Endogenous property rights and the nature of the firm

While focusing on residual control rights, the propertyrights theory of the firm overlooks that the legal protec-tion of each party’s input shapes itsex postbargainingpower. To evaluate this issue, we assume that the propertyrights on the inputs are selected by a legislator to maxi-mize full investment and, conditional on this goal beingreached, minimize inefficient deviations to intermediateinvestment profiles. Our model delivers three key novelimplications. First, the strength of a party’s propertyrights is related negatively to the strength of its residualcontrol rights and determines entirely itsex anteincen-tives to invest. Second, the legislator tends to protecta firm less when its default payoff under its preferredownership structure is larger and when its contributionto the relationship is the greatest. Finally, the extent ofintegration falls weakly with the default payoffs and dis-plays an inverted U-shaped link with the intensity of thedownstream firm’s investment activity. Crucially, thesepredictions are consistent with the relationships betweenproxies for the strength of the downstream firms’ propertyrights and firms’ presence in the value chain, and measuresof asset specificity and R&D intensity for 119 countriesobserved over the 2006–18 period.