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Draft notes for Bob Wayland’s of Business

Class 1 Notes, Part 1: Economics: The Delightful Science1

Objectives: Part I of these notes sets out a framework of four economic concepts found in ’s work and introduces the class readings within that context. The readings are noted in bold face as they are introduced. There really is a story line to the course beginning with what is a firm and ending with the origins of new firms through entrepreneurialism. After the story line is set out there follows a very short history of business to convey its scale, ancient origins, and the often under-appreciated sophistication of early markets, especially in finance.

The second set of notes sets the stage for our discussion of Ronald Coase’s seminal contribution to the study of firms that describes how entrepreneurs choose to organize and conduct complex activities by combining resources from either the or through firms. I. Economics: the Delightful Science2

Adam Smith’s monumental 1776 book, The Wealth of Nations is the foundation work of modern economics. Smith changed the way people thought about markets and the creation of economic . His ideas also changed the intellectual environment within which political and economic theory and policy were debated. Smith, a Scottish professor of moral philosophy, created a coherent discipline based in part on four notions:

(a) The beneficial power of self-

1 My friend and colleague Jim Mulcahy, also a business , has served as a sounding board and contributor to these notes. He has suggested many improvements and corrected my errors. Jim is therefore responsible for all remaining errors. 2 Economics is frequently referred to as the “dismal science” a slander that would be less common if the critic realized that the term is actually a badge of honor bestowed on economics by the racist2 Economics is frequently referred to as the “dismal science” a slander that would be less common if the critic English historian realized that the term is actually a badge of honor bestowed on economics by the racist English historian Thomas Carlyle, originally in a particularly offensive 1849 article “Occasional Discourse on The Nigger Question” in Fraser’s Magazine (reprinted in Miscellaneous Essays, London, Chapman and Hall, 1888 Vol. 7, pp79-110). Carlyle’s notorious article mocked the political such as Smith, McCulloch, and particularly J.S. Mill, who argued that slavery was both immoral and in general inefficient. It prompted J.S. Mills’ famous January, 1850 rejoinder, “The Negro Question,” in Fraser’s Magazine 41, The exchange ended their already eroding friendship. Understanding the origins of the slur should encourage critics of economics to seek more savory authorities. The more frequent but erroneous citation is to Carlyle’s criticism of as “dreary, stolid and dismal” in an earlier 1839 essay, “Chartism,” also reprinted in Miscellaneous Essays. An interesting and accessible discussion of the 19th century economic debates over slavery is Peter Groenwegen, ”Thomas Carlyle, ‘The Dismal Science,’ and the Contemporary of Slavery,” History of Economics Review (Canberra, Australian National University) 34 (Summer 2001), 74—94.

Surprisingly, David Warsh, an economic journalist and author of the Knowledge and the Wealth of Nations, 2006, W.W. Norton, New York, devotes his Chapter 5, “How the Dismal Science Got Its Name, (pp. 48-60), to an exposition of Malthus’ and Ricardo’s pessimistic outlook without mentioning Carlyle, the slavery issue, or Mill’s rejoinder. , who plays a role in Warsh’s discussion of increasing returns, praised it here: http://www.nytimes.com/2006/05/07/books/review/07krugman.html?pagewanted=all&_r=3&

1 Draft notes for Bob Wayland’s Economics of Business

(b) The division of labor, or specialization, as a primary basis of a nation’s wealth3 (c) The importance of freedom to , among people, businesses, and nations (d) The market as a self-directed, autonomous system

There is far, far more to Smith’s work but these four concepts form an effective foundation and framework for an examination of the economics of business. The course is designed to explore these ideas through the work of eminent economists. The next sections introduce the ideas and the related readings.

3 We are simplifying here a bit to focus on the factors most relevant to the economics of business. Smith writing on the forces of national stated, “The annual produce of the land and labour of any nation can be increased in its value by no other means, but by increasing either the number of its productive labourers, or the productive powers of the labourers who had before been employed. The number of its productive labourers, it is evident, can never be much increased, but in consequence of an increase of capital or of funds destined for maintaining them. The productive powers of the same numbers of labourers cannot be increased but in consequence either of some addition and improvement to those machines and instruments which facilitate and abridge labour; or of a more proper division and of employment. In either case an additional capital is almost always required.” (Adam Smith, An Inquiry Into The Nature And Causes Of The Wealth of Nations, originally published in 1776. The edition quoted from here is the Modern Library Edition, 1937, 1965, page 326)

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I. A. The Beneficial Power of Self-Interest

Private enterprise is driven by private initiative and prospects for gain. Smith noted that for the most part men acted rationally and in their self-interest, famously pointing out that:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”4

Smith explains later that the aggregate effect of many people seeking to find the best use of their capital and exhorting the industries that they invest in to produce value will tend to increase the annual revenue of a society.

