Suppose a group of agents by making a joint effort could produce something of value. Much of economic theory is based on the idea that such potential gains from trade would be fully exploited. Implicitly, we assume the existence of institutions that ensure the cooperation of all parties involved, such as complete contracts and their enforcement by a legal system. But in reality contracts are incomplete and courts less than omniscient, and any ex ante agreement, such as on how to split the surplus resulting from a joint activity, is subject to opportunistic behavior ex post. In this paper, we argue that outside ownership of firms may be an institution that fills in the gaps left by imperfect formal enforcement.

Consider the costs that arise from imperfect enforcement. In a joint undertaking, such as a partnership or cooperative, individuals may be able to divert part of the jointly produced surplus for their own uses. There are many examples in the legal literature. A partner may use company money to finance private activities, but claim that the money was used for business purposes. Preparing to support such a claim before a court or an arbitrator, the partner may manipulate documents and accounting information, and hire lawyers or expert witnesses. Since the court has no information about the case apart from what is presented by the parties, the outcome depends partly on strategic, costly decisions by the parties themselves. Hence relying on courts to enforce contracts may in fact exarcerbate rather than reduce the total costs of conflict in a business transaction.