Birger Wernerfelt, MIT IIOC Boston April 8, 2017 DIVISION OF LABOR IN MULTI-BUSINESS FIRMS: Human Capital, Job Design, and Labor Contracts Birger Wernerfelt, MIT IIOC Boston April 8, 2017

Starting Point: Adaptation-Cost Theory of the Firm (Wernerfelt 97, 15, 16) 1. Workers perform services for businesses, there are gains from specializing in (acquiring human capital in) either, but businesses need different services each period 2. Bilateral contracting costly but bargaining costs are sub-additive => In a model where entrepreneurs may own one or two businesses each, one of four labor market mechanisms is the most efficient subgame perfect equilibrium: Employment (superintendent) negotiates with a single entrepreneur in the first period and the contract gives the entrepreneur the right to choose later period assignments (give orders) with no further negotiation. Sequential contracting (handyman) negotiates a sequence of one service contracts with the same entrepreneur Global Markets (plumber) agrees to perform a specific service for any entrepreneur Local Markets (plumber) agrees to perform any service to a small set of entrepreneurs

New: Not All Adaptations are the Same Businesses come in “neighborhoods” such that 1. The businesses in a neighborhood need similar human capital 2. The services needed by neighboring businesses are correlated => If an entrepreneur combines neighboring businesses, workers may be able to specialize in a narrower set of services and stay within a single employment contract (by “doubly specialized”, plumbers for MIT).

Key Results The theory predicts that -firms will combine businesses with three simultaneous properties: (i) Their workers use similar business skills, (ii) their service needs are correlated, and (iii) these needs change frequently. -multi-business firms will hire doubly specialized employees to perform services that single-business firms get from the market or from employees with more general human capital

Generalizes to Other “Lumpy” Inputs Labor is a lumpy input because it would be uneconomical to sell off fractions or rent it out The owner may hold excess capacity, only he/she can use it, and competitors cannot get it. The firm may expand its scope to utilize this asset The same forces apply to other lumpy inputs : brand names, teams of employees, corporate culture,.

Empirical Test Since excess capacity can be deployed at low (zero?) marginal cost, the firm will use more of these inputs and less of substitute inputs. => If acquisitions are motivated by a desire to leverage excess capacity of resources, targets should change behavior in the direction of acquirers. Operationalization: Predict post-merger advertising- and R&D intensities from pre- merger magnitudes: Weighted average ratio - actual ratio = α + β(target ratio – acquirer ratio) or = γ + μ(target share of combined sales)(target ratio – acquirer ratio) Hypothesis: β, μ > 0. If target has a higher (lower) ratio ex ante, ex post actuals are lower (higher) than the weighted average

93 US Mergers in 2012 and 2013: Model Adv., Add. Adv., Mult. R&D, Add. R&D, Mult. R&D, Add. W/o outlier R&D, Mult. W/o outlier Constant   Slope -.002 (.002) .546*** (.062) .794*** (.067) -.013 (.009) .053** (.023) -.016* (.008) .946*** (.193) -.019** .539*** (.101) -.018** (.007) 2.41*** (.311) N R2 93 .68 .78 .06 .46 92 .49 .63

Conclusion Based on advantages of specialization and sub-additive bargaining costs, we characterize the circumstances under which labor is traded in multi-business firms. The theory predicts that firms diversify to leverage excess capacity of resources It squares with many stylized facts and a test supports it. It is consistent with the way many managers and management scholars think about the scope of firms.