Coase explains the firm cooperation managed by organization as the transaction costs of using price mechanism is sometimes high. Williamson argues that these high transaction costs are due to high specificity when large assets or skill investment involve, which origin from incomplete contracts and lead to opportunism. Hart sees firm as assets and also start with the incompleteness of contracts which he think will make residual rights of control unclear and thus damage incentives.
To Coase, the transaction costs are mainly reconstructing costs. To Williamson, the costs are mainly the costs that might loss in future bargain, or say the risk from opportunism. To Hart, the costs are similar to Williamson’s costs as a result of incomplete contracts, but work as an incentive function rather than a hierarchy function. (that’s why in Williamson’s theory the firm has the weakest incentive effect)
However, just like some criticisms said, transaction costs are so elastic that can incorporate any costs when forming a transaction. The ones easily to be mentioned are searching for transaction participants, setting a suitable price, forecasting the prospect that related transaction, communication, bargain, and contracting costs, monitoring and enforcing costs, etc.. Lots of them are not mentioned or stressed by the theories above.
Here, I’d like to argue that a large part that have been largely overlooked is the searching cost that involve in any information searching and decision making of utility maximization and cost minimization. The information searching and decision making are not costless, and there is a tradeoff between efficient result and the transaction cost of finding the most efficient results. Within firm, having bounded needs to searching information and making decision (might be a little similar to bounded rationality) that would be demanded in market with price mechanism, employees accept the direction from entrepreneurs who instead do above works, and thus save the related transaction costs and can focus on efficient operation. In the case of intermediate product market, when one side find it costly to search the all possibility that the other will bring for the future transaction, it choose to integration to make transaction under management with less costs.
My simple idea has been artfully illustrated by economists who work on informational economics like Stigler or Demsetz. This post will thus gather and read most cited papers about firm and information costs.
– The economics of information GJ Stigler – Journal of political economy, 1961
– Production, information costs, and economic organization AA Alchian, H Demsetz – The American economic review, 1972
– On the impossibility of informationally efficient markets SJ Grossman, JE Stiglitz – The American economic review, 1980
– The theory of the firm revisited H Demsetz – Journal of Law, Economics, & Organization, 1988
– The impact of information technology on the organization of economic activity: The “move to the middle” hypothesis EK Clemons, SP Reddi, MC Row – … of management information …, 1993
– Technology, Information, and the Decentralization of the Firm D Acemoglu, P Aghion, C Lelarge… – … Quarterly Journal of …, 2007
Might be relevant
– The use of knowledge in society FA Hayek – The American economic review, 1945
– Rationality as process and as product of thought HA Simon – The American economic review, 1978
– Rational decision making in business organizations HA Simon – The American economic review, 1979
– Organizations and markets HA Simon – The Journal of Economic Perspectives, 1991
The theory of the firm revisited H Demsetz – Journal of Law, Economics, & Organization, 1988
Marshall’s representative firm and Walras’s auctioneer and the preoccupation of price system, undermines serious consideration of the firm as a problem solving institution
→ Knight (1921) + Coase (1937): markets do not operate costlessly / Williamson: shirking and opportunism
→ more complete theory must give greater weight to information cost, as an important component of transaction costs >> Knight’s risk sharing + agency theories’ private information
1. perfect decentralization
intellectual origins in 18th debate between mercantilists and free traders → not about competition per se, and certainly not about the organization of the firm / “Smithian” and dissenting views led to a closer examination of the conditions necessary for the price system to function in a manner: formalized in the perfect competition model = complete abstraction from centralized control of the economy
=>> not competition but extreme/perfect decentralization: actors maximize utility or wealth in complete disregard of the decisions of others or, indeed, of even the existence of others = if such impersonal maximizing behavior is competition, it is a very restricted variety ← As Knight points out, doing better than others is not involved
=> authority, or command, plays no role in coordinating resources ← all parameters (tastes + technologies + prices) are beyond the control of any of the model’s actors or institutions =>> a powerful tool for understanding how prices guide decisions in a decentralized economy + assessing the impact of exogenous changes in the parameters (taken as given by the model)
=>> contributes little to our understanding of the workings of a command economy or of processes around authority = not the behavior of actors + not legal institutions that prevent fraud (costless property rights system that function price system)
*** =>> the model sets the maximizing tasks of the firm in a context in which decisions are made with full and free knowledge of production possibilities and prices → The real tasks of management, to explore uncertain possibilities (=to devise or discover markets, products, and production techniques), and to control resources consciously where owners of resources have a penchant for pursuing their own interests (=actively to manage the actions of employees), have no place in the perfect decentralization model because it assumes that all products, markets, production techniques, and prices are fully known at zero cost.