…As every individual, therefore, endeavors as much as he can, both to employ his capital in support of the domestic industry, and so direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it.5

The outcomes of market operations are sensitive to the initial distribution of resources and the rules of the society. However, most economists argue that people are generally best able to discern their own interest and to allow them freedom to do so, with only a few compelling restraints, is in the general interest of society. Given an initial distribution of resources or wealth voluntary free market interactions among people will produce the highest valued total output and social wealth.

Students sometimes equate the pursuit of self-interest with Gordon Gekko’s signature line in the 1987 film Wall Street, "Greed, for lack of a better word, is good." Adam Smith was a moral philosopher and certainly did not endorse unbridled avarice, the corruption of trust and relationships, or the exploitation of privileged information for self- enrichment. Self-interest is not the same as selfish. Acting selfishly (in the sense that game theorists call “defecting”) can be against one’s . Self-interest need not be a strictly monetary or self-centered objective.6 Smith and his followers knew well that people gained or satisfaction from many things.7 In fact Smith would have been a

4 Adam Smith, An Inquiry Into The Nature And Causes Of The Wealth of Nations, originally published in 1776. The edition quoted from here is the Modern Library Edition, 1937, 1965, page 14. 5 Page 264 of 570 of electronic Kindle edition 6 Selfless behavior provides satisfaction to some people but it is not evidence either of acting irrationally or against their self-interest. Apparent altruism is common among humans and some other animals such as bats. In most cases it can be explained by as a form of tit-for-tat strategy in which repayment is expected. In other cases, we simply admit that some people find utility in being noble and selfless. 7 Today there is a branch of called hedonic psychology that was founded by , (see Well-being: The Foundations of Hedonic Psychology. New York: Russell Sage Foundation. Kahneman, D., & Tversky, A. 2000) a who became interested in what made people happy based on his exposure to the economic concept of utility. Kahneman, who never took a course in economics, was awarded the 2002 Nobel Prize in Economics, largely for his work on prospect theory and his founding work, with , on

3 Draft notes for Bob Wayland’s Economics of Business notable scholar based only on his earlier work, The Theory of Moral Sentiments. But his point was that whatever those things were that provided satisfaction, a person pursued them and made decisions in light of their value to him.

Until relatively recently, the concept of self-interest employed in the theory of production was almost entirely confined to the pursuit of maximization by the entrepreneur. In contrast, self-interest in the theory of was expressed in the concept of a utility function and guided by the consumer’s desire to maximize his utility – a measure of the personal value placed on a good or . Now we realize that production decisions are not solely based on profit maximization (if such a thing were possible). Managers happen also to be people who place different values () on the various aspects of their job. These values will be represented in various degrees within decisions. For example an entrepreneur or executive may balance his pursuit of profits with a desire for social standing and choose investments accordingly. The values of the managers may not align perfectly with those of the people they work for, or who work for them, and hence we have the agency problem or the principal-agent problem and the issues of opportunism and shirking. Shirking and the difficulty of detecting it in team-based production are part of the reason for the emergence of firms, as we’ll see in Alchian and Demsetz, Production, Information Costs, and Economic Organization.

Smith’s insights into the role of self-interest also underlie the study of incentives that plays an important role in business management and other areas. If self-interest operates in aggregate to promote social interest, does it follow that all arrangements between individuals promote both parties’ interests? Unfortunately, the answer is, “not always.” Our reading of Robert Gibbon’s “Incentives in Organizations” provides an overview of the ancient art of sharing risk and aligning across principals and agents. Gibbons also addresses the problems of asymmetric information, inadvertent consequences, and moral hazard that flow from people acting rationally on their own behalf but contrary to that of their employer. Poorly designed incentive plans can even decouple entirely the parties’ interests. 8

