Organizational economics.

• Position: Bureau News - Meeting of National Bureau of Economic Research's Working Group on Organizational Economics

The NBER's Working Group on Organizational Economics, directed by NBER Research Associate Robert S. Gibbons of MIT, held its third annual meeting on November 5-6. The papers presented covered many of the working group's major themes, illustrating the broad range of topics within the emerging field of organizational economics. All of these themes and topics share a common focus on "governed transactions" (that is, transactions that do not occur in frictionless markets). Naturally, the group's main focus is on transactions within firms. As a result, many of the group's members are drawn from the relevant margins of other NBER Programs and Working Groups that study resource allocation and other processes within firms, such as Corporate Finance, Personnel Economics, and Productivity. The papers delivered by Scharfstein, Benabou, Schmidt, Shaw, Oyer, Klein, Gibbons, and Winter addressed these kinds of issues.

The group is also pursuing a significant interest in governed transactions between firms, such as contracts, "hybrid" governance structures (that is, alliances, joint ventures, and networks), and activities that change firms' boundaries (that is, start-ups, spin-offs, and mergers). As a result, some of the group's members are drawn from the relevant margins of NBER Programs and Working Groups such as Entrepreneurship, Industrial Organization, and International Trade and Organization. The papers delivered by Hart, Perotti, Bidwell, Azoulay, and Garicano addressed these kinds of issues.

Finally, many of the principles that apply to governed transactions within and between firms also apply to other kinds of organizations and institutions, so the group is also pursuing a subsidiary interest in organizations such as schools, hospitals, government agencies, and beyond. The papers delivered by Khwaja and Tadelis addressed these kinds of issues.

The meeting program was:

David S. Scharfstein, NBER and Harvard University, and Ilan Guedj, MIT, "Organizational Scope and Investment: Evidence from the Drug Development Strategies of Biopharmaceutical Firms" Asim Khwaja, Harvard University, and Atif Mian, University of Chicago, "Do Lenders Favor Politically Connected Firms? Rent-seeking in an Emerging Financial Market" Discussant: Antoinette Schoar, NBER and MIT

Roland Benabou, NBER and Princeton University, and Jean Tirole, University of Toulouse, "Incentives and Prosocial Behavior" Alexander Klein and Klaus Schmidt, University of Munich, and Ernst Fehr, University of Zurich, "Contracts, Fairness, and Incentives" Discussant: W. Bentley Macleod, University of Southern California

Ben Klein, University of California, Los Angeles, "When Does a Contractual Adjustment Involve a Holdup? The Dynamics of Fisher Body-General Motors" Robert Gibbons, "A Rent-seeking Theory of the Firm?" Discussant: Scott Masten, University of Michigan

Kathryn L. Shaw, NBER and Stanford University, and Ann P. Bartel and Casey Ichniowski, NBER and Columbia University, "The Strategic Investment in Information Technologies and New Human Resource Practices and Their Effects on Productivity: An Insider Econometric Analysis" Paul Oyer, NBER and Stanford University, "Salary or Benefits?" Discussant: George Baker, NBER and Harvard University

Oliver D. Hart, NBER and Harvard University, and John Moore, London School of Economics, "Agreeing Now to Agree Later: Contracts that Rule Out but do not Rule In" Enrico Perroti, University of Amsterdam, and Thomas Hellmann, University of British Columbia, "The Circulation of Ideas: Firms versus Markets" Discussant: Daron Acemoglu, NBER and MIT

Matthew Bidwell, INSEAD Singapore, "What Do Firms Do Differently? Comparing the Governance of Internal and Outsourced IT Projects" Pierre Azoulay, NBER and Columbia University, "Agents of Embeddedness" Discussant: Francine LaFontaine, University of Michigan

Sidney Winter, University of Pennsylvania, "Towards an Evolutionary Theory of Production" Discussant: Bengt R. Holmstrom, NBER and MIT

Steven Tadelis and Jonathan Levin, Stanford University, "Employment versus Contracting in Procurement: Theory and Evidence from U.S. Cities" Luis Garicano, University of Chicago; Pol Antras, NBER and Harvard University; and Esteban Rossi-Hansberg, Stanford University, "Outsourcing in a Knowledge Economy" Discussant: Michael Waldman, Cornell University

