This paper develops a theory of the firm in which a firm's centralized asset ownership and low-powered incentives give the manager, as an equilibrium outcome, interpersonal authority over employees (in a world with open disagreement). The paper thus provides micro-foundations for the idea that bringing a project inside the firm gives the manager control over that project, while explaining concentrated asset ownership, low-powered incentives, and centralized authority as typical characteristics of firms. The paper also leads to new perspectives on the firm as a legal entity and on the relationship between the Knightian and Coasian views of the firm.

Managers often face a choice between authority and persuasion. In particular, since a firm’s formal and relational contracts and its culture and norms are quite rigid in the short term, a manager who needs to prevent an employee from undertaking the wrong action has the choice between either trying to persuade this employee or relying on interpersonal authority. 1 Simon (1947) noted, for example, that ‘when... disagreement is not resolved by discussion, persuasion, or other means of conviction, then it must be decided by the authority of one or the other participant ’ and that ‘in actual practice [...] authority is liberally admixed with suggestion and persuasion. ’ Obviously, in choosing between persuasion and authority the manager makes a cost-benefit trade-off. This paper studies that trade-off, focusing in particular on agency conflicts that originate in open disagreement, in the sense of differing priors. To that purpose, I will study a setting in which a principal and an agent are involved in a project. The project’s outcome depends on decisions by both the principal and the agent and also depends on complementary private effort by the agent. A key issue is that the principal and agent may openly disagree on which decisions are most likely to lead to a success, even though no player has private information, i.e. the players have differing

Rational agents with differing priors tend to be overoptimistic about their chances of success. In particular, an agent who tries to choose the action that is most likely to succeed, is more likely to choose an action of which he overestimated, rather than underestimated, the likelihood of success. After studying the comparative statics of this mechanism, I show that it also causes agents to attribute failure to exogenous factors but success to their own choice of action, to disproportionately believe that they will outperform others, to overestimate the precision of their estimates, and to overestimate their control over the outcome.

This article develops a theory in which a firm's adoption of a prosocial purpose can increase profitability by strengthening employees' reputation and identity—leading to higher effort and lower wages—as long as implementing purpose is costly with respect to direct monetary payoffs. Employees who value prosocial action will select into firms with a social purpose, which then become a visible carrier for these employees' identity and reputation.