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WORKING PAPER
SLOAN SCHOOL OF MANAGEMENT
BENEFITS OF NARROW BUSINESS STRATEGIES
by
Julio J. Rotemberg
Massachusetts Institute of Technology
Garth Saloner
Stanford University
WP#3217-90-EFA
November 1990
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139
BENEFITS OF NARROW BUSINESS STRATEGIES
by
Julio J. Rotemberg
Massachusetts Institute of Technology
Garth Saloner
Stanford University
WP#3217-90-EFA
November 1990
Benefits of
Narrow Business
Julio J.
Strategies
Rotemberg
Garth Saloner
current version: November 14, 1990
Abstract
Firms often claim that they concentrate on a narrow range of
ities
are
shunned even though the firm could make positive
activities while other activ-
profits in
such narrow strategies receives applause from some academics
agement.
We
them. The pursuit of
who study
strategic
present two related theoretical models in which firms do indeed benefit from
pursuing narrow strategies and foregoing apparently profitable opportunities.
of a narrow strategy in these models
is
that
it
enables the firm to motivate
search for valuable profit-enhancing innovations.
We
its
their innovations are adopted.
that they are tempted to
The disadvantage of broad
make ex post
inefficient
One
benefit
employees to
obtain this result in an environment
where contracts are incomplete so that employees can only be remunerated
when
man-
for their ideas
firms in this setting
is
adoption decisions.
•The authors are respectively Professor of Applied Economics at M.I.T.'s Sloan School of Management and Professor of
Management and Economics and B.P. America Faculty Fellow at Stanford University's Graduate School of Business.
Strategic
We
wish to thank Benjanun Friedman, Oliver Hart, David Scharfstein and Birger Wernerfelt for helpful conversations as well
Foundation and the International Financial Services Research Center at M.I.T. for support
as the National Science
Benefits of
Narrow Business
Julio J.
Strategies
Rotemberg
Garth Saloner
Many
firms have narrow objectives.
(A&P) which,
growth and
prices.
sell
was the
tastes
of providing consistently
As a
divisional president put
"I
it:
it's
just not our businesd'
1
Perrow (1970)
many
cites
that seem to give up profitable ventures because they do not
is
selling other items as
is
to
a higher profit margin on
other examples of companies
in well
fit
at low
think our primary purpose
food cheaply, and tangents tend to hurt the food operation. There
non-foods, but
good quality foods
changed and other grocery stores profited from
did not follow suit.
Company
largest chain of grocery stores in the U.S. Its considerable
was based on a strategy
profitability
When consumer
A&P
well,
until the late 1960's
Consider the Great Atlantic and Pacific Tea
with "what the company
does"
A
narrow emphasis
is
applauded by some academics working
In his classic book,
agement.
Andrews (1971
proposition that every business organization
keeps
it
moving
in a deliberate direction
Andrews says that the
goals
must be
Omega and
should have a clearly defined set of goals which
...
and prevents
its
drifting in undesired directions".
means quite narrow
One example,
strategies.
in a price
"Our theory begins with the simple
a
as
watchmaker
is
When
evident from the
"plan[s] to
range between the hand-made ultraexclusive
produce
level
and
The
firm
Rolex"
Narrow
may have
23) says
"clearly-defined" he
examples he gives of well- formulated
watches of the highest quality -
p.
man-
in the field of strategic
objectives need not be
synonymous with narrow product
lines,
however.
a broad product line yet set itself narrow objectives in the kind of product line
it
has.
Porter (1980), for example, strongly advocates that firms restrict themselves to pursuing either
high-quality or low cost. Within those general constraints, however, the firm
product
line or "focus"
may
pursue a broad
on a narrow one. Firms are cautioned against attempting to pursue both
a high quality and a low cost strategy, however, even
if
that
means having
to forego profitable
opportunities. For example, the power tool company, Skil, which repositioned its product line in
the early 1980s receives praise for turning
down a
substantial
around $100m) from a distribution channel that was no longer
'Quoted
in
Perrow (1970
p.
160)
who added
the emphasis.
1
amount
in
of business (estimated at
keeping with the firm's stated
narrow objectives.
This emphasis by some companies on the steadfast pursuit of narrow objectives seems to run
counter to the prescription that tends to emerge from economics. In economics, firms are deemed
when they maximize
to be doing their job
away profitable opportunities
not generally recommended, certainly not on the basis that
away from corporate
lead to "drifting"
that diversification
rates.
is
valuable even
is
the expected present discounted value of profits. Turning
objectives.
when
it
If
it
would
anything, economic models tend to suggest
reduces expected profits discounted at market discount
3
One seemingly
cialization.
plausible rationale for narrowness
Another
is
is
that there are increasing returns to spe-
that narrow objectives promote coordination. For example, Milgrom and
Roberts (forthcoming) study a coordination game among managers within a firm. This coordination
game sometimes has multiple
They argue that a broad statement
equilibria.
avoid the dominated equilibria in this game.
explain
why one
Neither of these possible candidates can, by
fear that their existing lines of business will suffer
may
be attractive
if
if
Nor do these theories explain why
they branch off into other
the proliferation of specialized groups within the
same orga-
Top management might
and these monitoring
might even reduce the performance of the groups that
difficulties
find
constituted the core of the firm. In other words, monitoring
The
difficulty
with this view
is
that, in practice,
Perrow (1970) provides an example from the
panies like Indian
Head
its activities is
we
difficult to
may be
monitor such groups
initially
subject to diminishing returns
narrow firms coexist with broader
He
textile industry in the early 1960s.
firms.
contrasts com-
Mills which dispassionately pursued a strategy of manufacturing a range
of different textiles with others
In the theory
it
firms
lines.
nization generates diseconomies.
to scope.
itself,
firm cannot have different groups each of which pursues a narrow objective and
achieves the economies of specialization and coordination.
Narrowness
of strategy can
who pursued
a single textile with great devotion.
4
present, a firm that sets narrow objectives and thereby restricts the scope of
better able to motivate
its
employees
of setting narrow objectives has been anticipated by
needs clearly articulated corporate purposes
in
in the activities it is
engaged
Andrews (1971) who
says:
in.
This attribute
"He (the manager)
order to provide the incentive and control systems
that will reward the specialist contributions in proportion to their organizational value" (p. 25).
2
See the video program Michael Porter on Competitive Strategy.
While such diversification is not desirable when financial markets are perfect it is attractive when bankruptcy is costly.
4
Some of the specialized firms seem to be emotionally attached to their product. Perrow (1970) recounts a meeting in the
early 1960's of the Fashion Institute of Technology where an "executive of one large textile company was hissed by "silk men"
in the audience when they felt that their true love had been slurred". According to Mintzberg (1987), these emotional links
justify narrowness. He argues that a focused strategy helps botr. insiders and outsiders to understand the organization. It is
3
needed "to aid cognition, to satisfy intrinsic needs for order..." (p. 26). In other words, having narrow objectives makes it easier
to get employees to "rally around the flag". The difficulty with this theory is, once again, that it does not explain why some
broad firms who lack emotional attachment to their product, are successful. James Robinson, the chairman of Indian Head
Mills, said of the broad strategy that they pursued: "We have no emotional involvement ..." (p. 164).
This
in contrast to the
is
standard principal-agent setting, where there
tion that having different agents
work
whenever the actions of one agent
itable insofar as
facilitates
it
other agent's activities.
6
for the
same
principal
affect the payoffs of other agents.
making the compensation
In the
of one agent
environments we study there
exacerbated by increasing the number of activities the firm
We
To do
A
study a setting
in
is
5
advantageous
also generally prof-
It is
depend on the
profits
from
a countervailing cost which
is
involved
which the firm's employees can generate ideas
key element in our setting
is
in.
for
is
that, as in the sequential
R&D
improving
profitability.
model of Roberts and Weitzman
(1981) the employees' innovation must be implemented by the firm before
it
can reap the increase
model, the decision of whether to implement the innovation rests with senior
In our
management, perhaps
idea
is
they must exert effort researching innovative ways of increasing sales or cutting costs.
this,
in profits.
This
beneficial.
is
actually a presump-
is
in part
because top management
is
in a better position to
know whether
the
useful.
is
In order to exploit the possibilities for innovation, the firm
employees
We
for generating innovative ideas in the first place.
must
find
ways of compensating
its
study a setting in which firms have
only an indirect method of doing this. In particular, the most effective incentive device the firm
has at
disposal
its
is
to reward employees
by the firm. Since the employees
who
who
generate innovations that are actually implemented
exert effort are not always successful, however, this
means
that employees' rewards take the form of occasional large incentive payments.
Once the
This feature of the available incentive scheme has an unfortunate characteristic.
employee generates an innovative idea, that idea should be implemented
innovation exceed the costs of implementation.
benefits of the innovation plus the
mentation
innovation
may be
costs.
when
Ex post
it
The
if
the benefit from the
implement
firm, however, will only
it if
the
compensation to the innovative employee exceeds the imple-
therefore, profit
maximizing senior management
should from an efficiency point of view.
reluctant to exert effort in the
first place.
That
is,
7
may
not implement the
As a consequence of
the firm
may have
this,
difficulty
employees
motivating
employees ex ante.
The
point of the paper
exacerbated
find
it
if
that this distortion of the firms ex post implementation decision
the scope of the firm's activities
difficult to
We
is
is
is
broad. Therefore, broad firms might, in addition,
provide appropriate incentives ax ante.
study two circumstances in which these deleterious consequences of breadth
arise.
Fol-
lowing Hart and Moore (1990) we treat the firm as consisting of a profit maximizing manager (or
owner) and some
(specific) assets.
The
firm has a choice over the
number
of activities in which to
s
See, for example, Holmstrom and Milgrom (1989).
'See Holmstrom (1982).
7
Profit maximization by manager* is to be expected
paid a proportion of total firm profits.
We show
some extent by hiring top managers whose
in
if managers are risk neutral, care only about their income and can be
Rotemberg and Saloner (1990) that these inefficiencies can be resolved to
utility function also
depends directly on the welfare of their employees.
deploy these specific assets. In particular, we suppose that there are two activities a and b in which
the assets can be put to profitable use. Each activity requires the
this
employee
specific assets
b, if
capable of generating profit enhancing innovations,
is
more
The
first
one
arises,
circumstance
in
which breadth creates
can sometimes also be used
Then
applicable in a.
the firm
by
b raises profits
in activity a.
employee's innovation
that
it is
and
for deploying the
less
is
and the innovation
for their activity
tempted to apply the innovation
is
It
in activity
For example both employees might be
in 6 to
might do
in 6
might be
a and thereby save
this even
when
itself
the innovation
once one ignores incentive payments. Consequently the employee in
a will rationally expect that he will be compensated only
is
methods
i.e.
where the innovation
difficulties is
the incentive compensation of the employee in activity a.
One
of an employee
profitably.
working on improving inventory control systems
from
employment
not useful in
a.
When
impossible to motivate him at
when he
is
successful
and the other
the case there are two possible outcomes.
that
is
all.
