The division of labor by itself doesn’t say anything about the boundaries of the firm. The division of labor by itself doesn’t say anything about the boundaries of the firm



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The division of labor by itself doesn’t say anything about the boundaries of the firm.

  • The division of labor by itself doesn’t say anything about the boundaries of the firm.

  • Are the stages of production each a separate firm, or are some stages within a single firm?

  • Vertical integration.



The neoclassical theory of the firm doesn’t help much.

  • The neoclassical theory of the firm doesn’t help much.

  • The firm as a black box.

  • Boundaries of the firm assumed.



The Market.

  • The Market.

    • The exchange of products or outputs.
    • Exchange is coordinated spontaneously, in the sense that relative prices rather than fiat direct resources.
  • The firm.

    • Replaces contracts for products with employment contracts, effectively substituting a factor market for a product market (Cheung 1983).
    • Replaces spontaneous coordination with some kind of central design or direction.


“The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.”

  • “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.”



The size of the firm not its output (Q) but the number of transactions or activities within its boundaries.

  • The size of the firm not its output (Q) but the number of transactions or activities within its boundaries.



Why doesn’t the firm expand forever?

  • Why doesn’t the firm expand forever?

  • V. I. Lenin: “The whole of society will have become one office and one factory.”

  • But: diminishing returns to internal coordination.

    • Management as a fixed factor.








The “costs of using the price system” came to be called transaction costs.

  • The “costs of using the price system” came to be called transaction costs.





Neoclassical tradition.

  • Neoclassical tradition.

    • The costs resulting from the transfer of property rights. (Allen 2000, p. 901.)
    • Dahlman: identical to transportation costs.
    • The iceberg model.


Property rights tradition.

  • Property rights tradition.

    • The costs of establishing and maintaining property rights. (Allen 2000, p. 898.)
    • Direct costs as well as indirect costs of misallocation from rent-seeking activity.
    • The “Coase theorem.”




Coase seems more interested in costs of exchange.

  • Coase seems more interested in costs of exchange.

    • Cost of discovering the relevant prices.
      • Not completely eliminated by intermediaries.
    • Costs of negotiating and concluding a separate contract for each exchange.
      • Employment contract vs. spot contract.
    • Costs of coordinating when tasks are uncertain.


Why not pay for office services by the piece?

  • Why not pay for office services by the piece?

  • Manager unlikely to know in advance which services needed.

  • Manager pays for the secretary’s time, and decides tasks later.

    • Contract for “job description.”
    • Manager chooses x  .


But is a firm something different from a market?

  • But is a firm something different from a market?

  • “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.” (Alchian and Demsetz 1972, p. 777.)

  • The firm as a nexus of contracts.



Williamson is more interested in contract than exchange.

  • Williamson is more interested in contract than exchange.

  • Three “critical dimensions” of transactions:

    • Uncertainty;
    • Frequency;
    • Asset specificity.
  • “The most critical dimension for describing transactions is asset specificity.”

  • Agency, monitoring, incentive alignment.



Alchian and Woodward: two sources of “opportunism.”

  • Alchian and Woodward: two sources of “opportunism.”

    • Moral hazard and plasticity.
      • Measurement and monitoring costs.
    • Asset specificity and holdup.
      • Governance costs.


Cheung: the emergence of the firm involves “the replacement of a product market by a factor market, resulting in a saving in transaction costs.”

  • Cheung: the emergence of the firm involves “the replacement of a product market by a factor market, resulting in a saving in transaction costs.”

  • Measurement cost as another “cost of discovering prices.”





Moral hazard: the incentive to cheat in the absence of penalties for cheating.

  • Moral hazard: the incentive to cheat in the absence of penalties for cheating.

    • Origins in insurance.
  • Another kind of “plasticity” of behavior after contract is signed.

  • If monitoring is costly, agents have incentive to supply less effort than they agreed to.

  • Alchian and Demsetz: costly monitoring explains the organization of the firm.



Marginal products of team members not separately measurable.

  • Marginal products of team members not separately measurable.

    • Members paid on the basis of the whole team’s output.
  • Incentive to shirk.

    • Each member receives all the benefits of shirking (leisure) but can spread the costs of shirking to other members.
  • Inefficiency.

    • Since everyone has the same incentives, all shirk, and the team ends up in a low-output equilibrium no one wants.


Solution.

  • Solution.

