The Space Between Markets and Hierarchies

The decision to pool production within a firm raises a fundamental tension for corporate law scholars. On the one hand, channeling activity into a centralized entity can economize on transaction costs by replacing the hassles of arms-length contracting with managerial discretion. Instead of attempting to write a complete contract to insulate against counterparty opportunism, firm managers retain the control necessary to make optimal decisions later—if and when a potential contingency arises. On the other hand, agency costs and production costs may be somewhat higher when business is conducted within a firm—because the activity is walled off from the relentless pricing pressure that comes with well-functioning markets. Recent work in the legal academy also shows how intra-firm activity can result in suboptimal capital structures for a given collection of assets. As the story goes, the precise location of a firm’s borders at any point in time will be the result of a mindful balancing between these competing effects.

Yet this account has always been somewhat misleading: there is space between markets and hierarchies. Business alliances, joint ventures, franchise agreements, and other structures offer firms a middle path between market exchange and unconditional firm control. Furthermore, the recent rise in business outsourcing transactions presents another intriguing context for studying hybrid organizational structures. Under many of these arrangements, assets (both physical and intangible) are legally owned by an offshore vendor, but the use of these assets is subject to partial control rights retained by the operational client.

This Article explores the growth of business outsourcing, how it works, and why two firms might logically enter into an outsourcing arrangement not only to cut production costs—but also to craft a sensible governance compromise. It also asks, more generally, whether increased diversity of organizational structures is starting to provide firms with a richer menu of strategies for sharing operational risk—in the same way that recent innovations in corporate finance and capital markets are dramatically altering ownership strategies on the right side of the balance sheet.