The other
is
that he can be motivated with
an even higher incentive payment when he alone produces an innovation which raises the profits of
activity a.
Each of these
an ex ante kind;
is
it
possible outcomes
may be
profitable ex ante.
inefficient.
In the first case the inefficiency
impossible to motivate the employee in a even
The other
innovation of the employee
may be
is
when
is
of
his innovation
an ex post inefficiency, both employees exert effort but the
in activity b is
implemented
in
a even though
it is
an inferior one. The
firm does this simply to conserve on incentive payments. These inefficiencies can provide a rationale
for
narrowness. By choosing to be narrow, and focusing only on activity
not to research innovations that could jeopardize the effort of
Obviously this advantage of narrowness does not arise
We would
Head
words,
commits
itself
innovative employee in activity
a.
firms are not actively engaged in research.
therefore expect innovation oriented firms to be narrow while others, such as Indian
issue that arises at this point
why
innovation?
is
it
Why
is
whether narrowness
is
a credible commitment. In other
harder for a narrow firm to replace the innovation generated in a by another
can't the narrow firm simply import innovations from outside the firm? There
two reasons why narrowness
must
the firm
Mills, are not.
One
are
if
its
a,
is
credible as a
commitment.
First, to
be valuable, an innovation
raise the productivity of the firm's specific assets. Therefore, people
who do not work with
these assets are not in a good position to generate valuable innovations. Only by having employees
with experience deploying the firm's assets can innovations that are useful be developed. Second,
the top
manager
the innovation in
of a firm that
b.
is
involved in b must, in any event, spend resources to evaluate
Having spent those resources, he knows both the value of the innovation
6 as well as its applicability in a.
He thus know more about
for
applicability in a of ideas generated
elsewhere in the firm than he does about the applicability of ideas generated on the outside.
The second circumstance where breadth can be detrimental
activities
can pursue innovations but,
is
where employees
in
two unrelated
they both succeed, only one can be implemented because
if
the firm faces financial constraints. Here again the firm will implement the innovation that gives
the highest ex post profits net of incentive payments.
arise.
not
The former
make an
inefficiency arises
when
Once more ex ante and ex post
because he rationally anticipates that his innovation
effort
when both employees succeed. Even when he does make an
present as a result of having to offer
This occurs
more
the employee in the ex ante
when
his innovation
payments but, at the same time,
is
is
him
large incentive
the
more
effort,
inefficiencies
profitable activity does
not be implemented
will
the ex post inefficiency
payments when
profitable one ex post
his innovation is
when one
the less profitable one after incentive
it
may be
adopted.
ignores incentive
payment are taken
into
account.
The firm may again be
more
firm to the ex ante
better off by setting narrow objectives
The
profitable activity.
setting of
and
restricting the scope of the
narrow objectives commits firms not to
supplant the ideas of their innovative employees by the ideas of employees
This commitment
discover
if
top
credible insofar as those
is
new ways
who do
finds
it
more
difficult to
unrelated activities.
not work with the firm's specific assets cannot
of deploying these assets profitably as easily as those
management
in
who
do.
It is
also credible
evaluate ideas developed without the firm's specific
assets.
An example
Donaldson (1984
of a decision that
p. 115).
He
is
consistent with this
discusses the case of a
form of commitment
company who had
All they get
is
newcomers who
really doesn't
will
want
acquisitions.
compete with them
[for
presented in
to choose between renovating
A
an aging plant or scrapping the plant and acquiring a different company.
commented: "Internal management
is
There
Donaldson interviewee
nothing in
is
company
When
when they
them.
much
to
lower
usually required.
The above discussion supposes that
ignored even
for
The company chose
resources]".
renovate the plant even though this decision could only be rationalized by applying a
hurdle rate than the
it
are valuable.
ideas that result in losses net of incentive
This would not occur
if
payments are
there was efficient recontracting.
the employee realizes that his idea would not be implemented under the original contract,
he would presumably accept to rewrite the contract so that the idea
receives a lower
payment. Moreover, when the idea produces positive
is
implemented while he
profits gross of the employee's
compensation a new contract of this type can make both the employee and the firm better
off.
It
should be apparent that efficient recontracting solves the problem of ex post inefficiency but not
that of inefficient ex ante effort.
adopted.
Efficient recontracting ensures that the
most valuable ideas get
But, whenever the contract has to be renegotiated because the profits from the idea
are less than the incentive payments, the
position of the firm
is
strong (the situation
payments to the worker
fall.
we examine), the payment
Indeed,
to the
if
the bargaining
employee
is
quite low
Thus, from the point of view of the employee making the
in these circumstances.
renegotiation
is
The case
not very different from lock-out of valuable ideas.
of efficient recontracting provides a slightly different intuition for the result that a
narrow focus can be profitable.
Insofar as employee
in
effort, efficient
Broad firms have a wider range of investment projects ex
post.
compensation depends on whether projects are adopted, broad firms are ex post
a stronger bargaining position vis-a-vis their employees. They can reduce what the employees
them against each
get by pitting
other. While this raises profits ex post
also reduces the effort
it
employees make ex ante to find valuable projects.
Our models hinge on the
of complete contracts.
In this, they are closely related to
and Moore (1990). The difference
potential owners of firms.
their
on employee
effects of the scope of the firm
is
is
that in those models the
main incentive problems
activity
worsens performance on existing
Our paper proceeds
can make
it
as follows.
In Section
1
made by
in profitable activities. Their
the
can have this
A&P
Vice-President where
activities.
we show that
the synergy between two projects
profitable for a firm to concentrate only on one of them.
financial constraints
involve the
Because they do not consider incentive contracts with their workers,
thus unable to explain the sort of statement
new
entering a
absence
Grossman and Hart (1986) and Hart
models imply that firms always benefit from becoming involved
framework
effort in the
effect as well. In Section 3,
In Section 2
we conclude by
we show that
relating our findings
to the empirical literature on the consequences of diversification.
1.
Synergy
We
consider senior
and
related activities, a
management which can
potentially involve its risk neutral firm in two
To begin with, we suppose that
b.
it
showing what the firm can achieve with a alone, we consider the
adding
own.
b.
We
We show
focuses exclusively on
expanding
effects of
that the addition of b can reduce the firm's profits even
consider synergies between a and
firm under complete contracting
of these activities within the
is
same
b
if b is
its
After
a.
scope by
profitable
on
its
such that the carrying out both activities in the same
attractive.
We show
firm unattractive
that these very synergies
when contracts
make
the joining
are incomplete.
The Narrow Firm
In activity a, there exist opportunities for improving the product, reducing its costs, increasing
its
market,
etc.
For the firm to take advantage of these opportunities,
can be discovered in two ways. First, employees
some chance
of finding
employees involved
one
who
is
ways to
raise profits.
in activity a, for simplicity
in a position to
make such a
required effort lowers his utility by
d.
in activity
discovery.
explicitly
We
must innovate. Innovations
a can exert effort e and thereby have
While we have
we
it
in
mind that
there a
number
examine the case where there
call this
employee
A
is
of
only
and assume that the
The other source
tices, senior
of innovative ideas
management
profitability of a. Since
we
the firm)
senior
is
management
itself.
By observing
methods that
learns about the industry and routinely finds
we think of these
them
shall refer to
industry pracraise the
ideas as being externally generated (at negligible cost to
as "outside improvements".
We want
to consider situations where
the outside improvements are, at least sometimes, substitutes for an the ideas being developed by
A. For example,
method
A comes
if
or choose another
up with a new way to market the product, the firm can implement
method that
has come up with on
it
After the firm discovers a profit-enhancing innovation
nity to evaluate
surveys or
it
before proceeding with
its
learned by the employees, senior
superior to that of
its
own.
managers typically have an opportu-
implementation. For example, managers
runs to refine their knowledge of
trial
its
its
its likely value.
management information
his
may
Because this information
conduct
is
not
all
be substantially
area
is
likely to
employees. In part for this reason, management
is
given the right to decide
in this
whether or not to proceed with implementation.
We
thus envisage a three period model.
exert effort. In the second period, top
uncovered by
A
or
In the first period,
management
A
decides whether or not to
decides whether to implement the innovation
whether to implement an outside improvement. Finally,
in the third period, the
firm's actions bear fruit.
For concreteness
we assume
it
could equally well affect costs.
A
does not make the
If
A
does
which
is
make
effort.
that the profit-enhancing innovation affects revenues, S, though
We
assume that third period revenues from
Thus Sa incorporates the
the effort then he
is
Sa
if
value of the firm's best outside improvement.
successful with probability P.
In this event he has an idea
superior to the firm's best outside improvement. In particular, the implementation of his
idea leads to revenues which equal
Sa +
g,
where g >
0.
With
and the firm's revenues are Sa as when he does not exert
,
We
activity a equal
probability
1
—P
he
is
unsuccessful
effort.
wish to concentrate on situations in which A's efforts are worthwhile on average.
We
therefore assume that:
Pg
- d > o,
(l)
so that the expected benefit to the firm of A's effort exceeds the cost to him.
ensure that the employee
(l) implies that
We
it
raise its profits
are cor.cerned with situations
(common
*Lack
the effort by paying
would thereby
sufficient to ensure that
case
made
A
where the
him d
in the initial
offer of a
payment of d
would do so
since
management be unable
in the initial period is not
In other
on the principal-agent problem) where
of contractibility does not require that senior
it
the firm could
on average.
searches actively for an innovation.
in the literature
period
If
words, we focus on the
effort is non-contractible.
to observe the level of effort.
It
8
requires only
that effort not be observable by those outsiders who are responsible for enforcing contracts. If they cannot observe effort, then
it ia not possible to sign a contract with A that guarantees that he is paid d if he makes the effort.
The
impossibility of enforcing contracts which specify
need not create
A
contract leads
consider has A's
is
We show
losses.
to exert as
that, indeed,
much
when
directly
effort
payment depend on whether or not
is
The most
They
a.
realize
when
his innovation
is
implemented. This contract
him
implementation
candidates for these parties are the other employees in activity
logical
A
the innovation that
the firm to compensate
effort
The simple contract we
contractible.
feasible as long as the parties responsible for enforcing contracts can verify the
of A's innovation.
on A's
the firm has access to a alone, a rather simple
when
effort as
payments that depend
accordingly.
If
the firm
mechanism
Instead of modelling this reputational
is
implemented and they expect
so, its
reputation for fairness suffers.
has been working on
to
fails
do
we simply assume
explicitly,
the enforceability
of contracts in which A's compensation depends on the implementation of his ideas.
With
him
access to such contracts the firm
be able to motivate
we
directly for his effort. In particular, suppose as
must be paid
the following two characteristics: he
Now
risk-neutral concerning income beyond w.
