Specialized supply firms, property rights and firm boundaries

Abstract

The proper specification of intellectual property rights (IPRs) is a delicate and controversial matter. In this paper, we consider one specialized context in which IPRs can add to efficiency. We build on contributions of both ‘firm capabilities’ scholars (e.g. Teece, Pisano et al.) and ‘property rights’ economists (e.g. Hart) to show that IPRs can affect efficiency by influencing the location of technological innovation. Using a simple set up, where the key choice is whether a technology-intensive input will be supplied by an independent firm or produced in-house, we analyze how the choice is affected by the strength of IPRs and by the existence (and nature) of information spillovers. Specifically, we show that when the supply relationship is likely to produce new information of value to the supplier, stronger property rights favor independent suppliers over vertical integration. An important implication of our model (backed by empirical case studies) is that strong IPRs therefore encourage investments in specialized firms with strong ‘firm capabilities’ in the area of innovative input supply. IPRs therefore may play a role—along with multiple other factors—in the location of firm boundaries in some cases. This contribution to the viability of small, specialized firms, with their superior ability to innovate in some cases, must be taken into account in evaluating recent criticisms of over-fragmented IPR ownership (i.e. the ‘anticommons’ problem). It also contributes to an understanding of IPRs in the ‘post-Chandlerian’ economy, where smaller, specialized firms play a prominent role.

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