3 Incomplete contracts, ownership and the boundaries of the firm
3.1 Introduction
The modern literature on the theory of the firm began when Coase (1937) asked which transactions are more efficiently conducted in a firm than a market. Contractual incompleteness was at the core of the issues that Coase, Oliver Williamson (1979) and others explored, particularly as they were apparent in the distinction between the highly incomplete contracts within the firm and the necessarily more complete contracts with third-party providers of goods or services. While outsourced contracts with third parties are necessarily incomplete, the choice to outsource must reflect a greater value in the ex ante specification of aspects of the contractual relationship than is true for those activities conducted inside the firm.
Since the 1970s there has been a profusion of work on this question, but in many respects a unified theory of the firm is more rather than less elusive (Gibbons, 2005; Garrouste and Saussier, 2005). The reason is that a unified theory of the firm must be able to cope with external and internal organisational choices. In particular, a theory of the firm must be capable of providing a unified analysis of the costs and benefits of integration of activity within a firm.
Our focus in this chapter is on elaborating the “incomplete contracts” or “property rights” approach to the theory of the firm, which is currently the most popular paradigm for investigating the boundaries of the firm. But to provide some context for understanding why this approach is considered to be so important, we begin with a survey of the transaction-cost-based theories of the firm developed in the 1970s and 1980s. Applications of the incomplete contracts approach to a variety of private and public-sector ownership issues, including public-private partnerships, are reserved for subsequent sections of this paper.