(the
may
minimum wage)
if
his innovation
a
as
minimum wage w
— d/P
more
if it
implements
is
a positive increment by (1).
is
indifferent
P(d/P)
—
place
P{g
is
d
Knowing that
between making the
=
—
his idea
effort
= d/P
than
d/P)
contracts that paid
every period and he
w+
k
A
is
w
earns
if it is.
with such a contract
A
successful. If
is
have
is
in place
successful, the firm
implements an outside improvement. This
if it
his idea
could pay
enables the firm to generate the
this, notice first that
implemented whenever he
is
and not making
it;
Finally, the firm's ex ante expected gain
0.
if it
consider a contract which specifies that
the firm chooses to implement A's innovation whenever he
earns g
in
not implemented and that he earns
is
were contractible. To see
if e
as well as
shall throughout, that A's preferences
In this setting a contract of the above type with k
same outcome
A
is
doing so raises his expected
from putting
A
successful,
this incentive
utility
by
scheme
in
= Pg — d. Thus the firm's profits are indeed the same as if it had access to
d to A in exchange for his effort. The firm is able to achieve the "first-best"
outcome.
The Broad Firm
We now consider
b in
addition to
particular,
revenues of
and
P
a.
a firm that pursues a broader strategy, in particular one that includes activity
We
we suppose
b.
We
suppose that activity
denote by S^,
respectively.
B
that employee
We
g'
d'
,
assume that
,
S),
analogous to activity a
in
every respect.
and P' the variables that are analogous to Sa
— w
In
new opportunities that enhance the
able to generate
is
e'
b is
,
g,
d,
e
so that, even absent any effort, the expansion into
activity b does not reduce profits.
We
for
B
assume, by analogy with
a,
that P'g'
to the one explored above for A, that
is
>
d!
where
.
Then by implementing
k'
=
1
d'/P
,
the firm
'This result depends on our assumption that the random outcome that follows A's
the general case where profit maximiring managers do not achieve the
8
first
best, see
is
effort
the analogous contract
able to
make nonnegative
has a two point distribution. For
Rotemberg and Saloner
(1990).
profits in
b.
Adding
One would
if
not detrimental even without complementarities.
is
think that the attractiveness of adding activity b only becomes more pronounced
We
synergy.
to St
+ g',
there
may
a probability
>
That
b.
successful,
is
cannot profitably implement both ideas
on B's success
when applied
idea,
One way
in a.
to a,
B
B
if
in activity b
in raising profits in activity
successful, his
is
method
is
Sa + g
a substitute for A's the firm
is
To motivate
are each trying to invent superior promotion or distribution
then possible that,
consider the following
to think of this synergy
increases the "outside improvements" available for activity a.
and
we
that his invention can be applied in a and raise revenues there to
However, because B's
0).
see this,
Willig (1982))
has an idea that raises revenues
i.e.,
also be useful in a. Conditional
P"
To
not always the case.
is
B
suppose that, when
his idea
is
(where g
is
Baumol and
there are synergies (or economies of scope in the sense of Panzar,
between activities a and
b,
range of activities
b to the
methods
is
B
that
sometimes
A
imagine that
this,
for their products. It
also applicable to the products of a at
no
additional cost.
Because the two methods are substitutes, top management must choose which innovation to
implement
in a
revenues in a
is
become Sa
g so that the firm
to pay d
A
when
successful
+ g;
if it
and B's idea
and d to motivate
its
applicable in A.
implements B's they become Sa
would implement A's
1
is
if it
it
has only
A
implements A's, average
+ g. We
suppose that g exceeds
had access to complete contracts that would enable
it
two employees.
Suppose that such contracts are enforceable. The firm must
to motivate. If
If it
exert effort
it
earns
Sa — w + Pg —
still
choose which,
d. If it
motivates
if
B
any, employee
alone,
earns
it
PV + P"g) - J.
(2)
- P)P'P"g if it induces both to search for
ideas. Expression (2) is strictly positive both because B is worthwhile on its own (P'g' > d
and
because B's innovation adds value to a on average [P"{1 — P)g > 0). This implies both that the
Finally,
it
Sa - w + Pg -
earns
d
+
P'g'
-
d'
+
(1
1
)
firm
is
certain to motivate
B
and that
its
involvement
in activity b is profitable.
Our model
is
thus
one where, with complete contracts, the firm chooses to be broad.
After inducing
B
to
make
the effort, the firm gains from motivating
Pg-dOtherwise, the firm
Pg — d
in a.
is
The
is
better off
if it
gives
positive because A's invention
line
corresponding to
(3)
PP'P"g >
up on A's
is
worth
as well
if
0.
(3)
effort altogether.
less (only g
holding as an equality
A
is
—
g)
This can happen even when
when B's innovation
is
useful
represented graphically in Figure
1.
Points above this line satisfy the inequality (3).
We now
consider the equilibrium outcome
Our key assumption
in
what
follows
is
when the
firm
is
broad and contracts are incomplete.
that the firm's contractual payments with
9
its
employees
can only depend on whether their innovations are implemented in their
compensation can depend on whether
whether B's innovation
whether B's idea
last
of
is
implemented
implemented
is
his innovation
in
b.
in a. In principle, A's
We
in a.
Thus A's
activities.
It
cannot depend on
compensation might
also
ignore this possibility in this subsection but
depend on
show
in the
subsection of this Section that the main results obtained here are robust to the introduction
more complicated contracts of
The motivation
of B's idea in a
is
this kind.
assumption that A's payments are independent of the implementation
for the
The
the following.
compensated when he
This test
is
is
successful
i.e.,
when
tell
from the accounting
They thus cannot base
The
are responsible for enforcing the terms
the project he has been working on
A
firm's contract with
implemented
contract with
in 6.
B
is
A's idea
be
implemented.
A
thus stipulates a payment k that
B
specifies a
Because P'g'
>
d!
,
payment
and
A
k'
B
B
consider the possibility that
this possibility not only
it
may be
when
receives
succeeds and that
B when
B makes
implemented
is
in
convincing
A
makes the
offers A. In the first,
does not exert effort at
For an outcome of the
A's idea ex post
first
that the
We
do not
in a as well.
We
neglect
B
is
profitable with our
whose payments do not
if
B
fails
equilibrium outcomes that can emerge
A chooses
to exert effort and,
B
In the second,
the firm implements his innovation regardless of what
the firm only implements his innovation
is
in a.
effort, there are three possible
from the contract that the firm
result
in the
that the firm has no incentive
basic contracts, the firm has an incentive to sign a secret contract with
B
his innovation
the effort.
to substitute A's innovation with B's. However, insofar as this substitution
Given that
is
the equilibrium
6,
The
d'/P'.
10
impractical but also because such contracts are not
necessary to motivate B. Their only possible role
depend on the implementation of B's idea
his innovation
narrow firm we considered
=
all.
a.
provides no synergies for
gets paid for having his ideas
because
on
which accrues to
In particular, the contract specifies that k'
firm implements B's idea in 6 whenever
not implemented, they
is
effect of B's inventions
identical to the equilibrium contract of the
previous subsection.
A
is
whether management implemented any idea at
compensation on the
their
When
for the firm.
profits in a
implemented. The contract with
third,
A
Their sense of "fair dealing" requires that
the only one that they can apply since they cannot conclude simply from A's presence
on the job that he has generated surplus
cannot
who
"outside parties"
of A's contract are his co-workers in activity a.
is
implemented
is
own
does.
A
if
he
is
successful,
exerts effort but
to generate a useful innovation for a.
In the
all.
kind to be an equilibrium, the firm must be willing to implement
when both he and B produce
viable innovations. This requires that g
10
—
k
>
g.
We could have considered a more complicated model where the co-workers have access to accurate accounting information.
Then, compensating A as a function of the implementation of B's ideas in A would still be problematic if management also had
access to other ideas that are substitute for A's. It would be hard for A'e co-workers to determine the origin of the imported
idea.
10
Moreover, for
A
the cost to him,
kind exists only
Pk >
i.e.,
d.
g
- d/P -
A's innovation. In Figure
all
first
1
we draw a
g
>
0.
(4)
proceeded with implementation of A's idea whenever
it
now, the firm has access to revenues of
(4) is different because,
> d/P. Inequality
by
must exceed
if:
the firm had access to a alone,
satisfied
effort
Putting these two expressions together, an equilibrium of the
g
When
payment from exerting
to be willing to exert effort, his expected
where
line
(4) holds as
Sa + g
without
an equality. The inequality
(4) is
points above this line.
For an outcome of the second type to be an equilibrium the firm must be willing to implement
A's innovation in the event that only
A
expects to be compensated only
for a. Therefore,
A
A
is
successful. Therefore g
when he
prepared to exert effort only
is
P(l
i.e., if
>
d/P(l
—
P'P"). Note that
equilibrium because he
in this
g
>
k
k, for
successful
is
A
must be
B
k.
In this equilibrium
does not generate a useful innovation
if
- P'P")k >
compensated
is
and
must exceed
d
(5),
offered higher
less often.
compensation when he
Combining
(5)
is
successful
with the condition that
an equilibrium of this kind to exist we must have:
d
g
Clearly (6)
may be
violated even
horizontal line in Figure
that
effort.
the
it
is
0.
Equation
(6),
holding with equality, appears as a
The
inequality holds in the region above
d.
independent of
g.
V
neither (4) nor (6) holds there does not exist an equilibrium in which
The unique equilibrium then has only
first,
that
the firm
B
6'
must pay
A
whenever he
is
A
is
motivated to exert
exerting effort. This occurs in the region below (4)
There are only two scenarios
(6) in the figure.
may be
If
since
Pg >
if
>
- P'P") ~
line.
If
and
1
P{\
in
which the firm can hope to motivate A. In
successful.
However the incentive payment required
so large that ex post the firm will, instead, implement S's innovation in a
is
the case,
i.e.,
,
if (4) is
generate a useful innovation for
whenever
it
can.
A rationally expects to be compensated only if B does not
Since A then expects to be compensated less often, he requires
violated,
a.
an even higher incentive payment (equation
(5)).
However that incentive payment may be so high
that the firm would not implement A's innovation even
when
it
has no other innovation available
(equation (6)).
The
payment
firm's incentive
to
A when
compensation
his innovation
ante to put forth effort.
is
is
thus a two-edged sword.
A commitment
implemented has the desirable
effect of
to
make
a large
motivating him ex
However, ex post the incentive compensation looms as a large penalty
11
that the firm must pay
if it
does implement his innovation. At that stage the firm
implement other opportunities which do not require the payment of
this "penalty"
is
hungry to
Management
.
thus cannot resist searching for opportunities developed elsewhere in the company which might be
substitutes for A's idea.
We now
wish to consider whether the equilibrium outcomes with incomplete contracts are
other words,
inefficient. In
contracts (as
did for the narrow firm).
it
now emerge. The
(4)
we ask whether the equilibrium reproduces the outcome with complete
first arises
is
successful.
is
The
inefficiency here
be implemented also when B's innovations
inefficiency. In
Figure
The second kind
case, the
1,
A
able to motivate
is
even though
is
We
useful in a.
broad firm abstains from inducing
when
A
to
(4)
it
exists.
and
>
g,
(6) holds while
A's innovation should
the ex post
call this inefficiency
is
shaded with horizontal
(6) are violated
make an
Then,
inefficiencies
only implements his innovation
that, because g
the region where this inefficiency arises
of inefficiencies arises
Two
generally in the negative.
is
whenever equilibria of the second kind
does not. So, the broad firm
when he alone
The answer
lines.
while (3) holds. In this
effort so that only
B
makes one. Given
that (3) holds, the firm would gladly pay d in exchange for A's effort. Thus, here the incompleteness
of contracts reduces A's effort. Because this effort takes place in the
first
period we call this the ex
ante inefficiency.
