Ulric B. and Evelyn L. Bray Seminar

Productivity dispersion among seemingly similar firms has been widely documented and often viewed as symptomatic of an underlying misallocation of resources. Why does a firm that is marginally more productive than others not expand? Following Penrose and Chandler, I argue that in order to produce efficiently, a large firm must decentralize operating decisions to managers. In order to decentralize, a firm's owner must make credible promises to reward judicious use of the firm's resources. I therefore develop a model of relational contracts in a competitive environment with heterogeneous firms. Credibility requires collateral, which takes the form of future competitive rents. In equilibrium, competitive rents are allocated inefficiently: high-ability firms are better able to solve their credibility problem than low-ability firms and therefore, the marginal collateral value of competitive rents is not equalized across firms. Improvements in formal contracting institutions reduce the importance of credibility and therefore disproportionately benefit low-ability firms. Cross-country differences in contracting institutions can therefore partially explain the observed pattern that productivity dispersion greater in developing countries.