=>> The only management task that seems to remain in traditional price theory, is the selection of profit maximizing quantities of outputs and inputs ← but the model strips management of any meaningful productivity in the performance of even these tasks as cost of maximizing (=required information + required calculations) is ignored or implicitly assumed to be zero //de facto, the resources that might be required to make maximizing decisions are treated as if they are not scarce
->> the sole exception to this generalization is the rationale sometimes adopted to justify U-shaped average cost curves-diminishing returns to “entrepreneurial capacity” ← this capacity cannot be increased in proportion to increases in other inputs → inconsistent with the model’s assumptions → difficult to rationalize why size of the firm should affect the owner/entrepreneur’s decision making capacities
** absence of substantive managed coordination in the perfect decentralization model
→ its source of strength in understanding of the price system in extreme decentralization
→ its source of weakness in analyzing managed coordination
==>> recognizing that management is a scarce resource employed in a world in which knowledge is incomplete and costly to obtain = Knight (firm as an institution for efficient risk-sharing is based on risk aversion and costly knowledge) + Coase (costly managing and exchanging, which certainly contain important components of information cost) + theories based on monitoring cost
2. The transaction costs theory of the firm: some problems
a) transaction cost and management cost to refer to the costs of organizing resources, respectively, across markets and within firms = Coase
b) governance costs of internal organization exceed those of market organization = Willamson
c) recent sometimes use transaction cost to refer indiscriminately to organizational costs whether these arise from within the firm or across the market
# (firm lower transaction costs that exist in market transaction but not eliminate all, thus there should still have some transaction costs left, which indicates the organization is to some extent a hybrid structure of market and hierarchy. It make senses if we think of the opportunity costs and negotiating costs that one would always take account when deciding to stay or leave the organization)
comparison of transaction and management costs has become the focusing conceptualization of the transaction cost theory / Difficulties with it have gone unrecognized:
 Purchasing inputs are substituted for purchasing goods that are more nearly complete → hence, in-house production does not constitute a clear elimination of transaction cost // purchasing goods from another firm, rather than producing these in-house, involves an implicit purchase of the management services undertaken by the other firm → so management cost is not eliminated by purchasing more nearly complete goods across markets
=>> not comparing costs but whether the sum of management and transaction cost incurred through in-house production is more or less than the sum of management and transaction cost incurred through purchase across markets (either option entails expenditures on both cost categories)
 tc=0, mc>0 => no firm = each individual acts as a firm, selling output of his efforts to others => management cost are not eliminated, but incurred by each one as he plans and executes production activity, as long as meaning of management is restricted to dealing with others)
=>> [all production is individualized if transaction cost is zero] is wrong ← Whether individuals act independently, or cooperate through a multi-person firm, depends on the extent of scale economies to management: tc in firm = 0 if scale economies to management => tc=0 only informs cooperating efforts will be organized with greater reliance on explicit negotiations === “employment contract” ////// the substance of the firm is reflected in the style of cooperative behavior that obtain
 tc=0, mc>0 => not purchase a firm but purchase the good + however the firm cost on managing the production when independent, thus cost must factor into price of good => implicit management cost must be paid whether the firm or its output is purchased
=>> the decision rests on whether management subject to economies of scale?
=>> in a more realistic context in which tc/mc/pc >0 => assessing whether merger or independent production yields the lowest unit cost, taking all these costs into account, over the relevant range of output
 the cost of transacting is only one element of the cost of purchasing from others: A firm purchases an input if the price asked for the input, which reflects the production cost of prospective sellers, when added to the costs of transacting and transporting, comes to less than the cost of making the input in-house
=>> make-or-buy not = tc <> mc, but + pc (internal cost of production that burden the potential purchaser and supplier) =>> a comparison of all the gains and losses that attach to external procurement relative to in-house production
=>>> tc ↑ > mc => not to (a substitution of managed coordination for market coordination), but to (a substitution of managed coordination within fewer, larger firms for managed coordination in more numerous, smaller firms) === Managed transfer of inputs inside a now larger firm is substituted for managed buying and selling // One type of management substitutes for another
 1+2+3 => new terminology(using governance or transaction costs to refer to all costs, whether they be within the firm or across markets/transaction cost taking account of all costs of organization) are confusing: firms are used when they are cheaper, all costs considered, but not when markets are cheaper? → it deprives transaction cost theory of any predictive content
 Williamson imply asset specificity as higher cost of using market governance of activities ← the linkage is weak ↓
 the problem of tc is [implicitly assuming that all firms can produce goods or services equally well] (implicitly: “other” firm = “market” = a perfect substitute in production for a firm) =>> since firms generally will not be perfect substitutes in the production of goods given information cost is positive → it might be in the interest of a firm to produce its own inputs even if tc=0 & mc>0, given the production cost of other firms might simply be so high as to make superior to buy /// firm might purchase its inputs even though mc=zero, if the production cost incurred by other firms is sufficiently low
<= a hidden presumption that still guided by perfect decentralization model: information remains full and free for production purposes (costly for transaction or management control purposes) → only compares transaction and in-house management costs(more correctly, the sum of these costs in each alternative offered by the make-or-buy choice) / ignores productivity differences between firms may be affected by outside the these cost categories: Merged firms may be unable to duplicate the sum of what independently standing firms can accomplish for a variety of reasons
=>> Each firm is a bundle of commitments to technology, personnel, and methods, all contained and constrained by an insulating layer of information that is specific to the firm, and this bundle cannot be altered or imitated easily or quickly (transaction cost are not exclusively)
(The brief general critique of tc theory above is that the emphasis on comparison of transaction and management costs as a paradigmatic use has led to the neglect of other determinants of economic organization, and one is the production functions/costs.)
##### the problem is that transaction costs and management costs are defined by the place where costs occur not by the function they serve. What Demsetz argue is that there could be mc in market and tc in organization, where the production costs have been neglected but existed in both cases.
 The further problem is that It is difficult to provide a clear distinction among transaction, management, and production costs, and then discuss the relevance:
a) a tax on transactions → certainly transaction costs in market
b) a person phones another and directs him to purchase specific assets by a certain time if less than a stipulated price → might be from an owner/manager to employee in the purchasing department or from a customer/investor to brokerage house
=> sometimes hard to know whether we are dealing with a transaction or management cost until we already know whether we are discussing a firm or a market
=>> inherent difficulty is that the same organizing activities often characterize exchange and management (I have mentioned above)
 we know little about the forces that might influence the relative magnitude of these costs:
Does an increase in the size of the market decrease transaction cost relative to management cost? Does dealing in services rather than products? Does dealing across national boundaries?