To understand the parameters
Figure, the parameters where
it
for
If
P'P" were equal
g
to one so that
while (3) holds
B
— d/P — g. Thus
if
P'P"
nonempty only
is
as well.
(3) to
hold while (6)
However
fails, g
is less
than
when he
is
paid his
is
valuable to the firm under
then no distortion induced by the
large. If g
were very large then the firm with
is
it
A
to search for innovations only
becomes possible
successful ((6)
for the firm to
becomes
profitable
The
on
was quite
g
A
motivate
large
by promising
turn to demonstrating the major conclusion of this subsection, namely that the firm
its
own and has
first is
6), it is
if
satisfied).
can earn higher profits by being narrow and giving up activity
where both
able to motivate
positive spillovers into a.
(4)
B
and
(6) are violated.
but not A.
profitable
when
it is
narrow
if:
12
b,
even though that activity
There are two situations
Then
Its profits are
narrow, on the other hand, and restricts attention to
more
P'P"
is
post. There
must not be too
as g gets very large
payment when he alone
large
We now
and
if
his net ex post contribution
equal to one, A's effort
is
access to complete contracts would encourage
arise.
apparent from
It is
implementation decision.
For
him a
shaded region.
In this
always generated spillovers, A's ex ante net marginal
same circumstances ex ante and ex
exactly the
firm's
is
fails
Pg — d — Pg. However,
contribution would be
marginal cost
this inefficiency exists consider Figure 1.
arises are inside the vertically
the figure that the region where (4)
one.
which
if
the firm
then P'(g'
a, its profits are
+
is
this
can
broad (pursues both o
P"g)
Pg —
which
in
is
d.
—
1
d
The
.
If
firm
the firm
is
is
therefore
Pg-d-
+
P'(g'
Here the desire for narrowness
when he
opportunities
It is
is
employed by a broad
is
—
1
d
is
successful.
+ P P"g + P(l — P
innovation.
more
It is
-
d]
- \P'g' -
- P'P"g >
d'\
0.
(7)
not to seek
firm.
from being narrow when
A
A
as well as B, but
(4) is violated
even though
P")g
profitable
—
On
d.
(6)
can only implement A's innovation
it
the firm chooses to be broad under those circumstances
If
t
J
[Pg
driven by the ex ante inefficiency which leads
is
also possible that the firm profits
when he alone
=
d'
Then, the broad firm can motivate
not.
P'g'
+
P»g)
earns
it
the other hand, the narrow firm always implements A's
if:
1
+ P P"(g-Pg)>0.
,
-d'}
[P'g
(T)
This rationale for narrowness obtains because narrowness eliminates the ex post inefficiency.
Equation
above
P'g'
In Figure
it.
—
(7) applies
tf is
It
Ex
if
is
P* P"
smaller than P,
is
is
is
Ignoring P'g'
bigger than P'P"g,
A's invention, g
i.e.,
only
if
—
—
d!
—
P* P"
is
when
(4)
(4) is violated
where
and
(6)
while (6)
the spillovers from
B
—
d'
is
A's innovation
— d/P
g
i.e., if
,
is
exceeds
large only
if
p
is
is
(7)
is
undesirable
when A's
abandon A's
more valuable than B's ex ante only
g.
On
if
the other hand, the temptation
the synergy g exceeds the ex post profits from
if
the odds of B's success are
violated, g cannot, once again, be too large.
large (and the odds of
with complete contracts. However
is
when
are less frequent than A's success.
ante, but the presence of b leads the firm to
B
coming up with a
not too unfavorable), g has to be large too or else the firm would
him when he alone
(4) is violated
smaller to P.
to that for efficiency. If g
1
when
Then,
0.
d/P. These two requirements are compatible only
For (7) to hold while (6)
As Figure
(7') applies
for the instructive case
the following. Broadening the scope to include b
to supplant A's innovation ex post
low,
i.e.,
more valuable than B's ex
innovation ex post.
Pg — d
while
(6) fails),
consider these in turn.
intuition for this
innovation
drawn
post inefficiency has the same effect
instructive to look at the case where P'g'
is
holds only
The
We
hold.
(7')
are
(7')
(where
1
ante inefficiency leads the firm to prefer a narrow strategy
are violated while (7) holds.
and
Figure
line in
the relevant parts of (7) and
1
Ex
zero.
below the horizontal
g
if
is
too large,
it is
fail
The
intuition
is
similar
useful innovation for a are
A
to encourage
possible to motivate
A
to invent even
by compensating
successful ((6) holds).
illustrates,
P P"
provided
1
< P,
region)
where the firm
restricts itself to the
results
from breadth.
This region
is
there exists parameters (those in the cross-hatched
narrow strategy to avoid the ex ante
somewhat smaller but continues
13
to exist
inefficiency that
when
P'g'
—
1
d
is
positive as long as P'g'
apparent
It is
reason
—
not "too large"
d' is
both our formulae and
in
are complete. But,
if
A's effort
of b to obtain A's effort
We now
is
is
surely not profitable either (so (7)
we
is
see in Figure
1
that this region
in
some sense become
is
more
is
relatively small.
less likely
his innovation
having him exert effort at
We
is
alone
which
have shown that the firm
is
is
successful.
is
more
may
benefit
Second, even when
A
fails),
contracts
the elimination
it
violated while (7') and (6) hold and
However, when
does hold,
(6)
when a broad
above
While not
strategy
from
narrowness
may be
A
and
than not
first-best, this is better
itself to
does
it
(7) so the region
at least able to obtain effort
from committing
First,
when
The
is.
(7)
profitable only because
what happens below the horizontal
two kinds of benefits from a narrow strategy.
exert effort ex ante.
is
see this in that (7') lies
that here the firm
whenever
to search for ideas
that the firm would choose to be narrow
when he
all,
(4) is
generally nonempty.
profitable with complete contracts.
The reason
satisfied
fails).
consider the possibility that the narrow strategy
This occurs when
We
A
is
not worthwhile with complete contracts ((3)
eliminates the ex post inefficiency.
implement
that (3)
1
would not encourage
that, unless (3) holds, the firm
is
Figure
in
line.
stay out of
There are
b.
required to induce
A
to
can be induced to search for opportunities anyway,
narrowness ensures that the firm takes advantage of A's ideas more often. In both cases the benefit
of narrowness stems
from the implied commitment not to supplant A's innovation with B's when
both are successful. Firms that want to innovate might thus be led to take great pains
their objectives very narrowly
That
is
and
in erecting institutional barriers that
not to say that firms would not supplant their
in defining
prevent breadth.
own employees
innovations ex post
if
they came to learn of valuable substitutes through other means. Thus, as Burgelman (forthcoming)
RISC
reports, Intel eventually decided to enter the
proven.
It
did this in spite of
in-house capability in
It
RISC
its
processor business once
having earlier tried hard to suppress the development of an
technology.
might appear that our demonstration that synergy can be detrimental implies that the
expansion of a firm into areas related to their core area
areas. This
is
not the case.
As two
activities a
of these increases can be seen in Figure
we
start with g
=
0.
1.
and
b
is
worse than expansion into unrelated
become more
Suppose that d/P < g < d/P(l
Increases in g from this point
first
effort
and narrowness
is
profitable.
also a feature of the first best.
When
each other and having one employee
The
related, g increases.
—
effect
P'P") and that
make a broad strategy more
Further increases in g lead us to the cross-hatched area where broad firms cannot induce
an
had been
its viability
attractive.
A
to
make
But, as g gets very high, the abandonment of A's effort
the synergies are very high the efforts of
make
the effort
is
A
and
B
is
duplicate
enough. At this stage expansion into
b is
attractive even with our incomplete contracts.
This argument can be generalized to explain
why
14
large scope can be detrimental in our analysis
whereas large scale
is
generally beneficial.
not necessarily require that
many
value of the employees ideas
is
are less likely to pass
An
The reason
when
larger
up a valuable
broad range of
up potential
be used
synergies.
in o.
activities
may
In practice this
For instance, A's senior
the firms' scale
is
large.
Thus
the other hand, the
firms
whose
scale
is
mear
\
ways of committing themselves to
management might be kept ignorant
b.
of B's activities by the
Again, Burgelman's Intel study
is
relevant.
He
writes:
The
...
idea, however,
was
able to get support
corporate venturing program and became a separate business."
from narrowness that we describe are
Head
Head
Mills' strategy
their operations
Mills which
was to purchase nearly bankrupt
and keep only the profitable
textile
In that
was proud to be broad.
Indian
companies, close down a large part of
pieces. Their objective
from existing technologies and not to innovate.
suffer.
Thus, our analysis
consistent with the experience of the textile industry outlined in the introduction.
industry, narrow firms coexisted with Indian
17,
(p.
do not have
entirely absent in firms that
access to projects where employee effort can lead to valuable innovations.
is
The
to develop add-on boards for personal computers.
emphasis added). Of course, insofar as these walls are not credible to employees, incentives
benefits
give
creating a structure where B's innovations cannot
strategic planning process initially rejected the idea
The
large
that innovative firms that wish to be involved in a
is
benefit from seeking
"Some middle-level managers had the idea
Intel's internal
On
portunity ex post.
c
erection of a "Chinese wall" between a and
through
that firms operating at a large scale do
individuals generate innovative ideas.
additional implication of our analysis
relatively
is
was thus to extract revenues
In declining industries such a strategy can be
profitable, even alongside a strategy of searching for innovations.
Renegotiation
So
far,
we have assumed
B
that,
when
(4) is violated, the firm gives
both
A
and
both
A
and the firm could make themselves better
are successful even
event the contract between
A
though the innovation
off
is
valuable.
up A's innovation when
Ex
post this
is inefficient,
by implementing A's innovation.
In this
and the firm would perhaps be renegotiated. For renegotiation to be
possible, those in charge of enforcing the contract
must
realize that a
new contract has been drawn
and that the new schedule of payments does not simply represent a breach of the
Such renegotiation may thus be
difficult
when
the contract
is
initial contract.
an implicit one that
is
enforced by
the employees' co-workers.
We
nonetheless consider efficient recontracting here.
