Grossman and Hart

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Takeover Bids, The Free-Rider Problem, and the Theory of the Corporation Author(s): Sanford J. Grossman and Oliver D. Hart Source: The Bell Journal of Economics, Vol. 11, No. 1 (Spring, 1980), pp. 42-64 Published by: The RAND Corporation Stable URL: http://www.jstor.org/stable/3003400 . Accessed: 11/05/2011 20:16 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . http://www.jstor.org/action/showPublisher?publisherCode=rand. . Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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Takeover bids, the free-riderproblem, and the theory of the corporation Sanford J. Grossman* and Oliver D. Hart**

It is commonly thought that a widely held corporation that is not being run in the interest of its shareholders will be vulnerable to a takeover bid. We show that this is false, since shareholders can free ride on the raider's improvement of the corporation, thereby seriously limiting the raider's profit. We analyze exclusionary devices that can be built into the corporate charter to overcome this free-rider problem. We study privately and socially optimal corporate charters under the alternative assumptions of competition and monopoly in the market for corporate control.

1. Introduction
* In all but the smallest groups social choice takes place via the delegation of power from many to few. A fundamental problem with this delegation is that no individual has a large enough incentive to devote resources to ensuring that the representatives are acting in the interest of the represented. Since the representatives serve the Public Good, the social benefit to monitoring their activities is far larger than the private benefit to any individual. That is, the Public Good is a public good and each person attempts to be a free rider in its production. It is often suggested that in a corporation the free-rider problem can be avoided by use of the takeover bid mechanism. Suppose that the current directors of the corporation are not acting in the shareholders' interest, but that each shareholder is too small for it to be in his interest to devote resources to overthrowing management.1 It is argued that this situation will not persist because an entrepreneur (i.e., a "raider") can make a takeover bid: he can buy * University of Pennsylvania. ** Churchill College, Cambridge.

We are grateful to Christopher Bliss, Frank Hahn, John Mitchell, Howard Sosin, Joseph Stiglitz, and members of the Cambridge SSRC project on "Risk, Information, and Quantity Signals in Economics" for useful suggestions. We would also like to thank an anonymous referee and the editors of the Bell Journal for helpful comments. We are grateful for research support from the U.K. Social Science Research Council and N.S.F. Grant no. SOC76-18711. 1 See Williamson (1964) for a discussion of the separation of ownership and control in the corporation. 42

GROSSMANAND HART /...
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