 is one such force as asset specificity, which raises the prospect for opportunism and thus presumed to raise tc (Klein, Crawford, &Alchian, Riordan&Williamson, Williamson)
<= the change in the cost of contracting when asset specificity is involved is unlikely to be very great → Asset specificity problems may be almost as easy to resolve through contract as through vertical integration
=>> it is not a predictably significant variation in transaction cost that motivates VI, but the presumption that losses are greater if an agreement fails when asset specificity is involved than not =>> as → loss attendant on failure of agreement ↑ not tc ↑
 Coase: costly transactions lead to greater reliance on longer-term contracts (employment relationship) ← avoidance of costly transacting is part of the motivation for this interest (since employees can quit at any instant, or be fired, we have a long-term arrangement only because it is in the interest of both parties to continue in association) => may ignore other important reasons for continued association that can achieve a long-term contract even if tc=0 (firm that is characterized in terms of employment contracts would be achieved through costless repeated market negotiations)
=>> tc would then determine only how the firm is achieved, not whether it exists (the behavior that characterizes the firm)
3. Moral hazard, shirking, and opportunism
diverge from tc (→”Why do firms exist?” or “Why is there vertical integration?”): problem of achieving incentive alignment (from the alleged separation between ownership and control) : moral hazard analysis, shirking, and opportunism-the problems of incentive compatibility → explain the internal organization of the firm
(a board tc is involved in these problems by presupposing a positive cost of negotiation, but role like gravity in chemical reactions)
differences in shirking opportunities/monitoring needs that result → organization of the firm:
 a presumed correlation between asset specificity and the loss to be expected from contract failure, and not on variations in transaction cost
 organizations selected and the incentive systems brought to moderate incentive incompatibilities are analyzed through variations in the nature of the monitoring problem that is faced, not through variations in the cost of transacting
=>> incentive incompatibilities offer an alternative to tc analysis in the developing theory of the firm
Shortcomings of shirking opportunism alternatives:
 Alchian&Demsetz view shirking as an activity to which firm-like organization particularly susceptible ← revenues of the firm must be shared by the various owners of inputs used by the firm without the full guidance or protection (normally offered by intervening competitive market if buy not make)
=> more productive under particular conditions if it survives in the face of the greater shirking costs it must bear → however fail to discuss the sources of this special productivity → provides no rationale for the firm’s existence
 post-contractual opportunistic behavior (Klein, etl., Williamson)
→ firm-like production, through vertical integration, reduces the severity of opportunism in the presence of asset specificity -> market contracting as bearing the special costs of opportunism but offer “high-powered” incentives not provided by the firm
<<= if market offer keener incentives, firms are subject to more shirking
([firm organization is preferred when it is superior] explain nothing)
<<<== Alchian&Demsetz: firm-like organization raises the cost of dealing with free-riding while lowering the cost of dealing with guile
(survivability of firm-like organization in the absence of asset specificity /Coase: opportunism associated with asset specificity may be easier to resolve through contract stipulation)
 asset specificity = commitments between owners and management in order to solicit many years of devoted service / human capital specificity arises from long term tenure
← not opportunism break these commitments but exigencies of changing economic conditions (they seek to keep them, both for reasons of personal honor and for reasons of continuing to solicit devoted duty from other employees) => merges or takeovers → facilitate opportunism toward those who have invested in human capital
(transaction and monitoring approaches confined too much: firms would exist in a world in which transaction and monitoring costs are zero => an alternative approach, one based on aspects of information cost)
4. Firm-like organization
The firm properly viewed is a “nexus” of contracts:
← no clear notion of firm-like contractual arrangements ← difficulty of distinguishing between coordination achieved “across markets” and “within firms”
=> 3 aspects of firm-like contractual arrangements: (substitute for self-sufficiency and spot market)
 an agreement to specialize/specialization: produce mainly for persons outside
(maintain compatibility with firm in the theory of price)
 expected length of time of association between the same input owners: firm viewed as team production exhibits significant continuing reassociation between same parties
 degree of conscious direction that is used to guide the uses to sources as input (the spirit of managed coordination)
(interest centers mainly on the cooperative efforts, but the one-person firm is not ruled out by these characteristics ← Because of conflicts arisen between the capabilities and tastes of a person today and the “same” person tomorrow, a person sometimes finds it desirable to restrict his activities by entering into binding precommitments that control his future behavior (Thaler and Shefrin) =>agency problem resides within each of us as well as in interactions between us)
### (Demsetz held such an idea quite recently: Coase (1937) defines the firm in terms of the employment relation. A one-person operation, in this definition, is not a firm … independent contractors are firms, and hence it makes little sense to speak of “firm” and “market” as alternatives / For Knight, Williamson, Hart, in contrast, the firm is defined not by the employment relationship, but by the ownership of alienable assets )
These frequently found characteristics of firm-like organization → they are productive in many circumstances
<= productivity derives in part from transaction and monitoring cost considerations, but it also depends on other conditions, particularly important the acquisition and use of knowledge
5. Knowledge and the organization of specialization
Smith: specialization is productive, gains achieved through division of labor:
 dexterity realized by each workman;  time saved by avoiding switching tasks;  easy conceive of innovating improvement in a single task
← as take place within different departments of a firm, but they could also take place across different firm (Stigler (1951) the impact of market size on vertical integration)
=>> how the activities of cooperating specialists are organized == the way in which specialization is achieved (can not left to the invisible hand of natural liberty)
Information (Stigler, 1961): connections to moral hazards and transactions
Economic organization, including the firm, must reflect the fact that knowledge is costly to produce, maintain, and use → economies to be achieved through specialization
=> firm in different industries and even firms in the same industry differ somewhat in the knowledge and equipment upon which they rely
Cooperation of knowledge:
the use of knowledge requires that a specialist somehow rely on the knowledge of other specialists => everyone had become a jack-of-all-trades ← cannot be done only by learning what others know or only by purchasing information in the form of facts
=>> difference between the economics of acquiring and using knowledge → profound implications for social organization:
 specialized knowledge → much communication must consist in the giving of directions about product use or work activity (direction substitutes for education/an important dimension of managed coordination)→ Direction may be purchased through short- or long-run commitments, depending partly on tc
 the more specialized/complicated the knowledge that is required, the greater the reliance that must be placed on the direction of some by others → the division of this direction between the direction of employees and the direction of buyers of the good is relevant to the issue of vertical integration
=> produce and sell goods that require less information to use than is required to produce them → buy is cheaper than make because the instructions needed to use them do not require in-depth knowledge about how they are produced (+ transport considerations)
=>> the vertical depth of the firm may be considered from the perspective of the need for conserving on information costs:
“products” could continue to be processed into downstream derivatives that are even easier to use = buy everything ← this process of further product refinement is halted when the next version of the product will be put to many multiple uses downstream that rely on different bodies of knowledge
