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchases firm 2 when firm 1's control increases the productivity of its management more than the loss of control decreases the productivity of firm 2's management.

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.