Most people accept the general notion of designing incentives to provoke good business decisions but the suspicion lingers in the public mind that senior executives and investment bankers are over-compensated and have been allowed to let their pursuit of self-interest run riot. Many, if not most, people believe that the executives would perform about as well if the market valued their services at a significantly lower level.9 Labor unions and others track the ratio of CEO to worker pay and declare that its increase

. Some older economic works, such as Eugen Slutsky in his 1915 paper, refer to earlier psychological theories as hedonistic psychology – the pursuit of and avoidance of pain. 8 Gibbons builds off of Steven Kerr’s famous plaint, “On the Folly of Rewarding A, While Hoping for B,” which is recommended reading for perspective on the enduring nature of the problem 9 Large investment banks and institutions such as Fannie Mae and Freddie Mac enjoy a sort of franchise right to low interest capital and nearly certain protection from corporate failure that engenders a moral hazard of higher risk taking that, when successful, produces very high returns to share among the bankers. In these situations, flawed compensation plans may exacerbate the risky behavior. This is why efforts to make the firms perceive the real cost of capital and subject to failure are more likely to prevent future disasters than vigilante actions against bankers.

4 Draft notes for Bob Wayland’s Economics of Business indicates growing and invidious income inequality.10 One prominent candidate for the 2016 presidential election repeatedly claimed that average CEO pay is 300 times that of the average worker and represents a serious defect in the U.S. system.11 In many cases suspicions of particular CEO packages are well founded but it is not clear that proscriptions on the types or levels of executive compensation plans will do anything but further distort an already imperfect market.

Economists generally view executive compensation as a principal-agent problem of aligning the executive and shareholder objectives.12 Most agree that alignment is best served by including stock and stock options in the executive pay mix and that approach has been most widely adopted in the U.S. Much of the growth in CEO compensation can be ascribed to the stock and option components of compensation. This has also increased the volatility of compensation and some worry that will encourage excessive risk-averse behavior. There are also problems with filtering out general stock market effects from individual firm performance and this has led to efforts to establish relative performance measures. Most studies of the relationship between CEO compensation find a positive but imperfect connection. Executive compensation and performance measurement problems are not unique to large corporations.13

10 A thoughtful survey of the income inequality issue is N. Gregory Mankiw, 2013, “Defending the One Percent,” The Journal of Economic Perspectives, Vol. 27, No. 3 (Summer 2013), pp. 21-3 11 The Institute provides a deeper analysis of the pay gap issue at http://www.epi.org/publication/ib331-ceo-pay-top-1-percent/ 12 A good overview is John M. Abowd and David S. Kaplan, 1999, “Executive Compensation: Six Questions That Need Answering,” The Journal of Economic Perspectives, Vol. 13, No. 4 (Autumn, 1999), pp. 145-16. 13Among major U.S. sports baseball has the least constraints on player mobility and compensation and as result the highest paid players. Basketball and football have formal caps on team salaries (baseball has a weaker luxury tax system). The baseball free agent system provides for more vigorous bidding for players and leads to some enormous contracts, some of which turn out to be poor management decisions. Alex Rodriguez would certainly have continued to play baseball for less than the 10-year $252 million contract negotiated in 2000 with then- Texas Ranger owner Tom Hicks. Hicks’ belief that A-Rod would produce enough incremental revenue to offset his contract was apparently unwarranted and he traded him in 2003 to the Yankees. But New York would not assume the full contract obligation and the Rangers remained on the hook for a substantial amount. The A-Rod contract and other mistakes by Hicks contributed to the embarrassing bankruptcy of the Rangers who were acquired in 2010 by a new ownership group including Hall of Fame pitcher Nolan Ryan that will be responsible for the $24+ million the teams still owes Rodriguez as well as some other deferred compensation to other players. A-Rod’s recent (2013) problems stemming from likely use of performance enhancing drugs may offer the Yankees a chance to trim their contract obligations. He was suspended for the 2014 season after losing an appeal. He returned to baseball in 2015 and, to the disgust of many, played well through the time of this writing. Major league baseball managers, the rough equivalent of chief operating officers, are drawn from a fairly small and slowly growing pool of people who are very well compensated despite the fact that most research indicates that the manager, per se, accounts for very few wins and that differences in incremental wins across competent managers are probably tiny. The relatively recent adoption of and success of fact-based baseball analysis through sabermetrics that has contradicted much long-practiced managerial philosophy has further eroded the perceived value of the experienced traditional managers. Although baseball managers are frequently fired, members of the brotherhood have a very good chance of getting another position. It appears that the market for baseball managers is not very competitive and that those in the club are somehow sharing rents produced by some imperfection in the market for field generals. Similar circumstances may apply in parts of the CEO market. Robert Nardelli, ex-GE-Power CEO (1995-2000), ex-Home Depot CEO (2000-2007), ex-Chrysler CEO (2007- 2009), ex-Freedom Group CEO (2010-2012), is an example of an itinerant executive analogous to the well- traveled baseball manager. He looked good on a strong team, hurt a team in a league he was unsuited for, and could do nothing with a fatally wounded franchise.