As
in the related
model of renegotiation
of Hermalin and Katz (1990), this renegotiation eliminates the ex post inefficiency. However,
show that when the firm has
all
we
the bargaining power at the renegotiation stage, renegotiation does
not resolve the ex ante inefficiency. With renegotiation, narrowness has no role in reducing the ex
post inefficiency but continues to be attractive
recontracting eliminates ex post inefficiencies
is
in the presence of the
ex ante inefficiency.
not surprising. With perfect information there
15
That
is
no
reason to obtain an inefficient outcome at the renegotiation stage. The robustness of our conclusions
may
regarding ex ante inefficiency
stemmed from the
Nonetheless,
fail
firm's unwillingness to
we prove that adding
adopt A's invention when both employees succeeded.
remains costly with renegotiation when
activity b
effort is
known
make one new
offer to the
workers
to the firm. This offer specifies a
The worker then has
idea.
idea so that the old contract
all
(4)
and
(6)
We
first
As
new
will
the success of the employees'
to the employee
if
the firm implements his
offer or sticking to the original contract.
in
exchange
This form of renegotiation
voided.
is
2, after
is
implementation of the
for
particularly simple because
be apparent, this assumption of relative
not crucial to our analysis.
is
show
payment
form of renegotiation,
that, even with this
his initial contract specifies a
B
continues to
offers
him
less
1
when
initial
his idea
is
when he succeeds and
contract with
A
is
thus willing to make the
has, once again, a
implemented. Suppose
first
effort
in
b.
if
For
than d'/P' at the renegotiation stage. He can then
turn the offer down; the firm will proceed with implementation anyway since
thus sure to get d'/P
make an
payment of d'/P' whenever the firm implements B's idea
suppose he succeeds and the firm
The
We suppose
of efficient renegotiation.
period
new payment
the bargaining power to the firm.
bargaining power
in
the choice of accepting this
the worker accepts the offer, he accepts the
gives
game
this in the context of a particularly simple
that the firm can
it
previous subsection, this too
in the
while (7) holds.
We show
If
be more surprising since,
payment
that (4)
fails
of
w
g'
>
is
effort.
plus an incentive
while (6) holds.
case, the existence of renegotiation enables the firm to reproduce the
He
d'/P'.
11
payment
We show
of k
that, in this
outcome that prevails with
A must specify a k equal to d/P(l — P'P"). Suppose
that, with this contract, A is successful while B does not generate any knowledge useful in a. Then,
the above argument implies that the firm pays k to A and implements his project. Thus A's effort
complete contracts. The
nets
him
at least
~
ptTZpipu]
Suppose instead that
his project will
contract with
initial
A
is
d\
ne
is
thus willing to
him w and A's idea
A
is
and
is
implemented.
B make
payment of
We
w
the effort.
useful in a. If (4)
not be implemented under the terms of the
stage he thus accepts any offer with a
contracts.
and B's idea
successful
make
is
initial contract.
or greater.
12
violated
A
knows that
At the renegotiation
Consequently the firm
offers
have thus obtained the same outcome as with complete
the effort while A's idea
is
implemented whenever he succeeds. This
establishes that our renegotiation eliminates the ex post inefficiency.
We now show
(6)
1 '
both
The
fail.
that renegotiation does not change the earlier subsection's analysis
In this case,
A
never receives any incentive payment when
case where (4) and (6) both hold
is
trivial in
A:
when
equals d/P{\
that the complete contracts outcome prevails whether
we have
—
(4)
and
P'P").
renegotiation
or not.
12
Actually, with an offer of
him a
trivial
w
he
is
indifferent
between accepting or not. Since the firm could induce him to accept by offering
amount more than w, we assume that he accepts when he
16
is
indifferent.
now
this value of k, the firm
With
w
at the renegotiation stage
even when he alone
accepts this offer because, since (6) does not hold, the firm would
He
successful.
him
offers
fail
is
to adopt his
innovation under the original contract. Lower values of k do not solve the problem either. Consider
—
any k between d/P and d/P{\
a.
a.
A
w
(4) holds, the firm again offers
Because
and
and suppose that
P*)
accepts. So, at best,
A
is
But, this means that he earns
to
A
than
w+d
successful while B's idea
is
exchange
in
paid such values of k
less
A
is
useful in
implementation of
for the
when he alone has an
idea that
is
his idea
useful in
and prefers not to make the
after exerting himself
effort.
Absent renegotiation, the
A when
effort.
both he and
difficulty that the firm faces is that
B are successful.
As a result
Renegotiation doesn't change that.
ensures that an ex post agreement
the ex post efficient
this
added
idea
is
Since the firm has
efficiency.
available for a,
in return.
A
Since
is
and he does not exert
A
allows
it
all
As long
if
is
post.
A
has
power
it
can ensure that, when B's
as A's effort
is
him ex
of the bargaining power.
all
and g
as
A
—
A
Then
g in the event that
able to
is
both his and B's
profitable with complete contracts (3) holds
ante.
13
This result
with a great deal of bargaining power
As long
implemented. Thus
A, however, he does not reap the fruits of
of the bargaining
successful,
these payments are sufficient to motivate
him ex
for
is
effort in the first place.
ideas are valuable in a.
A
which A's innovation
in
a, renegotiation
forward-looking, he understands ahead of time that this situation will arise
extract g in the event that he alone
endowing
can raise profits in
to implement his innovation without getting any compensation
Clearly these conclusions change
since
When A and B both
outcome obtains. Unfortunately
cannot commit to compensate
sometimes impossible to motivate him to exert
it is
worked out
is
it
is
is
and
not surprising in our context
similar to committing the firm to
pay
does not have "too much" bargaining power, however, the above results
continue to hold.
More Complex Contracts
We now
consider the more complicated contracts in which A's compensation can depend on
whether B's innovation
that link
A
is
adopted
in b.
Such contracts may seem quite natural;
and B's compensation to the implementation of
outside party
must know that these implementations took
ought to be able to enforce contracts that
link A's
The reason we have ignored such contracts up
as compelling.
We
have
in
mind
the contracts
ideas are enforceable,
But then, these outside
place.
to this point
that
is
we do not regard
some
parties
income with the implementation of B's
idea.
this reasoning
situations where the enforcers of contracts are the employee's
co-workers; these are in a good position to punish the firm
believe that an
own
their
if
employee has been exploited. So, the workers
if
in b
their information leads
know whether B's
them
to
idea has been
l3
Note the similarity with Hermalin and Kati (1990). They show that, in their model, the equilibrium outcome can improve
with renegotiation as long as the agent is given some bargaining power at the renegotiation stage.
17
implemented.
much
It is
less plausible that
workers
who
in a,
enforce the contract with A, have
access to this information.
We now show
that the availability of these more complicated contracts can, but need not,
change our conclusions. Our two forms of
when P"
is
B
high. In this case the probability that
when B succeeds and
his idea is
implemented
of B's innovation in b allows A's
become
inefficiency
payments
prevalent with these contracts
has an idea that
Thus the
in b.
less
is
useful in a
linking of A's
to be contingent
is
relatively high
payments to the adoption
on the firm's outside opportunity
for
a.
With these more complex
when
a payment
the firm adopts neither innovation. This
firm would like to pay as
only A's project
little
is
The
A:°.
We
third
is
is
implemented
payment when only B's idea
is
implemented, which we denote k c
implemented
we had no
Since,
B
assume that
set of
is
in
1
paid cf/P
is
a
when
c
b
payments k ,k ,k can be
The second
A
a
is
is
implemented.
which results
makes the
effort
first is
payment when A's innovation
.
The
fourth
is
a
.
Our
interest
in the first-best
and
The
a payment when
to search for profitable opportunities,
his idea
specified
there an equilibrium such that
successful. For that to
B
trouble inducing
in b.
specified.
denote that payment as k
a and S's
is
can be
zero since, for incentive purposes, the
as possible in these circumstances.
implemented, which we denote
is
A
contracts, four different payments to
his idea
is
we continue
in seeing
is
to
whether a
outcome. In other words
implemented whenever he
is
be the case, the following four conditions must be met.
must prefer to implement A's idea when both employees generate ideas that
First, the firm
are useful in a. This requires that g
—
k
>
b
—
g
k
c
i.e.,
,
g-g>k -k
b
c
(8)
.
Second, the firm must prefer to implement A's innovation
when only he
succeeds. This requires
that:
9
Third,
willing to
must be the case that when only
it
implement
his innovation in a,
P)P'k c
A
-d>
must be
P'k
c
.
k
a
B
>
0.
(9)
generates ideas that are useful in a, the firm
is
i.e.,
g
Finally,
~
-
willing to exert effort.
k
c
>
0.
(10)
That condition
is
P(l
- P
1
)*"
+ PP'k +
1
'
(1
-
Simplifying, this gives:
P(l
-
P')k
a
+ PP'{k -k )-d>0.
b
18
c
(11)
The
issue
concerned
is
whether (8)-(ll) can be
is
it is
only
small. Therefore, k
that k
(8) implies
b
difference with k
its
c
satisfied simultaneously. Notice first that as far as
c
that matters. Moreover, (10)
is
most
hold
likely to
is
A:
if
k
c
should be set equal to zero and k should be adjusted accordingly. But then
—
should be set equal to g
be as large as possible without violating
Finally, since (11)
g.
(9), i.e.,
k
a
should equal
g.
is
increasing in k
Substituting k
a
a
,
a
k
and k
b
should
in (11)
using (8) and (9) gives the overall condition:
Pg-d- PP>g
If
equation (12) holds, the firm
contracts considered here.
fails it
may
A
When
raising k
b
Any
.
in
increase in k
A
Hence
then that
be smaller than
possible only
a
beyond
motivating A.
useful in a.
it
is
It
but can also use
When
his ideas.
all
(12)
b
receives
beyond g
A:
g.
(9)
hold as equalities are not sufficient to induce
The motivation
—g
in
adopt A's innovation.
A
of
can only be achieved,
at
if
means that the firm pays k b only when B's idea
only with probability PP'(1
Using these facts and
(9)
we
—
P").
The only
by
all,
not
is
constraint on k
see that the motivation of
A
is
is
now
if:
-
P'P")g
-d>0
identical to (6).
instructive to
is
compare
worthwhile for the firm to have
PP'P" >
0.
P"
If
firm to have
A
contracts.
P"
case, the
A
outcome with the more complex
this point leads the firm never to
P(l
which
and
(12) fails, k's such that (8)
cannot help
this
(12)
able to obtain the first-best
cannot only motivate
to search for ideas. Raising k
Thus
0.
be possible to motivate A. However, the more complex contracts do not help
still
this regard.
It
is
>
If
(12) to (3).
A
exert effort
if
B
is
going to exert effort anyway,
equal to one (3) and (12) are identical. That
is
exert effort in addition to B,
is
Recall that (3), the condition under which
it is
is, if it is
possible to motivate
him
Pg —
worthwhile
is
d
—
for the
to do so with complex
smaller than one, however, (3) can be satisfied while (12)
more elaborate contracts do not
is
it
is
violated. In that
necessarily resolve the difficulties encountered with the
simpler contracts considered above.
These results follow from the
innovation in
in a.
It is
committed
6 is
fact that
when P"
is
equal to one the implementation of B's
a perfect signal that the firm has the opportunity of implementing B's innovation
precisely
when B's innovation can be implemented
to paying
A
relatively little. In that
way
it is
in a that the firm
able to convince
A
would
like to
be
that his effort will be
rewarded and that the firm won't prefer to implement B's innovation ex post. Therefore the more
complex contracts considered here are quite powerful
The
all
case in which
innovations in
P"
equals one
b are useful in a.
is
in that case.
very special however.