=>> (others also matter) the vertical boundaries of a firm are determined by the economics of conservation of expenditures on knowledge:
A single firm require greater costs of information acquisition and maintenance when continue developing product lines = avoided cost from additional simplification of each product line for potential downstream users
→ further work on derivative products is likely to become the task of other firms == boundary degree of vertical integration
(e.g. The town baker may find it expedient to master knowledge of kitchen chemistry, recipes, and cash accounting himself, and to purchase only products from others = bring a product to the boundary / but the capacity of an individual to acquire and use knowledge is too limited to allow this boundary to be reached without requiring the services of several people each of whom is occupied in a different vertical stage of production)
Information cost works here like Economies of scale:
giving of directions to others may be subject to scale economies of a limited sort → efficient utilization of the services of a “direction giver”
how these services are secured = continuity of association:
not practical to purchase the knowledge itself → a growing reliance on additional knowledge requires securing the services of additional persons
→ through short-term transitory purchases or through long-term (tc influences but)
← productivity benefits derivable from different arrangements, particularly important when knowledge-based benefits:
 accumulating firm-specific and person-specific information (see the large literature on specificity of human capital)
 knowledge about the objectives and organization of the firm is learned “cheaply” through continuing association, and so is knowledge about the capabilities and limitations of persons within (favorable in stable, regulated environment)
 continuing association, however, implies commitment, which has the disadvantage of inflexibility (favorable in changing, deregulated environment)
=>> benefits to be derived from continuing association = the cost of inflexibility → determining the best manner to acquire the talents and services of many persons
(while long-term employment relies on the direction of employees in a changing pattern of tasks, great variability in such tasks makes any one employee less suitable than a series of employees each better suited to the immediate requirements of the job)
Production, information costs, and economic organization AA Alchian, H Demsetz – The American economic review, 1972
resources owned and allocated by organizations as firms, households, and markets
=> resource owners increase productivity through cooperative specialization → economic organizations facilitate cooperation
2 important problems:  which one is beneficial →  explain the structure of the organization
firm: power to settle issues by fiat, by authority, or by disciplinary action
= ordinary market contracting ? (employer can fire or sue, customer also):
power to manage, direct and assign workers to various tasks → the employer continually is involved in renegotiation of contracts on terms that must be acceptable to both = consumer’s power to manage and assign his grocer to various tasks of obtaining whatever the customer can induce the grocer to provide at a price acceptable to both parties
[Telling an employee to type this letter rather than to file that document is like my telling a grocer to sell me this brand of tuna rather than that brand of bread. I have no contract to continue to purchase from the grocer and neither the employer nor the employee is bound by any contractual obligations to continue their relationship]
=> Long-term contracts between employer and employee are not the essence of the organization we call a firm.
##### this is certainly not true. You can only buy whatever the grocer would like to sell, while your boss can always tell you to do something you don’t like. Of course you have the choice to appeal or quit, just like you turn off to look for another grocer. But doing the former is obviously not as easily as doing the latter. The key is the bargain power raising from different transaction costs and risk taking. It takes marginally more for you to find the next job and to suffer the risk of losing income and safety than your boss to find the next workers and to suffer the lost from firing you. Another way (Knight) to see this problem is that in market, individuals with fitted interests/objectives are combined to transaction as long as the various transaction costs have been overcome, while in firm, the interests/objectives themselves of different individuals are combined into a general one. The one in the hierarchy who manage, direct and assign are the one who share the interests/objectives to others and give permission of future benefits from submission. The manager save transaction costs and get other advantages from sharing interests/objectives to the same worker comparing to find the one fitted every time he changes idea. (this explain why we can’t use a long-term contract to substitute for firm hierarchy)
=>> It is in a team use of inputs and a centralized position of some party in the contractual arrangements of all other inputs. It is the centralized contractual agent in a team productive process
not some superior authoritarian directive or disciplinary power.
=>>> exactly what is a team process + why does it induce the contractual form -the firm?
### this argument of team use/centralized arrangements of inputs are similar to residual control theory
I. The Metering Problem
input owners → [economic organization] → cooperate by better using of their comparative advantages ← incentives ← facilitates the payment of rewards in accord with productivity ← [economic organization]
Metering problems: ← sometimes resolved well through the exchange of products across competitive markets → in many situation a high correlation between rewards and productivity → meters the output directly: marginal product = reward → the success of this decentralized, market exchange in promoting productive specialization
# as I said, market works that individual with fitted interest/objective are combined to transacting. The classical analysis see this as a magic or invisible hand, which neglect the information/searching cost beneath this intended combination.
existence of an organization (market/firm) →to allocates rewards to resources in accord with their (marginal) productivity ← productivity not always automatically creates reward
specific system of rewarding → stimulates a particular productivity response:
[-] If the economic organization meters poorly → rewards and productivity only loosely correlated → productivity will be smaller
[+] if the economic organization meters well → productivity will be greater
# firm as an incentive/rewarding function
II. Team Production
when team production/cooperative productive activity, it’s difficult/impossible to directly and separably (i.e., cheaply) measure each person’s marginal productivity/contribution, when solely inseparable total output is observed ← f x1 x2 (Z) <> 0 // f(x1, x2) > f(x1) + f(x2) + c (costs of organizing and disciplining team member)
1) several types of resources are used
2) the product is not a sum of separable outputs of each cooperating resource / an additional factor: team organization problem
3) not all resources used in team production belong to one person
this costs of metering marginal products of the team’s members => types of organization, contracts, and informational and payment procedures used among owners of teamed inputs:
/ how can the members of a team be rewarded and induced to work efficiently?
(organization among different people, not of the physical goods or services, though always combined / # one-owner case can be seen as cooperation with himself)
 observing behavior of individual inputs:
[-] If detecting such behavior were costless → no incentive to shirk as can’t shirk
(# incentive to shirk may left as the benefits from free rider )
[+] But costs incurred to monitor each other → more part of a team (low elasticity) + more cost of monitor → more incentive to shirk
MR (team production) – MC (disciplining the team) > 0 => team production > a multitude of bilateral exchange of separable individual outputs
for each individual: [## MR (realized reward, t) >= MC (t) + MR (t’:leisure) – C(p=t’) ]
adjust rate of work and realized reward → MRS ( leisure, production of real output) = MRS in consumption // bring demand prices of leisure and output = their true costs
[+] with detection, policing, monitoring, measuring or metering costs → induced to take more leisure ← [the effect of relaxing on his realized/reward rate of substitution between output and leisure] < [the effect on the true rate of substitution] // realized cost of leisure << the true cost of leisure → “buys” more leisure.
