A Theory of Firm Boundaries with Long-Run Incentives and At-Will Employment

Abstract

Existing theories of the firm define its boundaries through the optimal allocation of ownership rights of alienable capital. However, a broad set of business services today rely on inalienable, i.e. human, capital. We provide a new theory of firm boundaries based on dynamic incentives and at-will employment. In our model, in each period, a principal can either write a short-term outsourcing contract in which parties commit to ending the relationship after one period or an employment contract that potentially lasts multiple periods. In environments in which an employee's past success increases his cost of effort in future periods, the principal's lack of commitment to re-hire an employed worker undermines her ability to provide incentives in earlier periods. Hence, in equilibrium, there is too much worker turnover and too much outsourcing relative to the first-best assignment of workers to firms. We characterize when outsourcing contracts strictly outperform employment contracts, and vice-versa. Notably, our theory does not rely on capital ownership, heterogeneous adjustment costs, or pre-existing boundaries, cornerstones of existing theories of the firm.