Endogenous property rights and the nature of the firm

Abstract

While focusing on residual control rights, the property rights theory of the firm overlooks that the legal protection of each party's input shapes its ex post bargaining power. To evaluate this issue, we assume that the property rights on the inputs are selected by a legislator to maximize full investment and, conditional on this goal being reached, minimize inefficient deviations to intermediate investment profiles. Our model delivers three key novel implications. First, the strength of a party's property rights is related negatively to the strength of its residual control rights and determines entirely its ex ante incentives to invest. Second, the legislator tends to protect a firm less when its default payoff under its preferred ownership structure is larger and when its contribution to the relationship is the greatest. Finally, the extent of integration falls weakly with the default payoffs and displays an inverted U-shaped link with the intensity of the downstream firm's investment activity. Crucially, these predictions are consistent with the relationships between proxies for the strength of the downstream firms' property rights and firms' presence in the value chain, and measures of asset specificity and R&D intensity for 119 countries observed over the 2006–18 period.