[+] If detecting relaxation need costs → part of its effects will be borne by others in the team == his realized cost of relaxation less than the true total cost to the team.
→ private costs of his actions to be less than their full costs
each person responds to his private realizable rate of substitution (in production) rather than the true total (i.e., social) rate + costs for other people to detect => it will not pay (them) to force him to readjust completely by making him realize the true cost.
// efforts: MR (detection) = MC (detection) => a lower rate of productive effort and more shirking than in a costless monitoring world
=> some degree of “privileges, perquisites, or fringe benefits” is allowed → the total of the pecuniary wages is lower because of this irreducible (at acceptable costs) degree of amenity-seizing activity /// Pay is lower in pecuniary terms and higher in leisure, conveniences, and ease of work /// cost acts like a tax on work rewards
it can be improved:
more costless and effective detection → more preferred position as incentive → more effectively producing team (reward-realized rate = true production possibility real rate /// no shirking /// a higher pecuniary pay and less leisure)
[1.1] market competition, in principle, could monitor some team production
(It already organizes teams ??? )
input owners outside team members can observe output and speculate capabilities and then replace excessively/overpaid shirking members with a smaller rewards → Market competition among potential team members would determine team membership and individual rewards:
=> a decentralized organizational control to work evolve in apparent spontaneity in the market + without any central organizing agent, team leader, manager, organizer, owner, or employer.
But completely effective control cannot be expected from individualized market competition:
 new challengers for team membership must know the shirking to compare and speculate increase of net output by replacing
→ probably possible for existing fellow team members to recognize the shirking ← costly for team production
 a the presence of detection costs a new input owner who accept smaller rewards/more producing → incentive to shirk would still be at least as great as the incentives of the inputs replaced ← still bears less than the entire reduction in team output for responsible part
III. The Classical Firm
One method of reducing shirking is for someone to specialize as a monitor to check the input performance of team members.
But who will monitor the monitor? One constraint on the monitor is the aforesaid market competition offered by other monitors, but for reasons already given, that is not perfectly effective. Another constraint can be imposed on the monitor: give him title to the net earnings of the team, net of payments to other inputs. If owners of cooperating inputs agree with the monitor that he is to receive any residual product above prescribed amounts (hopefully, the marginal value products of the other inputs), the monitor will have an added incentive not to shirk as a monitor. Specialization in monitoring plus reliance on a residual claimant status will reduce shirking; but additional links are needed to forge the firm of classical eco- nomic theory. How will the residual claimant monitor the other inputs?
We use the term monitor to connote several activities in addition to its dis- ciplinary connotation. It connotes mea- suring output performance, apportioning rewards, observing the input behavior of inputs as means of detecting or estimating their marginal productivity and giving as- signments or instructions in what to do and how to do it. (It also includes, as we shall show later, authority to terminate or revise contracts.) Perhaps the contrast between a football coach and team cap- tain is helpful. The coach selects strategies and tactics and sends in instructions about what plays to utilize. The captain is essentially an observer and reporter of the performance at close hand of the mem- bers. The latter is an inspector-steward and the former a supervisor manager. For the present all these activities are in- cluded in the rubric “monitoring.” All these tasks are, in principle, negotiable across markets, but we are presuming that such market measurement of marginal productivities and job reassignments are not so cheaply performed for team pro- duction. And in particular our analysis suggests that it is not so much the costs of spontaneously negotiating contracts in the markets among groups for team pro- duction as it is the detection of the per- formance of individual members of the team that calls for the organization noted here.
The specialist who receives the residual rewards will be the monitor of the mem- bers of the team (i.e., will manage the use of cooperative inputs). The monitor earns his residual through the reduction in shirking that he brings about, not only by the prices that he agrees to pay the owners of the inputs, but also by observing and directing the actions or uses of these in- puts. Managing or examining the ways to which inputs are used in team production is a method of metering the marginal pro- ductivity of individual inputs to the team’s output.
To discipline team members and reduce shirking, the residual claimant must have power to revise the contract terms and in- centives of individual members without having to terminate or alter every other input’s contract. Hence, team members who seek to increase their productivity will assign to the monitor not only the residual claimant right but also the right to alter individual membership and per- formance on the team. Each team mem- ber, of course, can terminate his own membership (i.e., quit the team), but only the monitor may unilaterally ter- minate the membership of any of the other members without necessarily ter- minating the team itself or his association with the team; and he alone can expand or reduce membership, alter the mix of membership, or sell the right to be the residual claimant-monitor of the team. It is this entire bundle of rights: 1) to be a residual claimant; 2) to observe input behavior; 3) to be the central party com- mon to all contracts with inputs; 4) to alter the membership of the team; and 5) to sell these rights, that defines the ownership (or the employer) of the classical (capitalist, free-enterprise) firm. The coalescing of these rights has arisen, our analysis asserts, because it resolves the shirking-information problem of team production better than does the noncen- tralized contractual arrangement.