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A person’s compensation reflects their value to their employer which may be higher, lower, or the same as their reservation - the level necessary to coax them into the labor market. Rational employers will seek to offer equal to the employee’s value marginal product. But, as we will see in reading Robert Gibbons, “Incentives in Organizations” this is much easier said than done.

Public enterprise is not immune to self-interest. The power of many public employee unions to extract rents from taxpayers in the form of higher-than-market wages, benefits, and pensions has attracted a great deal of attention recently. The principal-agent problem is also found in public service where many bureaucrats maximize their personal utility rather than strict compliance with legislated policy.

Smith’s two great books cover but never completely connect the human nature and analytical sides of economics. The Theory of Moral Sentiments sets out a framework of how people deal with one another both personally and commercially in terms of the contest among passions, reason, and conscience (called by Smith the impartial spectator) that defines our moral struggles and many of the choices we make.14 Some people see Moral Sentiments as a precursor to behavioral economics, the hybrid of psychology and economics that explores the implications of human psychology on economic decision- making.15 In contrast to Moral Sentiments, The Wealth of Nations hews a tighter, more rationalist course because Smith did not have the tools to integrate fully his psychological insights with his economic analysis.

A Brief History of Utility

Some find it curious and even disturbing that a fundamental concept of modern economics is utility – a subjective measure of the value people attach to quantities of or combinations of goods for a given budget or income. Ironically, economists themselves are uncomfortable with this most basic of assumptions. Economists grappled long with whether utility could be empirically measured and cardinal values attached to different levels of utility and determined finally that only relative or ordinal values of utility were necessary. The story of economist’s pursuit of a basis for individual decision- making or choice is long and tangled and, as a result, often misunderstood.

Economics has had a long and troubled relationship with psychology. A discipline grounded in free choice and consumer sovereignty needed some basis for asserting that consumer choice was a rational process that reflected and served the interests of

14 For a recent application of Smith’s philosophy and moral guidance to modern life see Russ Roberts, 2014, How Adam Smith Can Change Your Life” An Unexpected Guide to Human Nature and Happiness, Portfolio Penguin, New York 15 A short and very accessible summary of the notion that Smith was a proto-behavioral economist is at: http://hbswk.hbs.edu/item/5168.html. For more complete exposition see Nava Ashraf, Colin F. Camerer, George Loewenstein, "Adam Smith, Behavioral Economist," The Journal of Economic Perspectives, Volume 19, Number 3 (Summer, 2005). For a whole book on the subject of using behavioral economics to frame decisions see: Richard H. Thaler, Cass R Sunstein, Nudge, Improving Decisions About Health, Wealth and Happiness, Penguin Books, 2009 (paperback edition). While interesting, many of the examples seem obvious or common sense and some others seem to rest on suspiciously thin college student-based research.

6 Draft notes for Bob Wayland’s Economics of Business consumers. Choices based on the satisfaction or utility that goods provided was a natural basis for consumer theory. The early British theories of utility reflected late 18th and early 19th century philosophy especially a belief in measurable, or cardinal, utility. Jeremy Bentham, a fascinating philosopher, social reformer, jurist and legal theorist16 sought to develop a formal calculus of utility based on a scale of hedonistic pain and pleasure somewhat akin to a thermometer. and many other influential thinkers adhered to utilitarianism a doctrine that, like Epicureanism, identified good with value and believed people should act to achieve “the greatest amount of good for the greatest number.” Utilitarianism is democratic and egalitarian, regarding everyone’s happiness equally.17 Bentham was trying to develop a scientific basis for social policy and applied it much more broadly than economists do today. Much of the theory is still attractive as social philosophy but it is too damned hard to calculate and implement to be of practical value.18

In the late 19th century Francis Y. Edgeworth, a pioneering mathematical economist, influenced by a school of psychology called envisioned the creation of a hedonimeter, a device to measure a person’s level of pleasure.19 We’ll see later that progress on the concept has been made using brain scanning and MRI technology.

