26 Pages Posted: 20 Aug 2005
Date Written: April 2005
What are the links between the organizational and the financial aspects of an economic relationship? To answer this question, we propose a simple model of an economic organization composed of two cash constrained but privately informed agents. The model allows for conflict of interest between the organization and the investor, and within the organization. Using a mechanism design approach, we show that the optimal contract can not improve upon simple allocations of control rights such as centralized, decentralized and external control. The allocation of control rights within an organization affects the financial constraints of the organization itself. The allocation of control rights and the financial arrangements jointly depend on the average conflict between the organization and investors, the stability of the environment and the degree of alignment of interest within the organization. The model sheds some lights on the nature of the firm and is consistent with the work of legal scholars, business historians and anecdotal evidence.
Keywords: Control Rights, Limited Liability, Theory of the Firm, Group Lending
JEL Classification: D23, G32, K12, L22, O10
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