The relationship of each team member to the owner of the firm (i.e., the party common to all input contracts and the residual claimant) is simply a “quid pro quo” contract. Each makes a purchase and sale. The employee “orders” the owner of the team to pay him money in the same sense that the employer directs the team member to perform certain acts. The employee can terminate the contract as readily as can the employer, and long- term contracts, therefore, are not an es- sential attribute of the firm. Nor are “authoritarian,” “dictational,” or “fiat” attributes relevant to the conception of the firm or its efficiency
In summary, two necessary conditions exist for the emergence of the firm on the prior assumption that more than pecuniary wealth enter utility functions: 1) It is possible to increase productivity through team-oriented production, a production technique for which it is costly to directly measure the marginal outputs of the co- operating inputs. This makes it more difficult to restrict shirking through simple market exchange between cooperating in- puts. 2) It is economical to estimate mar-ginal productivity by observing or specify- ing input behavior. The simultaneous oc- currence of both these preconditions leads to the contractual organization of inputs, known as the classical capitalist firms with (a) joint input production, (b) several in- put owners, (c) one party who is common to all the contracts of the joint inputs, (d) who has rights to renegotiate any input’s contract independently of contracts with other input owners, (e) who holds the residual claim, and (f) who has the right to sell his central contractual residual status.8
Other Theories of the Firm
At this juncture, as an aside, we briefly place this theory of the firm in the contexts of those offered by Ronald Coase and Frank Knight.9 Our view of the firm is not necessarily inconsistent with Coase’s; we attempt to go further and identify refut- able implications. Coase’s penetrating in- sight is to make more of the fact that markets do not operate costlessly, and he relies on the cost of using markets to form contracts as his basic explanation for the existence of firms. We do not disagree with the proposition that, ceteris paribus, the higher is the cost of transacting across markets the greater will be the compara- tive advantage of organizing resources within the firm; it is a difficult proposition to disagree with or to refute. We could with equal ease subscribe to a theory of the firm based on the cost of managing, for surely it is true that, ceteris paribus, the lower is the cost of managing the greater will be the comparative advantage of organizing resources within the firm. To move the theory forward, it is necessary to know what is meant by a firm and to explain the circumstances under which the cost of “managing” resources is low relative to the cost of allocating resources through market transaction. The concep- tion of and rationale for the classical firm that we propose takes a step down the path pointed out by Coase toward that goal. Consideration of team production, team organization, difficulty in metering outputs, and the problem of shirking are important to our explanation but, so far as we can ascertain, not in Coase’s. Coase’s analysis insofar as it had heretofore been developed would suggest open-ended con- tracts but does not appear to imply any- thing more-neither the residual claimant status nor the distinction between em- ployee and subcontractor status (nor any of the implications indicated below). And it is not true that employees are generally employed on the basis of long-term con- tractual arrangements any more than on a series of short-term or indefinite length contracts.
The importance of our proposed addi- tional elements is revealed, for example, by the explanation of why the person to whom the control monitor is responsible receives the residual, and also by our later discussion of the implications about the corporation, partnerships, and profit sharing. These alternative forms for or- ganization of the firm are difficult to re- solve on the basis of market transaction costs only. Our exposition also suggests a definition of the classical firm-something crucial that was heretofore absent.
In addition, sometimes a technological development will lower the cost of market transactions while, at the same time, it expands the role of the firm. When the “putting out” system was used for weav- ing, inputs were organized largely through market negotiations. With the develop- ment of efficient central sources of power, it became economical to perform weaving in proximity to the power source and to engage in team production. The bringing in of weavers surely must have resulted in a reduction in the cost of negotiating (forming) contracts. Yet, what we ob- serve is the beginning of the factory sys- tem in which inputs are organized within a firm. Why? The weavers did not simply move to a common source of power that they could tap like an electric line, pur- chasing power while they used their own equipment. Now team production in the joint use of equipment became more im- portant. The measurement of marginal productivity, which now involved interac- tions between workers, especially through their joint use of machines, became more difficult though contract negotiating cost was reduced, while managing the behavior of inputs became easier because of the in- creased centralization of activity. The firm as an organization expanded even though the cost of transactions was re- duced by the advent of centralized power. The same could be said for modern as- sembly lines. Hence the emergence of central power sources expanded the scope of productive activity in which the firm enjoyed a comparative advantage as an organizational form
Some economists, following Knight, have identified the bearing of risks of wealth changes with the director or central employer without explaining why that is a viable arrangement. Presumably, the more risk-averse inputs become employees rather than owners of the classical firm. Risk averseness and uncertainty with re- gard to the firm’s fortunes have little, if anything, to do with our explanation al- though it helps to explain why all re- sources in a team are not owned by one person. That is, the role of risk taken in the sense of absorbing the windfalls that buffet the firm because of unforeseen com- petition, technological change, or fluc- tuations in demand are not central to our theory, although it is true that imperfect knowledge and, therefore, risk, in this sense of risk, underlie the problem of monitoring team behavior. We deduce the system of paying the manager with a residual claim (the equity) from the desire to have efficient means to reduce shirking so as to make team production economical and not from the smaller aversion to the risks of enterprise in a dynamic economy. We conjecture that “distribution-of-risk” is not a valid rationale for the existence and organization of the classical firm.
and organization of the classical firm. Although we have emphasized team production as creating a costly metering task and have treated team production as an essential (necessary?) condition for the firm, would not other obstacles to cheap metering also call forth the same kind of contractual arrangement here denoted as a firm? For example, suppose a farmer produces wheat in an easily ascertained quantity but with subtle and difficult to detect quality variations determined by how the farmer grew the wheat. A vertical integration could allow a purchaser to control the farmer’s behavior in order to more economically estimate productivity. But this is not a case of joint or team production, unless “information” can be considered part of the product. (While a good case could be made for that broader conception of production, we shall ignore it here.) Instead of forming a firm, a buyer can contract to have his inspector on the site of production, just as home builders contract with architects to supervise build- ing contracts; that arrangement is not a firm. Still, a firm might be organized in the production of many products wherein no team production or jointness of use of separately owned resources is involved.
