THE MODEL
We consider a model with three tv∙pes of agents: customers, employees and outside
owners. For most of the paper we shall suppose that there is only one customer and one
outside owner, but more than one potential employee. Only one employee is needed and
with more than one employee available there is competition for the provision of the service
between employees. To keep things simple wo assume that all agents are risk-neutral and
are primarily interested in maximizing income. The core transaction we focus on is a
service provided by employee(s) for a customer. The value of the transaction may be
enhanced if it is produced with the help of some (physical) asset, or on the premises of a
firm. The main question we shall be concerned with is who should control the use of the
asset or own the firm: employees, customers or outside owners? As in Grossman and Hart
(1986) we shall suppose that only owners have residual rights of control over the asset or
the firm. Before transacting employee(s) can invest in human capital. This investment
enhances the value of the transaction and is non-contractible..
There are manj, possible real world examples that may correspond to this stripped
down set-up: law firms, consulting firms, investment funds, professional schools. R&D
ventures, medical firms, etc. In all these examples employees must undertake several
λ*ears of training and undergo periodic retraining to be able to provide even basic services.
Also, by the time they are transacting their training costs are sunk and generally contracts
with customers are only written after training has been completed. For all these examples
one observes a variety of different ownership arrangements. Some firms are owned by
employees, others by customers or outside owners (see Hansmann (1996) for an overview
of the different ownership allocations observed in practice).
More formally, in the first stage of our game emplov∙ee(s) make a costly (unverifiable)
human capital investment of к at a cost of c(k). We shall assume without much loss of
generality that c(fc) = k. When this investment is completed, employee and customer
enter a service transaction. The total value of the service is given by v(k) if it takes place
outside the firm. When, instead, it takes place inside the firm it is given by V(fc). We
assume throughout this paper that :
V(Jt) > υ(fc) and Vz(Ar) > 0: υ'(k) > 0: V"(Jt) ≤ 0: υ"{k) < 0
A transaction in a firm creates more value either because the firm provides access to
facilities which Othenvise are not available or because the firm extends it’s reputation to
the transaction. As in Grossman and Hart (1986). wc assume that eɪ post contracting