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A Theory of Inefficient Intrafirm Transactions

The author considers a model in which the threat of customer departures induces sellers to supply high-quality goods. Permanent attachment of buyer and seller such that transactions take place inside a firm raises the social cost of delivering high quality. Yet, such costly integration is often profitable, because prices exceed marginal cost at equilibria where market transactions provide high quality. This theory can rationalize the empirical finding that middle managers are averse to transactions between profit centers. Copyright 1991 by American Economic Association.