The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration

TLDR

The theory of costly contracts distinguishes specific and residual rights, arguing that when enumerating all specific rights is costly, it is optimal for one party to acquire all residual rights—ownership—though this transfer creates distortions. Firm 1 acquires firm 2 when the productivity gains from its control outweigh the productivity losses from firm 2’s loss of control.

Abstract

Our theory of costly contracts emphasizes the contractual rights can by of two types: specific rights and residual rights. When it is costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchases firm 2 when firm 1's control increases the productivity of its management more than the loss of control decreases the productivity of firm 2's management.