    • One team member becomes the “boss” and specializes in monitoring the others.
  • But who guards the guardian?

    • “Boss” also becomes the owner — the residual claimant — and is monitored by the market.


Cheung: “My own favorite example is riverboat pulling in China before the communist regime, when a large group of workers marched along the shore towing a good-sized wooden boat. The unique interest of this example is that the collaborators actually agreed to the hiring of a monitor to whip them.”

  • Cheung: “My own favorite example is riverboat pulling in China before the communist regime, when a large group of workers marched along the shore towing a good-sized wooden boat. The unique interest of this example is that the collaborators actually agreed to the hiring of a monitor to whip them.”



Tasks have multiple dimensions.

  • Tasks have multiple dimensions.

    • Some dimensions more costly to measure than others.
  • Performance-based compensation leads agents to maximize the proxy.

    • Rewarding teachers for test scores.
  • May be better to pay fixed wages even when objective output measures available.





The “fundamental transformation.”

  • The “fundamental transformation.”

    • Incentives change once the contract is signed.
  • One party may have an incentive to “hold up” the other.

    • Transfer some of the quasirents of cooperation.


One party owns a generic asset.

  • One party owns a generic asset.

    • High value outside of the transaction (next best use).
  • The other party owns a highly specific asset.

    • Low value outside the transaction.
    • Next best use is as a boat anchor.
  • Assume also that parties cannot recontract until “next season.”



Cooperation nets $50,000.

  • Cooperation nets $50,000.

    • Agree to split 50/50.
  • Once the contract is signed, the party with the generic asset threatens to pull out of the contract.

    • Demands $49,000 of the quasirents of cooperation.
    • “Post contractual opportunism.”


Foreseeing such “contractual hazards,” parties will be reluctant to cooperate.

  • Foreseeing such “contractual hazards,” parties will be reluctant to cooperate.

    • Or will choose less specialized but therefore less efficient technology.
  • Vertical integration solves the hold-up problem.

    • The two parties jointly own both assets.
    • Incentives now properly aligned.


Choice between markets and internal organization.

  • Choice between markets and internal organization.

    • Markets promote high-powered incentives.
    • Markets can aggregate demands and realize economies of scale.
    • But internal organization can sometimes solve problems of opportunism.






























Knight: uncertainty requires use of “judgment” by entrepreneur.

  • Knight: uncertainty requires use of “judgment” by entrepreneur.

    • Judgment noncontractible.
  • Coase: uncertainty raises costs of output contracts and makes use of “authority” more economical.





Incomplete contracts.

  • Incomplete contracts.

    • Costly or impossible to specify all future contingencies in a contract.
  • When unanticipated contingencies occur, how are conflicts resolved?

  • Party with the residual rights of control has authority to decide outcome.

    • “Specific” rights can be contracted away.
    • Residual control rights non-contractible.


Possession of the residual rights of control constitutes “ownership.”

  • Possession of the residual rights of control constitutes “ownership.”

    • Even when specific rights contracted away.
  • Bright-line definition of the boundaries of the firm.

    • Firm as all owned non-human assets.
      • Machines, client lists, patents, etc.
      • Human assets can’t be “owned.”
    • Contrast with nexus-of-contracts view.


Core of the theory:

  • Core of the theory:

    • Misallocation of residual rights causes distortions.
    • Explaining the boundaries of the firm a matter of finding the efficient allocation of residual rights.


Why does misallocation cause distortions?

  • Why does misallocation cause distortions?

    • If you own assets, you have greater threat potential.
      • Contrast with asset-specificity approach: inalienable vs. alienable control rights.
    • Highly complementary assets should be owned in common.
    • Employers are “boss” because they control the physical assets workers need to be productive.


Demsetz: can residual control rights ever be rented?

  • Demsetz: can residual control rights ever be rented?

    • They can be divided (e. g., coops).
  • Foss & Foss: selective and asymmetric costs of enforcement.

    • Future contingencies costly to regulate by contract, but no “plasticity” in the present.
    • Contracts of human assets costly to enforce but not contracts over non-human assets.
  • Pagano: “holes of incomplete contracts are open in a desert of perfectly working and costless markets.”



Owners are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm’s residual earnings.

  • Owners are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm’s residual earnings.

    • Formal not de facto rights.
    • It is often efficient to assign the formal right of control to persons who are not in a position to exercise that right very effectively.
      • Because giving those rights to others would create worse incentives.
      • For example: why managers don’t have formal ownership rights.