Guedj and Scharfstein compare the clinical trial strategies and performance of large, established ("mature") biopharmaceutical firms to those of smaller ("early stage") firms that have not yet successfully developed a drug. The authors study a sample of 235 cancer drug candidates that entered clinical trials during 1990-2002 and were sponsored by public firms. Early-stage firms are more likely than mature firms to advance from Phase I to Phase II clinical trials. However, early-stage firms have much less promising clinical results in their Phase II trials, and their Phase II drug candidates also are less likely to advance to Phase III and to receive Food and Drug Administration approval. This pattern is more pronounced for early-stage firms with large cash reserves. The evidence points to an agency problem between shareholders and managers of single-product early-stage firms who are reluctant to abandon development of their only viable drug candidates. By contrast, the managers of mature firms with multiple products in development are more willing to drop unpromising drug candidates. These findings appear to be consistent with the benefits of internal capital markets identified by Stein (1997).

Rent-seeking by the politically connected often is blamed for economic ills, particularly in less developed economies. Using a loan-level dataset of more than 90,000 firms that represents the universe of corporate lending in Pakistan between 1996 and 2002, Khwaja and Mian investigate rents to politically connected firms in banking. Classifying a firm as "political" if its director participates in an election, the authors examine the extent, nature, and economic costs of political rent seeking. They find that political firms borrow 40 percent more and have 50 percent higher default rates. Such preferential treatment occurs exclusively in government banks; private banks provide no political favors. Using only within-firm variation, the authors show that government banks not only select bad political firms, but conditional on selection, lend larger amounts to them. Moreover, the extent of political rent-seeking increases with the strength of the firm's politician and whether he is in power, and falls with the degree of electoral participation in his constituency. Khwaja and Mian provide direct evidence that rules out alternative explanations, such as socially motivated lending by government banks. The economy-wide costs of the rent-seeking are estimated to be 0.3 percent to 1.9 percent of GDP every year.

Benabou and Tirole build a theory of prosocial behavior that combines heterogeneity in individual altruism and greed with concerns for social reputation or self-respect. The presence of rewards or punishments creates doubt as to the true motive for which good deeds are performed, and this "overjustification effect" can result in a net crowding out of prosocial behavior by extrinsic incentives. The model also allows the authors to identify settings that are conducive to multiple social norms of behavior, and those in which disclosing one's generosity may backfire. Finally, Benabou and Tirole analyze the equilibrium contracts offered by sponsors, including the level and confidentiality, or publicity, of incentives. Sponsor competition may cause rewards to bid down rather than up, and can even reduce social welfare by requiring agents to engage in inefficient sacrifices.

Fehr, Klein, and Schmidt show experimentally that fairness concerns may have a decisive impact on both the actual and the optimal choice of contracts in a moral hazard context. Explicit incentive contracts that are optimal according to self-interest theory become inferior when some agents value fairness. Conversely, implicit bonus contracts that are doomed to fail among purely selfish actors provide powerful incentives and become superior when there are some fair-minded players. The principals understand this and predominantly choose the bonus contracts, even preferring a pure bonus contract over a contract that combines the enforcement power of explicit and implicit incentives. This contract preference is associated with the fact that explicit incentives weaken the enforcement power of implicit bonus incentives significantly. These results are largely consistent with recently developed theories of fairness, which also offer interesting new insights into the interaction of contract choices, fairness, and incentives.

Klein's paper continues his quarter century of work on the relationship between specific investments and vertical integration. This paper provides a more complete analysis of the Fisher Body-General Motors movement to vertical integration, because a copy of the actual 1919 contract between these parties (previously unavailable from any public source) is now available. In particular, the paper focuses on the dynamics of the movement to vertical integration--from well-functioning contract, to contractual failure, to integration. After a detailed study of these dynamics, it becomes clear that there can be little disagreement about what occurred, even if there still can be disagreement about the interpretation of what occurred. In particular, Klein notes that there is no accepted, rigorous definition of what hold-up is, so clarifying this basic concept is a primary goal of this paper.

Gibbons defines and compares elemental versions of four theories of the firm. These elemental theories are distilled from important contributions by Hart, Holmstrom, Klein, Williamson, and others. Although these contributions have been widely cited and much discussed, Gibbons finds it difficult...