An Influence-Cost Model of Organizational Practices and Firm Boundaries

This paper combines Milgrom and Roberts's influence-activity paradigm with the alienable control-rights approach of the Property Rights Theory to develop a unified theory of organizational practices and firm boundaries. Business relationships are optimally organized to curtail influence activities---costly activities aimed at persuading decision makers. Sometimes, rigid organizational practices that reduce ex-post decision making quality may be adopted if they reduce managers' incentives to engage in influence activities. Unifying control (integration) may improve ex-post decision making, but it intensifies disempowered managers' returns to influence activities unless accompanied with rigid organizational practices. Interpreting influence costs under non-integration as "haggling costs" between firms and rigid organizational practices under integration as "bureaucracy," this model provides a unified account of the costs of both markets and hierarchies that accords with Williamson's classic trade-off. Under this view, however, bureaucracy within firms is not a cost of integration, but rather an endogenous response to influence activities.