Resource Allocation and Firm Scope

We develop a theory of firm scope based on the benefits and costs of resource allocation within firms. Integrating two firms into one makes it possible to allocate by authority scarce resources that are costly to trade. But to do so efficiently, top management must rely on information that is communicated by self-interested division managers. Two countervailing effects influence the design of optimal incentive contracts: first, intra-firm competition for scarce resources strengthens the incentives of division managers to expend effort on creating profitable projects. Second, a manager who is paid for his own division's performance has an incentive to overstate the quality of his project, which can be corrected only by paying for firm performance as well. We show that the second effect dominates, leading to overall higher costs of providing incentives in an integrated firm, relative to stand-alone firms. Integration thus creates new agency costs that are directly related to its benefits. We derive predictions about when two firms are likely to integrate, and about the optimal structure and incentives contracts in the integrated firm. In particular, we show why it is optimal to separate the tasks of allocating resources and running a division