This possibility rather clearly indicates a broader, or complementary, approach to that which we have chosen. 1) As we do in this paper, it can be argued that the firm is the particular policing device utilized when joint team production is present. If other sources of high policing costs arise, as in the wheat case just in- dicated, some other form of contractual arrangement will be used. Thus to each source of informational cost there may be a different type of policing and contractual arrangement. 2) On the other hand, one can say that where policing is difficult across markets, various forms of contrac- tual arrangements are devised, but there is no reason for that known as the firm to be uniquely related or even highly correlated with team production, as defined here. It might be used equally probably and viably for other sources of high policing cost. We have not intensively analyzed other sources, and we can only note that our current and readily revisable conjecture is that 1) is valid, and has motivated us in our current endeavor. In any event, the test of the theory advanced here is to see whether the conditions we have identified are necessary for firms to have long-run viability rather than merely births with high infant mortality. Conglomerate firms or collections of separate production agen- cies into one owning organization can be in- terpreted as an investment trust or in- vestment diversification device-prob- ably along the lines that motivated Knight’s interpretation. A holding com- pany can be called a firm, because of the common association of the word firm with any ownership unit that owns income sources. The term firm as commonly used is so turgid of meaning that we can not hope to explain every entity to which the name is attached in common or even tech- nical literature. Instead, we seek to iden- tify and explain a particular contractual arrangement induced by the cost of in- formation factors analyzed in this paper.
IV. Types of Firms
[A]. Profit-Sharing Firms
[B]. Socialist Firms
[C]. The Corporation
[D]. Mutual and Nonprofit Firms
[F]. Employee Unions
V. Team Spirit and Loyalty
VI. Kinds of Inputs Owned by the Firm
VII. Firms as a Specialized Market Institution for Collecting, Collating, and Selling Input Information
The economics of information GJ Stigler – Journal of political economy, 1961
information is a valuable resource:
Mostly it is ignored by economists:
the best technology is assumed to be known;
the relationship of commodities to consumer preferences is a datum
information-producing industries, like advertising, is treated with a hostility normally for tariffs or monopolists
some important aspects of economic organization take on a new meaning ← from the viewpoint of search for information:
one important problem is information – the ascertainment of market price
I. The Nature of Search
Prices change with varying frequency + no one will know all the prices which various sellers (or buyers) quote at any given time
→ a buyer/seller who wishes to ascertain the most favorable price must search
→ sellers’ price dispersion is ubiquitous even for homogeneous goods
→ manifestation of ignorance in the market // but a biased measure because there is never absolute homogeneity in the commodity/service = observed dispersion is presumably attributable to heterogeneity (sellers perform more service, or carry a larger range of varieties in stock)
a frequency distribution of the prices quoted by sellers:
← any buyer seeking the commodity would pay whatever price is asked by the seller whom he happened to canvass, if he were content to buy from the first seller ??
← But, if the dispersion of price quotations of sellers is at all large (v.s. cost of search), it will pay, on average, to canvass several sellers (search more → higher possibility of paying the lower)
### the pricing by sellers can also be a function of [buyers’ information and search cost] while the cost matters very litter in such market transactions. The problem is that cost of search is very subjective to every buyer, as it’s a unknown unknown. + One situation might be neglected is that sometimes price can work as a signal of quality
→ distributions of asking prices are probably skewed to the right ← seller will have some minimum but no maximum limit
→ if normal → more canvass more left-skewed
→ if rectangular
In fact, if sellers’ asking prices (p) arc uniformly distributed between zero and one, it can be shown that: (1) The distribution of minimum prices with n searches is
On the impossibility of informationally efficient markets SJ Grossman, JE Stiglitz – The American economic review, 1980
If competitive equilibrium is defined as a situation in which prices are such that all arbitrage profits are eliminated, is it possible that a competitive economy always be in equilibrium? Clearly not, for then those who arbitrage make no (private) return from their (privately) costly activity. Hence the assumptions that all markets, including that for information, are always in equilibrium and always perfectly arbitraged are incon- sistent when arbitrage is costly.
We propose here a model in which there is an equilibrium degree of disequilibrium: prices reflect the information of informed individuals (arbitrageurs) but only partially, so that those who expend resources to ob- tain information do receive compensation. How informative the price system is de- pends on the number of individuals who are informed; but the number of individuals who are informed is itself an endogenous variable in the model.
The model is the simplest one in which prices perform a well-articulated role in con- veying information from the informed to the uninformed. When informed individuals ob- serve information that the return to a secur- ity is going to be high, they bid its price up, and conversely when they observe informa- tion that the return is going to be low. Thus the price system makes publicly available the information obtained by informed indi- viduals to the uniformed. In general, how- ever, it does this imperfectly; this is perhaps lucky, for were it to do it perfectly, an equilibrium would not exist.
In the introduction, we shall discuss the general methodology and present some conjectures concerning certain properties of the equilibrium. The remaining analytic sections of the paper are devoted to analyzing in detail an important example of our general model, in which our conjectures concerning the nature of the equilibrium can be shown to be correct. We conclude with a discussion of the implications of our approach and results, with particular emphasis on the rela- tionship of our results to the literature on “efficient capital markets.”
I. The Model
II. Constant Absolute Risk-Aversion Model
A. The Securities
B. Individual’s Utility Maximization
C. Equilibrium Price Distribution
D. Existence of Equilibrium and a Characterization Theorem
E. Equilibrium in the Information Market
F. Existence of Overall Equilibrium
H. Comparative Statics
I. Price Cannot Fully Reflect Costly Information
III. On the Thinness of Speculative Markets
IV. On the Possibility of Perfect Markets
The impact of information technology on the organization of economic activity: The “move to the middle” hypothesis EK Clemons, SP Reddi, MC Row – … of management information …, 1993
investment → increase explicit coordination (co-located facilities/specialized human resource) with outside agents → increased risk → vertical integration/underinvesting in coordination
investment in IT:
→ without increasing transaction risk ← lower relationship-specificity + a better monitoring capability
→ lower coordination cost → more outsourcing/inter-firm coordination + less vertical integration → benefits from production economies of large specialized suppliers → transaction economics of scale + learning curve effects + … → a move toward long-term relationship with a small set of suppliers /// “move to the middle”
Technology, Information, and the Decentralization of the Firm D Acemoglu, P Aghion, C Lelarge… – … Quarterly Journal of …, 2007
This paper develops a framework to analyze the relationship between the diffusion of new technologies and the decentralization decisions of firms. Centralized control relies on the information of the principal, which we equate with publicly available information. Decentralized control, on the other hand, delegates authority to a manager with superior information. However, the manager can use her informational advantage to make choices that are not in the best interest of the principal. As the available public information about the specific technology increases, the trade-off shifts in favour of centralization. We show that firms closer to the technological frontier, firms in more heterogeneous environments and younger firms are more likely to choose decentralization. Using three datasets of French and British firms in the 1990s, we report robust correlations consistent with these predictions.
