DP70 The Cost and Benefits of Ownership: A Theory of Vertical and Lateral Integration

Author(s): Sanford J Grossman , Oliver Hart

Publication Date: July 1985

Keyword(s): Contracts , Horizontal Integration , Theory of the Firm , Vertical Integration

JEL(s): 022 , 611

Programme Areas: Applied Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP70.asp

What determines how integrated a firm is? We emphasize the benefits of "control" when there are difficulties in writing complete contracts. We define the firm as being composed of its assets. We present a theory of costly contracts which emphasizes that contractual rights can be of two types: specific rights and residual rights. When it is too costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. We show that there can be costs associated with the wrong allocation of residual rights.