Contract Law and the Boundary of the Firm

Abstract

This paper develops a simple structural model of the boundaries of the firm to formalize some of the aspects of the Williamsonian transaction cost economics that are distinct from Grossman, Hart and Moore's formal property rights theory. We build on two ideas. First, we employ Williamson's idea that alternative modes of governance of transactions work out of different contract law regimes; i.e., whereas interfirm transactions may be governed by court-enforced contracts, intrafirm transactions are governed by the implicit law of forbearance. The application of the forbearance doctrine to internal organization limits the use of incentive contracts within the firm and gives rise to the cost of integration. Second, we incorporate from the property rights theory the idea that it is easier to replace an employee-manager than to replace an independent subcontractor. As a result, some observable but unverifiable information can be effectively used in the internal governance of the firm but not in the governance of contractual interfirm relations. This difference is identified as the source of the benefits of integration. Moreover, while we treat contract law differences as an institutional constraint, we argue in the context of the model that such differences entail no efficiency losses.

Keywords: transaction cost, contract law, incomplete contract, firm boundary