1 Boundaries of the Firm: A Theory of Informational Uncertainty and Learning

This paper examines the determinants of the boundaries of a firm. In contrast to much of the existing literature, we shy away from hold-up problems and instead focus on the firm’s decision to redraw its boundaries in light of informational uncertainty. The firms faces uncertainty surrounding four key elements: (i) the profitability of a new market, (ii) whether the firm has the skills necessary for this new market, (iii) the compatibility of the new business with the firm’s existing portfolio, and finally (iv) the competitive environment. We find that a firm’s boundaries are determined dynamically as it tries to learn about these factors. The firm’s optimal learning strategy will either be to redraw its boundaries right away, or to invest a smaller amount to learn and put itself into a position to redraw its boundaries later, or to postpone any investment until uncertainty is resolved. We also apply our model to business portfolio decisions and the incentives for firms with varying market power to pursue technological innovations. The interactions between the elements of uncertainty generate a number of empirically testable predictions, including a positive relationship between the level of competition and both the frequency of firm restructuring activity and the incentives to develop technological innovations.