When contracts are incomplete, the property-rights theory of firms suggests that ownership of physical assets provides better outside options, which in turn strengthen the owner's incentives to invest in the enterprise. This approach is less suitable for human capital firms such as management consulting that lack physical assets. This article develops an alternative theory for integration that sheds light on the boundaries of human capital firms. In particular, when a relationship between parties includes large potential externalities, reducing the outside option of each party will be beneficial. Integration provides this reduction by blurring the contribution of individual parties within the firm, and thus lowering their independent market valuation. Unlike some results in the property-rights literature, the results here are robust to variations in ex post bargaining solution.

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Imposing caps on managers' pay has been a popular way to discipline managers of companies or banks that got into trouble during the recent financial crisis. Using a small extension of the standard principal-agent model, we argue that pay caps may serve the opposite purpose because the agent can be better off with a pay cap. Specifically, we show that, given a fixed effort level to be implemented, the agent's expected utility can be decreasing in an upper bound for the agent's reward. The model also offers a characterization of the effect of pay caps on the general structure of optimal incentive contracts.While improvement of contracting information always helps the principal, it may increase or decrease the marginal cost of imposing pay caps.

Socialism in internal capital markets (SICM) is the phenomenon whereby multi-division firms underinvest in high-profit segments and overinvest in low-profit segments. This article modifies and extends the Scharfstein and Stein (2000) model that explains SICM. The major modification is to abstract from rent-seeking behaviour - a central ingredient that is used by most SICM models and has the side effect of overturning SICM when the underlying rent-seeking game is slightly perturbed. It is shown that when division managers' private benefits are not exactly propotional to their division's production profit, as assumed by Scharfstein and Stein (2000), SICM arises due to the CEO's incentive to extract gain from the trade of capital between his division managers by equalizing their marginal private benefits, instead of accommodating rent-seeking. Furthermore, we show that 'diversification discounts' exist, increase in diversity and decrease in CEO ownership. The results are robust to endogenizing the investors' choice of the total capital provided to the firm, which allows the conditions for aggergate underinvestment or overinvestment to be determined.