The use of knowledge in society FA Hayek – The American economic review, 1945
to construct a rational economic order:
familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions. The conditions which the solution of this optimum problem must satisfy have been fully worked out and can be stated best in mathematical form: put at their briefest, they are that the marginal rates of substitution between any two commodities or factors must be the same in all their different uses.
This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solu- tion of the economic problem of society, does not yet provide an answer to it. The reason for this is that the “data” from which the economic calculus starts are never for the whole society “given” to a single mind which could work out the implications, and can never be so given
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circum- stances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources-if ”given’ is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.
This character of the fundamental problem has, I am afraid, been rather obscured than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathe- matics. Though the problem with which I want primarily to deal in this paper is the problem of a rational economic organization, I shall in its course be led again and again to point to its close connections with certain methodological questions. Many of the points I wish to make are indeed conclusions toward which diverse paths of reasoning have unexpectedly converged. But as I now see these problems, this is no accident. It seems to me that many of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.
Organizations and markets HA Simon – The Journal of Economic Perspectives, 1991
in classical and neoclassical economic theory, markets are at the center of the stage. The actors in these markets are workers and consumers (sometimes combined into households), firms, owners of resources, governments, and perhaps others. The economic world of the neoclassical textbooks is a world of transactions, and these transactions typically involve an exchange of goods, services, and/or money that both parties to the transaction find advantageous to achieve these goals. Along with consumption, work and leisure are important components of the utility functions of households. Often, profit is assumed to be the sole objective of firms and their owners.
The description of the parties who participate in these transactions is minimal. However, as soon as firms are elaborated to become more than simple nodes in a network of transactions, to be producers transformers of “factors” into products difficult and important questions arise for the theory. A large part of the behavior of the system now takes place inside the skins of firms, and does not consist just of market exchanges. Counted by the head, most of the actors in a modern economy are employees, who either do not spend their days in trading, or if they do (for example, if they are salesmen or purchasing agents) are assumed to trade as agents of the firm rather than in their own interest, which might be quite different.
This raises the question of why there are firms at all. Why are not all the actors independent contractors? Why do most of them enter into employment contracts, selling their labor for a wage? What determines the make-or-buy decisions of firms, hence the boundaries between them and markets? When will two domains of activity lie within a single firmi, and when will they be handled by separate contractinig firms?
A second set of (juestion-s asks how the enmployees of firms are motivated to wor-k for the maximizationi of the firm’s profit. What’s in it for them? How are their utility functionis reconciled with those of the firm? In the employee’s utility fuLnction, work is usually assum-ed to have negative utility and leisure (includinig loaflng anid wor-king lackadaisically) to have positive utility. Why do e-mployees often work hard?
TI’he simiple (neoclassical) answer to the motivational question derives from the enmploymlent contr-act, unde-r which workers maximize their utility by accepting the author-ity of the firm; that is, by agreeing to accept orders from the profit maximizers in charge. But this answer leads to the new question of how the emlploynment contract is enforced by the employer. In particular, how ar-e employees induced to work more than minimally, and perhaps even with initiative and enthusiasm? Why should employees attempt to maximize the profits of their firnms when nmaking the decisions that are delegated to them?
These questions about the scope of activity and operation of firms have spawned a vigorous cottage industry, a branch of which is sometimes called “the new institutional economics,” which tries to explain when activities will be carried out through the market and when they will be carried out within the skins of firms, and tries to explain also how it is possible for firms to operate efficien-tly. In the literature of the new institutional economics, two ideas that play a major role in the explanations are “transaction costs” and “opportunism” (for example, Williamson 1975, 1985). Sometimes the explanations are couched in terms of “information asymmetry” or “incomplete information” (Ross, 1973; Stiglitz, 1974). In other writings these topics are subsumed under agency theory, which treats the employment contract as an optimal contract between principal and agents, and studies how contractual arrangements can deal with shirking and other motivational problems.
The idea behind these ideas is that a proper explanation of an econonmic phenomiienion- will reduce it to maximizing behavior of parties who are engaged in contr-acting, given the circumstances that surround the transaction. The terms of the contr-act will be influenced by the access of the parties to information, by the costs of negotiating, and by the opportunities for cheating. Access to information, negotiation costs, and opportunities for cheating are most often treated as exogen-ous variables that do not themselves need to be explained. It has been observed that they even introduce a sort of bounded rationality into the behavior, with the exogeneity of the limits of riationality allowing the theory to remiiain within the nmagical domains of utility and profit maximization.
A fundamiienital feature of the new institutional economics is that it retains the centrality of markets and exchanges. All phenomena are to be explained by tranislating themii into (or deriving them from) market transactions based upon negotiated contr-acts, for exanmple, in which enmployers become “principals” and employees become “agents.” Although the new institutional economics is wholly compatible with and conservative of neoclassical theory, it does greatly multiply the number of auxiliary exogenous assumptions that are needed for the theory to work. For example, to explain the presence or absence of certain kinds of insurance contracts, moral risk is invoked; the incompleteness of contracts is assumed to derive from the fact that information is incomplete or distributed asymmetrically between the parties to the contract. Since such constructs are typically introduced into the analysis in a casual way, with no empirical support except an appeal to introspection and common sense, mechanisms of these sorts have proliferated in the literature, giving it a very ad hoc flavor.
In general, the new institutional economics has not drawn heavily from the empirical work in organizations and decision-making for its auxiliary assumptions. (For introductions to that literature, see March and Simon, 1958; Cyert and March, 1963: Kornai, 1971; Simon, 1979). Nevertheless, it is appropriately subversive of neoclassical theory in that it suggests a whole agenda of microeconomic empirical work that must be performed to estimate the exogenous parameters and to test the theory empirically. Until that research has been carried out (and the existing literature on organizations and decision making taken into account), the new institutional economics and related approaches are acts of faith, or perhaps of piety.