A Formal Theory of Firm Boundaries: A Trade-Off between Rent Seeking and Bargaining Costs

We develop a theory of firm boundaries in the spirit of transaction cost analysis, in which trading parties engage in ex post value split. We show that ex post inefficient bargaining under non-integration creates a trade-off between rent seeking and bargaining costs: while non-integration incurs lower rent-seeking costs than integration, it suffers from bargaining delay and breakdown, which never occur under integration. This result explains why rent-seeking activities within firms are likely to be more costly than those between firms, and offers a formal justification for the "costs of bureaucracy" in Williamson (1985).