October 2006

IZA DP No. 2396: On the “Adverse Selection” of Organizations

published as 'On Adverse Selection of Technologies ' in: Journal of Institutional and Theoretical Economics, 2008, 164 (2), 343-355

According to New Institutional Economics, two or more individuals will found an organization, if it leads to a benefit compared to market allocation. A natural consequence will then be internal rent seeking. We discuss the interrelation between profits, rent seeking and the foundation of organizations. Typically, we expect that highly profitable firms are always founded but it is not clear whether the same is true for firms with less optimistic prospects. We will show that internal rent seeking may lead to a completely reversed result. The impact of internal rent seeking on overall investment and the implications of firm size and competition on the foundation of organizations are also addressed.