The more
plausible case
19
It
is
corresponds to the assumption that
where only a relatively small subset
P"
of the inventions that are useful in 6 are useful in a as well. However, as
of
B
in b
becomes a poorer
exert effort and also
It is
make
signal
crucially
on P'
certainly violated
is
If
P'
is
when
is.
So,
if (4) is
the employee in b has an idea that benefits
6,
to
narrowness would benefit the firm in the previous
sufficiently large, (12)
(4)
A
innovation ex post.
via their product P'P".
where there are always innovations
special case
As
has an idea with wide applicability.
itself.
implementation
becomes impossible to provide payments that induce
possibility that
P" only
Section depended on P* and
B
it
the firm willing to implement
worth noting that the
probability that
and
falls,
By
the
contrast, the validity of (12) hinges
inconsistent with the failure of (4). In the
is
in activity
false
This product equals the overall
b,
the probability P* equals one and (12)
and there
is
a relatively high probability that
more elaborate contracts do not
help.
Financial Constraints
2.
In the previous Section
profitable activities
when
severe
if
we showed
that a firm might be unable to combine two independently
there are synergies between
them because agency problems become more
we show
the organization broadens. In this Section
two unrelated
lines of business
may
encounter
that even a firm that embarks on
difficulties if the firm is financially constrained.
In the presence of asymmetric information,
it is
easy to construct models where firms face
such constraints. For instance, outsiders might have difficulty knowing whether a firm's request for
credit
is
the result of low profits on existing activities or of high expected profits in
They may thus demand a premium on any new borrowing.
Following Gale and Hellwig (1985), we give the simplest reason
This
credit.
that he
credit.
is
is
that the extension of credit requires monitoring
repaid.
We
new
ventures.
14
if
why
the firm might be denied
make
the creditor wants to
Therefore, the creditor must charge for the monitoring costs
sure
when extending
simplify further to the point where the cost of funds inclusive of these monitoring costs
exceeds the rate of return on the firm's projects.
As a
result, the firms
do not borrow at
all
and
use only internal funds for investment.
We
effort,
an
start once again by supposing that the firm
no funds need be invested and,
effort e,
which gives him a
is
involved only in activity a.
as before, revenues equal
disutility
Sa Also
d for revenues to increase.
.
as before,
We now assume
a cost, F, to implementing A's innovation. In contrast to the previous Section,
after implementation, the revenues
from A's innovation are stochastic.
A's successful innovation, revenues rise to
1
—
q.
Sa
^
—^
'See
A
makes no
must make
that there
we suppose
Sa with
It
(1984).
20
is g.
to finance the implementation of A's
could ask for credit from a financial institution. Following Gale and Hellwig,
Myers and Majluf
that,
probability
Thus, as before, the expected net benefit from implementing A's successful innovation
F
is
the firm does implement
with probability q and are
Suppose that the firm did not have the necessary funds
idea.
If
A
If
we assume
must spend resources
that financial institutions
that
it
exceed
+
(F
led to revenues of
is
is
effectively
is
it
Now suppose
with
a,
A
can motivate
him d/P whenever
the firm
is
now
was
spend
also
F
>
d!
first-best
B
equal to
it
With
ployees are both successful.
unavailable.
Whether the
C
B
exert effort
it
earns P'g'
-
P')g
.
—
d'
.
If
the firm has only
If it
-d+ P'(l
is
-
the case
(l-P)P7 + PP
concentrate on this case because
up a profitable venture
Inequalities (13)
b.
1
but analogously
This implementation
to
assume that
B
and
we want
,
exert effort
it
A
and
if 6
its
two em-
it
earns
Pg —
P'g'
-
d.
If it
earns
B
exerting effort and where
d',
(13)
and
max(</-<7 ,0) >
exert effort
to
show that the firm can be
is
(14)
d'
B
better than having just
A
do
strictly better off
is
more
so).
We
by giving
profitable than
if
6.
contracts
once again, that a broad firm might only be able to have
21
effort
when
This can only happen when, ex ante, a
is,
=w
5),
to exert effort
and (14) imply that the firm would certainly pursue both innovations
were complete. The problem
offers
-d! + PP' max(j',j).
P)g'
profitable than b ex ante)
A
A
has both exert effort
Pg - d >
(which ensures that having both
only
is
outcome involves the firm having A, B, or both, exert
ex ante. That
more
not
is
monitoring costs, outside funds continue to be
more profitable than
is
the firm
if
implement both ideas when
a
(which ensures that a
in Section 1,
Sb + F +g' We continue
wish to focus on the case where the first-best involves both
6
the innovation
In contrast to Section
b.
We
is
If
in.
sufficiently high
first-best
P(l
are restricted in that the
outcome by signing a contract which
are insufficient to
depends on the values of the parameters.
has only
A
would be profitable to motivate
were the only activity that the firm was involved
Unfortunately, the firm's funds
im-
sufficient to finance the
order to implement 5's innovation.
in
Therefore
.
As
successful.
that the firm also has access to activity
also have P'g'
which are
implemented.
leads to expected revenues from activity
but
A
and obtain the
his innovation
must
C
the implementation of his innovation.
implemented, outsiders cannot know whether
involved in a,
that the costs of this needed monitoring
As before we assume that contracts with
contractible
would never admit
it
unable to borrow.
that the firm has funds equal to
plementation of A's idea.
only event that
We assume
was monitored.
it
As a consequence, the firm
We now assume
whether the implementation
g)/q or not. Since the firm has no other resources,
was successful unless
g.
to ascertain ex post
B
exert
when
effort
to a
As a
contracts are incomplete.
narrow strategy which involves only
To derive the equilibrium
model when the firm
of the
A
simultaneously offers incentive contracts to
of the
effort,
knowing the terms of
period their success or failure
first
implementation decision. In the
The
critical
assumption
final
is
that
we
it
During the
own
realized
is
we analyze
broad,
At the beginning
and B.
their
is
of the
A
and
period the firm
A
in this description
who
decide
At the end
contracts, but not the other's.
and
B
and
second period the firm makes
in the
is
must make
A
that
B
and
its
do not know the terms of each
The motivation
their effort decisions.
think of the co-workers as being responsible for enforcing contracts.
his co-workers,
itself
the natural ana-
first
period,
first
plausible that B's co-workers are apprised of the details of B's contract.
that
commit
profitable to
period revenues are realized.
other's contracts at the time that they
in part,
find
a.
logue of the previous Section's three period model.
whether to exert
might
result, the firm
much
It is
for this,
It is
then
less plausible
and are quite possibly
are involved in an unrelated activity
in a
geographically separate location, are apprised of the details of B's contract.
More importantly,
as
we
B
shall see below,
A
cooperate with senior management in deceiving
even
if
the terms of B's initial contract were
(and his coworkers)
may have an
about the terms of B's contract. For example,
common
knowledge,
B
and senior management would
sometimes have an incentive to "secretly" destroy that contract and replace
very poorly positioned to monitor such coordinated activity against him.
senior
management
effort decision in
A
to collude against
that
ex post when they both succeed.
k'
=
—
d*/P'(l
thus start by imagining that
B
A's innovation only
is
A
A
B
is
and
must make
his
is
efficient to
P).
g'
.
We
implement A's innovation
analyze this case
B
Therefore, inducing
effort,
to
is
successful.
— P)g —
As a
result,
B
is
first.
make an
In
effort is
the firm gains by offering
would surely
willing to
d relative to the profits when
B
make
makes no
the effort
effort.
We
has such an incentive contract.
in
which
A
implemented whenever he
when he alone
is
In the first type of equilibrium,
innovation
this ability of
In the presence of this contract, the firm
P).
There are two kinds of equilibria
his innovation
it is
from making an
refrain
implement B's innovation' when he alone
and, on average, the firm gains P*(l
—
d/P*(l
B
Relative to having
him a contract with
In the first
This occurs when g exceeds
this case (14) implies that g' exceeds
and
It is
with another.
ignorance of the terms of B's contract.
There are now two cases to consider.
straightforward.
it
captured by the assumption that
is
incentive to
is
makes an
successful.
effort. In
the
first,
A
In the second, the firm
exerts effort
implements
successful.
A
need only be offered an incentive payment of
implemented whenever he
deviations by the firm, however.
also
The
is
successful.
first is
A
since his
should be concerned about two kinds of
an ex post deviation: the firm
22
d/P
may implement
B's
innovation
when they
The
are both successful.
firm elects to do that ex post unless
d
The second
he
is
B
A
both
and
is
an ex ante deviation:
—
the firm
P). The firm's
k'
equal to d'/P (or a
to have
A
exert effort in the belief that his innovation will be implemented whenever
implement
A's incentive payment
If
should be concerned about
1
successful, but then to
is
(15)
g
a
(secretly) offers
plan here
A
deviation that
d!
,
-J- -pv^Ty
g
B
is
.B's
d/P and
more) instead of a
little
when both
innovation
B's
1
d'/P
is
,
A
of d/P*(l
k'
and
B
are successful.
when
the firm implements B's innovation
are successful unless
p
p g -d--[p'g
or
,
-d') >0.
(16)
P>
B's innovation
is
implemented ex post
also
1
accept the firm's offer of d'/P (or a
little
if
only he
more) when (16)
is
Thus
successful.
fails.
Equation (16)
is
B
is
willing to
the equivalent of
(4) in Section 1.
When
deviate
it
it
(16) does not hold, this deviation
earns
Pg -
d+
(1
-
P)P'{g'
also profitable to the firm.
is
- P ,,f_ P)
whereas
)
it
does deviate. Comparing these expressions, the firm finds
That expression holds whenever
Thus
manner.
unless (16) holds
it
is
(16)
it
the firm does not
- d + (1 - P')P{g - j)
profitable to deviate
if
g
—
p <
if
g'
fails.
possible and profitable for the firm to deviate ex ante
worth noting that (16)
It is
earns P'g'
If
1
is
a weaker condition than (15) so that
A
in this
should only be
concerned about the ex ante deviation.
We now
consider an equilibrium of the second kind. In an equilibrium of that kind
but his innovation
effort
one exists,
is
implemented
than
—
g.
only implemented
ex post inefficient since g
also
In order to
dl P{\
is
when both employees
motivate
A
P'). For the firm to
>
g';
alone
is
successful.
exerts
That equilibrium,
if
with complete contracts, A's innovation would be
succeed.
to exert effort in this equilibrium, his incentive
payment must be
adopt the innovation ex post, this incentive payment must be smaller
Therefore, an equilibrium of this kind requires that
J
B's innovation
is
implemented ex post when only he
P(l
-
>
P')
Pg-d- PP'g
or
lb
when he
A
is
successful
23
if g'
>
- d'/P >
0.
(17)
which
is
always the case since P'g' -
d'
>
0.
When
satisfied, the firm
is
(17)
over, offering this contract
on average by doing
Therefore
profitable for the firm in this case since
This requirement
so.
