Theory of the firm

► Full reference: R. J. Gilson, C. F. Sabel and R. E. Scott, “Contracting for Innovation: Vertical Disintegration and Interfirm Collaboration”, Columbia Law Review, vol. 109, no. 3, April 2009, pp. 431-502. - ► Summary: the authors observe that rapidly innovating industries do not behave as industrial organisation theory predicts. That theory holds that, when partners in a supply chain must make transaction-specific investments, the risk of opportunism drives them away from contract and towards vertical integration. Yet practice moves the other way: firms, unable to maintain cutting-edge technology themselves in every field their products require, are vertically disintegrating and entrusting to partners components they once made, developing forms of contracting that lie beyond the reach of contract theory models. A first part describes this vertical disintegration in a world of uncertainty, in Knight’s sense, and distinguishes modular, relational and iterative collaboration, the latter alone avoiding the “modularity trap”. A second part shows how contract responds to this continuous uncertainty, where the economic theory of incomplete contracts sees no general solution. A third part analyses three exemplary contracts: the Deere-Stanadyne, Apple-SCI and Warner-Lambert-Ligand agreements. In a fourth part, the authors draw from them a theory of contractual collaboration and co-design: “contracting for innovation” braids explicit and implicit commitments. The formal contract does not impose the outcome, which cannot be specified in advance, but organises a process of information exchange, joint evaluation and joint decision-making; the parallel investments each party makes in learning the other’s capabilities raise switching costs and deter opportunism, where neither explicit contracting, nor renegotiation, nor the prospect of future dealings suffices. A final part returns to the theory of the firm, whose boundaries are redrawn by contract. - 🦉 The article is available in full text to those registered in Professor Marie-Anne Frison-Roche’s courses.