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The "Fundamental Transformation" in Macroeconomics

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The TRANSACTIONALMICROSTRUCTURE AND MACROECONOMIC PERFORMANCEt The "Fundamental Transformation" in Macroeconomics By RICARDO J. CABALLERO AND MOHAMAD L. HAMMOUR* When factors enter into joint production, pensate the appropriatedfactors, providing a they often develop a degree of "specificity" highly inefficient macroeconomic "solution" with respect to each other. Their value in the to the unresolved microeconomic contracting context where they have come to produce ex- problem. Appropriabilityaffects major aspects ceeds their outside value. Committing a pro- of the macroeconomy. It results in misalloca- duction factor in such a relationship is a form tion, underutilization, and unemployment of of specific investment, whose sunk component the economy's productive factors; it hampers may have technological as well as institutional growth by depressing the incentives to replace origins. what is outdated and to utilize fully the econ- By itself, this "irreversibility" has impor- omy's resources; it disrupts macroeconomic tant and extensively studied implications for adjustment, by inducing a wedge between investment decisions. But, when combined timid creation and excessive destruction of the with contracting problems, it acquires an en- old system; and it exacerbates downturns by tirely new dimension. When two factors enter "elastifying" the cyclical response of inelastic into a joint-productionrelationship, specificity factors. creates ex post quasi-rents that need to be pro- tected through ex ante contracting. Unless L Microeconomics complete and enforceable contracts are avail- able, those quasi-rents may be appropriated The prototypical macroeconomic example by the other factor. This transformationfrom of specificity we choose to focus on is that of an ex ante competitive setting to an ex post the relationship between capital and labor. bilateral monopoly-what Oliver Williamson Other examples are also important and affect terms the "fundamental transformation"-is such diverse relations as that between an a central building block in the modem eco- entrepreneur and his external sources of nomic theory of institutions (e.g., Benjamin finance (e.g., Oliver Hart and John Moore, Klein et al., 1978; Williamson, 1979). 1994) or that between an upstream firm and The problem of appropriabilityspreads un- its downstream customers (as discussed ex- protected quasi-rents throughout the economy tensively in the microeconomic literature on and, in a partial-equilibrium setting, leads to vertical integration). underinvestment. In general equilibrium, the In the presence of specificity, the centralunit market system will adjust to help partly com- of analysis is the joint-productionrelation be- tween the factors. We embody this relation in the concept of a "productionunit" which, we assume, combines in fixed proportionsone unit of capital and one unit of labor. Because of t Discussants: Steven J. Davis, University of Chicago; specificity, productionunits cannotbe costlessly Mark Gertler, New York University; Abhijit Banerjee, reshuffled.It is thereforemeaningful to analyze Massachusetts Institute of Technology. * both the creation decision, by which factors Caballero: Departmentof Economics, Massachusetts choose to enter into a productionrelation, and Institute of Technology, 50 Memorial Drive, Cambridge, MA 02139, and NBER; Hammour: Capital Guidance, 32 the destructiondecision, by which factorswithin Avenue Hoche, 75008 Paris, France. We thank Olivier an existing productionunit choose whether to Blanchard and Steven Davis for helpful comments. continue producingjointly or not. 181 182 AEA PAPERS AND PROCEEDINGS MAY 1996 We outline a minimalist model to help struc- with respect to the relationship, so we repre- ture our discussion. For a more complete treat- sents both its ex ante and its ex post opportu- ment, we refer the reader to Caballero and nity cost. Hammour (1996a, b, c). The units of analysis that arise from the notion of specificity provide The Fundamental Transformation.-If cap- the natural setting for a Schumpeterian view ital and labor were able to precommit to their of a macroeconomy with ongoing creation and ex post terms of trade, they would follow the destruction (see e.g., Caballero and Hammour, efficient entry rule. But when complete con- 1994). In this short paper, however, we reduce tracts are costly to write and enforce, agents' our treatmentof dynamics to a minimum. We ability to precommit is limited, and a William- model destruction and creation decisions dur- sonian "fundamental transformation" arises: ing a single period. We assume that factors can the ex ante competitive relationship between either be part of a production unit in the capital and labor turns into an ex post bilateral "joint-production" sector, or remain in their monopoly. Assuming that no precommitment "autarky" sectors. The period starts with pre- is possible, the specific quasi-rents from a pro- existing production units as well as a supply duction unit is