(14) holds while (16)
if
which the firm
is
does implement A's innovation when he alone
broad and
is
A
and (17) do not, there does not
innovation being implemented whenever he
that,
as
by the same
Pg — d
logic applied above, the firm
A
The
1.
A
firm would encourage
new
to search for
P')g
—d
in
exerting effort and his
see that this
cannot secretly induce
—
any equilibrium
an equilibrium note
is
As
to exert effort.
positive, the resulting equilibrium exhibits the ex ante inefficiency
is
the Section
To
successful.
is
P(l
1.
exist
B
The only equilibrium has
exerts effort.
More-
successful.
earns gains
it
the equivalent of (6) in Section
is
is
long
we described
in
ideas but fails to do so with our
incomplete contracts.
If,
having just B. By restricting
Pg-d-
-
{P'g'
To
<f).
condition that
P
that the idea which
is
and
see that, indeed, (13)
be bigger than P'
Then
(16)
and (17)
analogous to the one we found before.
is
more valuable ex
ante, A's,
is less
g
>
-
is
P) be larger than
P
.
This
is
suppose
The
1.
required to ensure
This
is
relatively unlikely.
d'
fail,
and P' <
It is
valuable ex post.
the success of the ex ante relatively less attractive venture
inequality (14) requires that P'g'{l
and (17)
<
as soon as P'
fail
the firm would gain
a,
(14) can hold while (16)
if
g'
searching for ideas than
narrow strategy that includes only
itself to a
that (13) holds as a near equality.
A
would prefer to have only
in addition, (13) holds, the firm
only possible
Finally,
when
satisfied as long as
d
1
is
sufficiently small.
Ex post
while (16)
whenever
inefficient equilibria in
fails.
P
As before
> P' while
is
The
makes an
(14) requires only that
(17) holds as long as
,
valid simultaneously.
A
which
P
1
is
whenever
effort arise
1
d be small.
If
P'g'
-
d'
and (17) hold
(14)
= Pg -
d, (16) fails
These conditions can thus be
sufficiently small.
resulting ex post inefficiency can, once again, be so severe that the firm
better off being narrow.
By remaining broad
focusing only on a.
A
condition can hold
when
Pg-d=
P'g'
-d'
exactly. Since g
>
P
(13), (14),
PP'g'
+ e.
d'
+
P{\
therefore
more
—
more
P')g
—
d whereas
profitable
if
P'g'
—
and (17) do while (16) does not. To see
It is
immediate that (13) and (17) hold
profitable
is
PP'g >
P'g'
—
d'
it
earns
d!
< PP'g. This
this,
strictly
Pg — d by
suppose that
and
(14) holds
so that the condition for
met. The additional requirement that (16)
fail
requires
be sufficiently greater than P*
We now
turn briefly to the case where
contracts implements B's invention
imply (17).
is
—
the second equality implies that
a narrow strategy to be
only that
narrow strategy
+ eg'
the firm earns P'g'
The
g'
exceeds g so that a firm with access to complete
when both employees
firm thus always gains by inducing
to
make an
When
effort
g'
>
g, (13)
and
(14)
and can do so with a
— P ). While it is now easy to motivate A, there are two potential
with A and B might lead the firm to implement A's invention when
contract whose k equals d/P[l
problems. First, the contracts
A
succeed.
1
24
both employees find a useful innovation. This
find
it
impossible to motivate
B
to
make an
now ex post
is
effort.
inefficient.
Second, the firm might
The conditions under which
these effects are
absent area analogous to (16) and (17).
The main
latter,
firm
is
narrowness
is
exclusively on b
when
A
inefficiently, its
equilibrium profits exceed
narrow strategy that focuses on
broad firms cannot be
inefficiency
inefficient.
the second employee to
Pg — d
so they
edge case where g
In this
make
must a
=
the effort
is
g'
.
symmetric case,
that, in the
that, given (13), the
is
would not choose to focus
fortiori exceed the profits
If,
it
in addition,
P =
make an
if
P' and d
=
1
d
,
g exceeds
effort
contracts, inducing
—
d/P{\
P). But, in this
even with incomplete contracts.
associated with the classic "rat race" case where two teams with the
is
from a
does not matter which innovation
Even with complete
worthwhile only
possible to induce a second employee to
inefficiency
is
sometimes leads the firm to abandon B's invention
implemented ex post when both employees succeed.
No
g
b.
finally consider the knife
it is
it
>
g'
the ex ante inefficiency leads the broad firm to be unable to motivate B.
when the ex post
case,
Thus
than motivating only B.
Similarly, even
is
and the one where
g'
not a palliative for our two inefficiencies. The reason
better off just motivating
We
>
difference between the case where g
same ex
ante characteristics research the same project with the knowledge that the firm will adopt the
first
innovation. In this symmetric case, our model suggests no benefits of narrowness. These benefits
arise only
when
the two activities are so asymmetric that the activity with the ex ante more valuable
projects has innovations which, net of incentive payments, are less valuable ex post.
In this Section, the attractiveness of narrow focus
If
depends on credit market imperfections.
the firm can raise sufficient funds to finance both projects, narrow focus
the firm can provide good incentives for both employees.
Note that the
is
not necessary since
role of credit
market
imperfections in creating a rationale for narrowness of focus goes beyond the statement that a firm
with limited investable resources gains
from having a wide array of investment projects. In
little
our model having access to alternative investment projects actually reduces overall profits in the
presence of these financial imperfections.
This reduction would not take place
if
the firm could enter activity b while ensuring that only
the employee in activity a makes the requisite effort.
Then, the limited funds
only to implement the inventions of the employee in activity a.
activity 6 does not
If
the firm could
make
itself to this
when
it is
negotiating with
would be used
To ensure that the employee
the effort, his contract must stipulate that he earns
commit
F
its
w
in
in all circumstances.
employee
in activity a,
then
broadening the scope of the firm would not be detrimental.
Renegotiation
In this
inefficiency.
subsection
we
The purpose
consider efficient renegotiation which, once again, eliminates the ex post
of this subsection
is
to
25
show that
it
need not eliminate the ex ante
inefficiency
which
with g >
arises
when
g'
made
the case where the ex ante inefficiency
a.
We
thus show that narrowness
and (14) hold while (16) and (17)
(13)
it
more
This was
fail.
narrow and involved only
profitable to be
in
just as useful to reduce ex ante inefficiency with as without
is
renegotiation.
We model
renegotiation, once again, by supposing that the firm
to its employees.
An
payment the firm
offer specifies a
timing
is
we
analogous to the one
B. Then, after the firm makes
accept the
We
is
at least as large as
average even
it
if
B
degrees of freedom
consider a renegotiation stage whose
A
and
any, project to go forward with.
if
does not make an
d/P. The reason
is
effort unless the initial contract calls for
that lower values of k imply that
A
a k that
does not recoup d on
he receives this k every time he succeeds. With any k higher than or equal to d/P,
—
follows from (16) that g
with
now more
the two employees simultaneously respond whether they
its offer,
A
Even with renegotiation,
exchange for the
in
considered before: the firm simultaneously makes offers to
the firm picks which,
offer. Finally,
take-it^or-leave-it offers
prepared to make
is
employee's cooperation in implementing his innovation. There are
concerning these offers since there are two employees.
makes
calls for a k'
k
equal to
is
smaller than
— P)
J
g'
/P
(l
g'
We show
.
below that the optimal
initial
but the analysis at the renegotiation stage
contract
the same
is
for lower values of k'
Consider
pays
offer that
pay
If
exceeds
A:
knows that the
A
less
than
The reason
k.
is
if
only
g,
A
that he
contractual obligation of k anyway).
its
well.
the renegotiation stage
first
If
k
knows the firm
The
is less
will
than
A
g,
down any
turns
implement
his project (and
firm thus offers k at the renegotiation stage as
w
the firm offers the employee
project
succeeds.
(or
w+
e
to break his indifference). Since
would not be implemented under the original contract, he accepts
similar analysis applies
if
(14) implies that g' exceeds k'
.
B
only
succeeds.
Therefore,
B
If k'
turns
equals d'/P^l
—
P) or
this offer.
and g >
less
down any payment lower than
k'
A
g'
then
and the firm
offers k'.
The
interesting case
is
where both succeed. The best outcome
implements A's project and pays him
(slightly over) w.
It
then gains
for the firm
We show
g.
now where
is
that this
is
it
the
unique equilibrium outcome.
We
prove this in two steps by considering separately the case where g
the opposite holds. In the former case
A's project whether
offer.
On
A
the other hand,
implement B's idea and
strategy.
accepts his
B
if
A
own
were to
would get
Given B's acceptance,
B
A
is
knows
that,
offer or not.
if
B
reject his offer
slightly
he turns
down
k
and
B
>
g'
w
g'.
26
k'
and where
if
he rejects the
accepted his own, the firm would
more than w. Therefore, acceptance
strictly better off
—
the offer, the firm adopts
thus expects to earn
by accepting as
he will only earn w; the firm will implement B's innovation because
g-d/P<
—
A;
is
B's dominant
well. If he declines the offer,
must equal
at least
d/P and
In the case
where g
-
B's project for sure. Thus
case
is
We
irrelevant.
<
k
g'
-
k'
A knows
,
that,
if
he turns down the
now A whose dominant
it is
strategy
it is
the firm will adopt
to accept. B's action in this
w
have thus shown that both employees get paid
offer,
(or a little
more) when they
both succeed.
Now
A and B must decide whether or not to exert effort. As long
^//"(l - P), B makes an effort. The reason is that he can be sure
consider the stage at which
as the initial k' equals at least
to receive this k' whenever he alone
motivate A.
though
If
With
successful.
is
this contract for
the initial contract calls for a k of d/P, he receives
his project
now adopted). His average payment
is
do not help. For k between d/P and
failure of (17) implies that these
is
d.
does not search for ideas
if
less
d.
when A alone
than
payments average to
it is
not possible to
both are successful (even
thus less than
the firm pays k only
g,
w when
B,
is
Higher values of k
successful
and the
For k above g, the firm never
pays more than w.
This argument establishes that
make
to
the effort.
sufficiently
a
it
A
low that
equal to
alone
is
The question remains whether
B
stops exerting himself.
d/P and makes
successful.
However,
by offering a
It is
k'
k'
if
.
k'
The reason
equal to d/P'{\
equals d'/P'.
A
-
P)
The
When B
the contract with
the firm cannot offer
B
B
induces
B
a contract with a k
B has such a contract, he accepts
k = d/P, the firm does pay k when
believes that
is
that with
the firm has access to activity
thus impossible to motivate A.
contract whose
If
The reason
the effort.
contract calls for such a low
strictly
A
is
that (14) with g
if
this
is
6,
A
would not believe that B's
>
g'
implies that the firm gains
required to induce
B
to
make
the effort.
resulting equilibrium thus has the firm offering
succeeds, he receives this
k'
B
a
in spite of the existence of
renegotiation.
The
intuition for the appearance of ex ante inefficiency with renegotiation
from the intuition with binding contracts. In the former
the parties.