Ownership falls to a class of patrons.

  • Ownership falls to a class of patrons.

    • Capital suppliers.
    • Customers.
    • Input suppliers.
    • Workers.
    • Government.
    • No one (but non-profits have donors).
  • All ownership structures are really coops.



Which patrons should own the firm?

  • Which patrons should own the firm?

  • Balance the costs of contracting (with non-owning patrons) and the costs of ownership (for owning patrons).



Monopoly or monopsony.

  • Monopoly or monopsony.

    • Example: bottleneck stage.
  • Contractual lock-in.

    • Relation-specific assets.
  • Asymmetric information.

    • One party has specialized knowledge that is costly to transmit to others.


Monitoring (agency) costs.

  • Monitoring (agency) costs.

    • All else equal, patrons who are least-cost monitors are most efficient owners.
  • Collective decision-making.

    • How to aggregate the interests of members of a patron class?
  • Risk bearing.

    • Which class in the best position to bear risk?


A “capitalists cooperative.”

  • A “capitalists cooperative.”

  • Because of asymmetric information, all other patrons have higher agency costs.

  • Risk diversification benefits of investor ownership.

  • Common denominator of profit reduces costs of decision-making.



Retail coops rare.

  • Retail coops rare.

    • Customers not homogeneous.
    • Campus bookstores and monopoly.
  • Most customer cooperatives are at the wholesale level.

    • Ace, True Value, IGA, Associated Press, Sunbeam Bread.
    • Monopoly supply stage.
  • Coops and franchises.

  • Financial and insurance mutuals.



Analogous to customer coops.

  • Analogous to customer coops.

  • Monopsony processing stage.

  • Common in agriculture.

    • Ocean Spray, Land o’ Lakes, Cabot, Sunkist, much of French wine.
    • The electric power grid?
  • Problems of collective decision-making and flexibility?



Proletarian coops rare.

  • Proletarian coops rare.

    • Unskilled workers easier to monitor than other patrons.
  • Most worker-owned firms in professional services.

    • Law, medicine, consulting.
    • Professionals can monitor one another more cheaply than can outsiders.
    • Little physical capital per worker.
  • Are professional firms consumer coops?

    • Independent firms sharing common assets.


Some kinds of transactions pose special agency problems.

  • Some kinds of transactions pose special agency problems.

    • Payments to third parties to provide goods and services (United Way)
    • Support of public goods (PBS).
  • Customers (donors) are the natural residual claimants.

  • But monitoring by donors costly.

  • Ownership by other patrons creates incentives to appropriate donor resources.



So managers “hold the firm in trust” for the donors.

  • So managers “hold the firm in trust” for the donors.

  • No residual claims – but that needn’t mean no profit.

    • Reliance on formal rules and bureaucracy.
      • Because market control mechanisms absent.
    • Boards of directors chosen for impartiality not expertise.
      • Important donors sit on board.
  • Are non-profits really donors coops?



The rights assignment problem:

  • The rights assignment problem:

    • determining who should exercise a decision right.
  • The control or agency problem:

    • ensuring that self-interested decision agents exercise their rights in a way that contributes to the organizational objective.


Move the knowledge to those with the decision rights.

  • Move the knowledge to those with the decision rights.

  • Move the decision rights to those with the knowledge.



“Knowledge of the particular circumstances of time and place.”

  • “Knowledge of the particular circumstances of time and place.”

    • Tacit versus explicit knowledge.
  • Cost of moving knowledge to decision-makers suggests giving rights to them.

  • Minkler: monitoring agents who know more (in a qualitative sense) than the principal.



The existence of firms implies that there are offsetting benefits of not delegating rights.

  • The existence of firms implies that there are offsetting benefits of not delegating rights.

    • Transaction costs of decentralization.
  • Minkler: as tasks become more knowledge intensive, it pays to delegate greater authority to workers.

    • But why not vertical disintegration rather than worker participation?




Professional skills complex.

  • Professional skills complex.

    • Knowledge and judgment.
  • Professions as production organizations.

  • Shared routines (including common “toolkits”) permit decentralization.



Information-sharing and reciprocity.

  • Information-sharing and reciprocity.

    • Cooperation.
    • Competition.
    • Innovation
  • Authority and autonomy.

    • As the analogue to ownership in a network organization.
  • Reputation and self-monitoring.



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