A Location Model of a Firm's Organizational Mode Under Moral Hazard

Abstract

This paper explores the role of incomplete contracts when firms take into account their locations when deciding on their organizational form. For each of its activities, a firm faces the decision of whether to vertically integrate or to outsource, choosing the less costly of these two organizational forms. The firm vertically integrates or outsources in the location that minimizes the associated organizational costs. Location therefore becomes a source of motivation for outsourcing. Given that the firm chooses to outsource, incomplete contracting arises because of asymmetric information. This paper uses a principal-agent model to analyze the notion of asymmetric information, specifically moral hazard. In this model, the principal is the firm and the agent is the supplier of the intermediate input. This paper proposes that the principal-agent problem can be solved if the firm incorporates the moral hazard problem in its production decision. This paper shows that location and the risk appetites of the contracting parties determine the structure of the contract. Thus, we construct a location model of organizational mode under moral hazard.

Keywords: firm organization, location theory, moral hazard, outsourcing, principal-agent problem

JEL Classification: D23, D82, D86, F23, L22