A
in a
makes
The
inefficiency arises
because the presence of
poor bargaining position. This
it difficult
firm gives
up
for
him
case, there
is
B
is
is
sliehtly different
ex post bargaining between
(with his attendant innovations) puts
the source of A's low ex post compensation which, in turn,
to recoup his cost d.
b altogether is that the firm's
The
benefit of the
bargaining power
provide large payments which are contingent on A's
is
narrow strategy
in
reduced and this makes
which the
it
easier to
effort.
Integration
We
have shown that, when firms are financially constrained, they may benefit from maintaining
the firms' specific
a narrow focus. Narrow focus avoids having employees involved in activity 6 with
assets.
This provides a measure of commitment because
innovations into
activities a
and
6
it
makes
it
impossible for firms to introduce
ex post. Here we consider instead a somewhat more complicated problem
6 are carried
in
which
out by separate firms each of which has some specific capital and
also financially constrained.
27
is
We
ask whether, assuming that
it
can be done costlessly,
and thereby create a firm with access to 2C.
(1975
p.
attractive
We
when
is
continue to
We want
to
is
lower inside firms
know whether merger
two separate firms each of which has resources C, one
pursuing
6.
the firms are thus separated,
If
their innovations
suppose these two firms integrate.
still
merge the two firms
an interesting question given Williamson
is
between a firm and outside agents.
and both of
exert effort
projects
attractive to
is
does indeed lead to better functioning (internal) capital markets.
it
start with
other which
firm can
This
it is
146-7) suggestion that the cost of allocating funds to high-value uses
in transactions
than
16
implement both
make
A
and
would be implemented
if
B
is
pursuing a while the
can both be motivated to
they were both successful.
Now
This should not lead to any loss of funds, so the integrated
projects. Therefore, the
two employees of the integrated firm would
the effort knowing that, ex post, the firm would benefit from adopting both
when they
are both successful.
It
would thus seem that our theory has no implications
for
integration in this case.
However,
that, instead,
this
model
it is
possible for the integrated firm to spend
activity b in our
implement
model
gives no role for the internal capital
as follows.
If
B
all its
funds on B's project.
We
modify
exerts effort and produces an innovation, the firm can
and receive revenues of
his project as before
market of the integrated firm. Suppose
Si,
+F+
an innovation, however, with probability P" his innovation
is
g'
.
Conditional on his producing
also profitable
if
implemented on a
larger scale.
In that event the firm can earn revenues of Sj
That
is,
project.
the firm can earn additional revenues of g
One way
The conditional
P"
.
With
C
a large scale.
to think of this
probability that
+ 2F + g' + g by expending IF on
+ F by expending F to expand the
may have
is
that B's innovation
it
has a large market given that
smaller than 2F, the separate firm that
Whatever impediments
is
B's project.
scale of B's
either a small or a large market.
it
at least has a small
market
involved in b can never implement
it
is
on
exist for financial institutions to lend to the firm in b also
prevent the firm in a from doing so.
We
suppose that,
straightforward.
if
the firms integrate initially, transfers of funds between the firms
With complete
both employees make an
effort
contracts, this
but that only
B
is
valuable.
succeeds.
become
This can be seen by imagining that
The
integrated firm can
now implement
B's idea on a larger scale and thereby earn more. This ability to shift funds internally
is
now an
advantage of integration.
Nonetheless, even
strictly
when
it
has these favorable consequences on financing, integration can
reduce profits when contracts are incomplete in the way we have been describing.
not clear whether, in plausible models, costless mergers are consistent with the existence of financial constraints. The
markets and mergers typically require transactions in capital markets as well. Nonetheless, it
possible to imagine mergers where capital markets play no role and where the merger is simply a relabeling of the original
16
It is
latter involve a failure of capital
is
As
shares.
28
before
We
we suppose that contracts can only depend on whether an employee's innovation
adopted.
is
thus rule out the possibility that they depend on the scale with which they are adopted.
also continue to rule out contracts that
The structure
model
of the
depend on whether other projects are adopted.
now isomorphic
is
Implementing B's innovation on a small scale
B's innovation only in activity
model of Section
to that of our synergy
1.
equivalent in the synergy model to implementing
is
Implementing B's innovation on a large scale
b.
We
the synergy model to implementing B's innovation both in b and in
a.
Here
is
B
equivalent in
threatens the
implementation of A's innovation not because the firm implements B's innovation "in a", but
because the firm uses the
which B's innovation
is
F
that
A
to save itself A's incentive
ante inefficiency arises
is
in selecting the scale of
payment ex ante and ex post
inefficiency arises
but B's idea
for ideas
for his innovation to
expand the
scale
on
implemented.
Because the firm's incentives
The ex post
hoped was earmarked
when,
but
(6) is satisfied
B's innovation are distorted by
inefficiencies arise, as before,
(4) fails so that
A
is
its
when g >
(3) holds
but
(4)
and
(6) fail.
g.
encouraged to search
implemented on a large scale when both employees succeed.
when
desire
Then, the integrated firm
is
The ex
unable to
motivate A.
Either of these inefficiencies can be so great that the firms are strictly better off remaining
This occurs whenever the firm preferred to remain narrow in the isomorphic synergy
separate.
model. Preference for narrowness
in that
model
as a result of ex ante inefficiency obtained
when
the value of the synergies generated by B's inventions were less than the lost profits from A's
efforts.
Here that corresponds to the profits from A's efforts exceeding the profits from being able
to apply B's invention
on a large
scale.
A
similar analogy applies to the preference for narrowness
that results from ex post inefficiency.
The other
results obtained in the Section
that integration
may be
1
also apply here.
unprofitable survives renegotiation and the introduction of the more com-
which A's compensation can be made contingent on whether B's innovation
plex contract in
implemented (as long as the scale on which B's innovation
3.
have shown that innovation-oriented firms
objectives, even
implemented
is
not contractible).
though
this requires
may
earn higher profits by pursuing narrow
shunning some profitable opportunities. In these conclusions
discuss the relationship between our models and the empirical literature on diversification. This
literature,
which starts with Rumelt (1974), asks whether diversified companies have higher or
lower profits than their undiversified counterparts.
controlling for industry effects
17
is
is
Conclusions
We
we
In particular, the conclusion
is difficult.
The
results are rather mixed, in part because
Overall, however, unrelated diversification seems to
See Lubatkin and Rogers (1989) for a recent example and a discussion of this literature.
29
18
be associated with lower profitability and lower stock market prices.
this view
is
Additional evidence for
provided by the case studies of Ravenscraft and Scherer (1987) which suggest that
when they
the divisions that conglomerates divest tend to become more profitable
own. One possible conclusion from this literature
is
are on their
that managers are too keen on diversifying.
For example, Rumelt cautions against unrelated diversification as follows: "Management expecting
the synergistic effects of bringing two [diversified but unrelated] firms together should be warned
that the organizational problems rising from this type of merger have, on the average, nullified any
beneficial gains
We
due to scale or synergy."
have stressed the possibility that the profits of a diversified firm are low because
problems are more severe.
impossible to
manage a broad array
of activities effectively.
correlation between diversification
A
human
first
it
is
capital
reasons stressed by Grossman and
complete explanation of the cross sectional
and firm performance must include a rationalization
choosing to become diversified in the
is
Or, the incentive for
in diversified organizations for the
Hart (1986). However, these stories are not enough.
possibility
agency
Alternatively, diversified firms might have low profits because
investment might be lower
One
its
for firms
place.
that managers diversify by mistake.
Another
is
that managers have non-
profit-maximizing motives for diversification. They might be seeking prestige as in Jensen's (1986)
"free cash flow" theory.
(and managers
A
who have
related theory mentioned in
is
that inept managers
access only to low-quality projects) seek to diversify while competent
managers, who can create profits
(1989) provide
Rumelt (1974),
some evidence
in their existing businesses,
for this theory.
do not. Morck, Shleifer and Vishny
These "managerial" theories of diversification
all
suggest that shareholders would be better off curtailing this activity.
An
alternative view of the low profits of diversifiers
and Wernerfelt (1988). They regard
is
due to Penrose (1959) and Montgomery
diversification as an efficient response
excess capacity of productive factors.
by firms to their having
Firms who have more of some factors than they can use
productively in their industry of choice diversify so that these factors can become productive. For
example, a firm that has an underutilized "core competence"
in its existing business
might seek
other arenas in which their basic resource can be put to work.
Our model provides a
and
profits
third rationale for the cross sectional correlation between stock prices
on the one hand, and
diversification
on the other.
This rationale comes from our
conclusion that innovative firms must remain narrow while less innovative firms can be broad.
In
many
industries firms pursuing innovations coexist with firms that are content with imita-
tion. It is certainly possible for
Our model has
both these strategies to lead to the same
level of
economic
profits.
stressed the need to pay innovative employees after their effort bears fruit. However,
innovative firms must presumably also purchase an infrastructure that makes innovation possible;
18
The
latter result
is
due to Montgomery and Wernerfelt (1988).
30
in
other words they must also spend resources ex ante. For the innovative firms to have the same
economic
profits as their imitative counterparts, these ex ante expenditures
ex post rents. Accountants generally do not treat
all
must be matched by
these ex ante expenditures as capital.
On
the
other hand, a rational stock market would value the future rents that accrue as a result of these
expenditures.
Thus, we would expect innovative firms to have high
accounting profits, relative to their imitative
would expect innovative firms to be narrow while
By
their q's,
from
lose
diversification.
Thus we
and even their conventionally measured
contrast broad firms would be exclusively imitative so that their q's and
accounting profits would be low. Anecdotal evidence for this view
description of the relatively broad firm Indian
little
and perhaps even high
rivals.
According to our model, imitative firms have nothing to
profits, are high.
q's,
Head
is
provided by Perrow (1970)'s
According to him, Indian Head had
Mills.
interest in investment. Its strategy consisted of buying failing companies, closing a large part
of their operations
and keeping the profitable
bits.
Sorting out the validity of these theories empirically requires more information than simply
the correlation between profits and diversification. In particular, the analysis of which aspects of
the firm's endeavors
become
easier
divisions deserves further work.
and which become harder when firms either acquire or spin
According to our theory, the spinning
easier for that division to innovate. Similarly diversification
business to remain innovative. This latter implication
kind: "If
we
start to turn this stuff out in quantity,
to change the whole character of the
and
D men
will leave"
company; we
(Quoted by Perrow (1970,
is
p.
it
a division makes
harder for the existing
it
lines of
consistent with statements of the following
now
will
makes
off of
off
that
we know how
become a production
158)).
The
to
make
outfit,
it, it is
going
and our top
issue, then, is the extent to
R
which
statements of that kind describe a wide range of circumstances.
4.
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The
Free Press,
New
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32
Brooking Institution, Washington DC, 1987.
Roberts, Kevin and Martin L. Weitzman: "Funding Criteria for Research, Development and
Exploration Projects," Econometrica, 49, September 1981, 1261-88.
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Williamson, Oliver: Markets and Hierarchies, Macmillan,
33
New
York, 1975.
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