A Formal Behavioral Model of Firm Boundaries: Why Does Authority Relation Mitigate Ex Post Disputes over Trade Value?

Abstract

We explore why authority within firms helps trading parties immediately settle ex post disputes over trade value, which are invited by unprogrammed adaptation, despite the possibility of a subordinate's disobedience to the orders of his boss. By employing three crucial behavioral assumptions (reference-dependent preference, self-serving bias, and shading), we point out that the choice of governance structure affects trading parties' expectations about outcome of ex post value split and show that a subordinate is likely to obey orders of his boss because he is expected to do so. Nevertheless, our study also points out that such a positive aspect of authority comes with subordinate's psychological disutility.