the difference between the of uncommitted units of capital and labor. unit's revenue and its factors' ex post oppor- First, the factors in all preexiting units decide tunity costs: whether to produce jointly in the coming pe- riod or to separate and join the uncommitted (2) sY -We. factors; second, all uncommitted factors either form new production units or remain in au- Following the Nash bargaining solution for tarky; finally, production of the economy's sharing the unit's revenue, we assume that unique consumption good takes place in the each factor gets its ex post opportunity cost joint-production and autarky sectors. plus half of the unit's bargaining-surplus s. Using the superscript j to denote payments Creation. -We denote by y the production to factors in new joint-production units, we revenue of a newly created production unit, have and by wk and we the reward of capital and labor in autarky (all in terms of the consump- - tion good). In partial equilibrium, the efficient (3) Wk 2 decision is to create a production unit as long as (4) = We + W5 2 (1) Y?Wk + We. This rule would, in fact, be followed as long Underinvestment.-It is clear from equa- as factors of production can freely and cost- tions (3) and (4) that labor will willingly par- lessly move in and out of production units. ticipate in production as long as the surplus from joint production is nonnegative. Capital, Specificity.-Such freedom of movement the factor that is vulnerable to appropriation, rarely holds in reality. Let us take the extreme requires more. Its share of the ex post surplus irreversible-investmentview, where once cap- must be enough to justify forfeiting its ex ante ital is locked into a specific relationship, it is opportunity cost: lost if the relationship breaks up. Although it can also be due to such institutional factors as s - organized labor or legislated firing costs, we 2 Wk. view specificity here as a purely technological phenomenon. As a result, while the ex ante Replacing (2) into this expression yields the opportunity cost of capital is Wk,its ex post entry rule more explicitly: opportunitycost is zero. On the other extreme, we assume that labor develops no specificity (5) y 2 2Wk+ We VOL. 86 NO. 2 TRANSACTIONALMICROSTRUCTURE AND MACROECONOMICS 183 which states that a unit's revenue must not assume that preexisting production units are only cover its factors' opportunity costs, as in of infinitesimal mass. We assume that, in its the efficient condition (1), but must also gen- autarky sector, capital can be turned one-to- erate enough rents for capital to recover its ex one into the consumption good, so Wk = 1. ante opportunitycost after being appropriated. On the other hand, labor experiences decreas- This increased-revenue requirement generally ing returns in its autarky sector, resulting in gives rise to an underinvestment problem, a joint-production labor supply function: a result most clearly stated by Paul Grout (1984) in this context. (7) We = 2L"/77 r1> O Destruction. -The other decision of inter- where L measures joint-production employ- est to us is that of a preexisting productionunit ment. The supply of capital into joint produc- with production revenue x that must decide tion is therefore perfectly elastic, while the whether to remain in operation or shut down supply of labor is partly inelastic. Finally, we and free its nonspecific resources. The pri- restrict our analysis to values of y E (2, 3), vately efficient rule is to exit if the opportunity where both the efficient and inefficient econ- cost of the two factors of production cannot be omies exhibit positive but not full employment covered. Since capital is fully specific, its op- in joint production. portunity cost is zero. On the other hand, the opportunity cost of labor in a preexisting unit A. The Efficient Economy is pwle + (1 - p)we, where p is the proba- bility of finding employment in joint produc- If precommitment with complete and en- tion (see below). The exit rule is therefore forceable contracts is available, equilibrium will be efficient. Capital and labor will receive (6) x <pwJe +(1-p)We . their ex ante equilibrium opportunity cost in joint production. An interior solution in this In the context of bilateral bargaining, the case requires that entry condition ( 1) holds question of the private efficiency of separa- with equality. Denoting efficient levels by as- tions arises. When there is a "nontransferabil- terisks, and recalling that W* = 1, the oppor- ity" problem, due, for example, to asymmetnc tunity cost of labor is information (as in Robert Hall and Edward Lazear [1984], for example) or to a minimum- W*= y -1. wage constraint, the exit decision may be pri- vately inefficient (see e.g., Roger Myerson and Taking labor supply (7) into account, the ef- Mark Satterthwaite, 1983). We abstract away ficient joint-productionlevel of employment is from this possibility and assume for simplicity that exit decisions are privately efficient. As we will show, this is in sharp contrast with (8) L*= (Y2 1) their social inefficiency at the macroeconomic level.
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