SPILLOVERS, INVESTMENT INCENTIVES AND THE PROPERTY RIGHTS THEORY OF THE FIRM  David de Mezaw BenLockwoodz This paper examines the property rights theory of the firm when a manager’s relationship-specific investment can be partially appro- priated by the owner of an asset even if cooperation breaks down. The investments of non owners may then be devalued, but are seldom wholly lost to the owner. With such spillovers, the outside-option principle can be incorporated into the Grossman-Hart-Moore framework without implying that ownership demotivates. Enriched predictions on the determinants of integration emerge. I. INTRODUCTION Whether for good or ill, managers often have influence well beyond their tenure in a job. Examples are so numerous as to be commonplace. According to Chandler [1977], the American railroad network took its modern form by the 1880s and ‘ysalaried career executives played a critical role in the system building of the 1880s’ (p. 167). A theme of Peters and Waterman [1982] is that effective managers inculcate an enduring culture. Typical is the quote of Richard Deupree, former CEO of Procter and Gamble, ‘William Procter and James Gamble realized that the interests of the organization and its employees were inseparable. That has never been forgotten.’ (p. 76). The common element here and much more generally is that a firm may continue to benefit from an employee’s past efforts even when they part company. This feature evidently affects employees’ bargaining positions with employers and hence the incentives of both parties to make non- contractible investments in the relationship. The underlying perspective is the property rights theory of the firm (PRT). This is a bold attempt to explain patterns of industrial organization by the incentive effects of asset ownership. The seminal papers are Grossman and Hart [1986] and Hart and Moore [1990], henceforth GHM. They argue that costly verification of r Blackwell Publishing Ltd. 2004, 9600 Garsington Road, Oxford OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA. 229 THE JOURNAL OF INDUSTRIAL ECONOMICS 0022-1821 Volume LII June 2004 No. 2  We greatly appreciate the exceptionally helpful comments of the referees and editor. wAuthors’ affiliations: Interdisciplinary Institute of Management, London School of Economics, Houghton Street, London, WC2A 2AE, U.K. email: d.de-meza@lse.ac.uk zDepartment of Economics, University of Warwick and CEPR, Coventry, CV4 7AL, U.K. email: b.lockwood@warwick.ac.uk