Other 19th century economists such as , Stanley Jevons, and, a bit later, saw the futility of explicitly measuring utility and discovered that it was unnecessary for the objective of defining demand curves and so moved toward relative, or ordinal, utility. The notion of is often attributed to Stanley Jevons who called it “final” utility but did not develop it as rigorously as did Alfred Marshall later.20

16 Apropos of nothing course-related but a favorite story among economists: Bentham asked that his stuffed body be preserved in a box at University College London and displayed on special occasions. The cabinet and body (actually a wax head mounted on his skeleton, attired in his clothing, and sitting on his favorite chair) are called the Auto-Icon and are still on display and reputedly wheeled out for the occasional vote of the board at which times Bentham is recorded “present, not voting.” 17 An accessible overview of utilitarianism is presented at http://plato.stanford.edu/entries/utilitarianism- history/. One major problem with any table or formulae for quantifying utility, satisfaction, or happiness is that people have different tastes and the last increment of happiness derived from a good consumed by a rich man might be valued less than the happiness derived from the same good by a poor person. 18 George Stigler points out that Bentham listed four characteristics of pleasure (intensity, duration, certainty and propinquity) and thirty-two circumstances to consider when comparing utilities across different people. See: George J. Stigler, “The Development of Utility Theory, I,” 1950, Journal of Political Economy, August 1950, p309 19 See the amusing and accessible article by David Colander, “Edgeworth’s Hedonimeter and the Quest to Measure Utility,” Journal of Economic Perspectives, Spring 2007, pp215-225 20 As so often happens, someone else got there first but was not immediately recognized. George Stigler has called the Prussian economist, Herman Heinrich Gossen (1810-1858) “one of the most tragic figures in the history of economics. He was a profound, original, and untrained thinker who hid his thoughts behind painfully complex arithmetical and algebraic exercises. He displayed every trait of the crank, excepting only one: history has so far believed that he was right. (See George Stigler, “The Development of Utility Theory I” Journal of Political Economy, August 1950). Gossen published a rigorous exposition of marginal utility in 1854 that was neglected in part because it was densely mathematical (Stigler cites Edgeworth’s “magnificent understatement” about Gossen’s deficiency in mathematical elegance), it was not consistent with the German historical school reigning at the time, and was in German (English translation appeared 1983). He probably didn’t help his cause by beginning an earlier book with a modest declaration that he had done for the relationships among men what

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Other economists including Carl Menger and Leon Walras advanced independently similar concepts around the same time.

Even with the less philosophically demanding notion of marginal utility, economists continued to seek a basis that did not rely on psychological concepts. In the early 20th century Eugen Slutsky, set out the foundation of modern consumer choice theory and sought to eliminate all traces of hedonistic psychology (though he didn’t quite succeed). In 1938, (1915-2009), the first American Nobel Laureate in Economics (1970), put his considerable talents to work eliminating the taint of psychology and developed revealed theory that, he believed, was strictly based on observable behaviors and was “dropping off the last vestiges of utility theory.”21 Only he wasn’t. In 1950 the Dutch-born Harvard economist Hendrik Houthakker demonstrated that Samuelson’s analysis of revealed preference was incomplete and when made whole by introducing semi-transitivity, it was equivalent to ordinal utility.22 Despite his earlier claims about removing utility theory from economics, Samuelson embraced Houthakker’s synthesis, declared victory, and moved on.23 Revealed preference has pointed to better ways to measure peoples’ subjective evaluations of choices through conjoint and choice models.

By the middle of the 20th century economists conceded that any framework for human decision making necessarily involved some assumptions about cognitive processes and sought only to employ as neutral or minimalist a model as practical.24 Only recently has economics been able to combine modern psychological or sociological insights with economic frameworks in a rigorous manner and make testable predictions. Led by the 2002 Nobel Laureate in Economics, Daniel Kahneman, and the late Amos Tversky, the behavioralists have refuted the long held belief that economics could not be an experimental discipline. Behavioral economists have found that several seemingly obvious assumptions in the standard neoclassical consumer choice theory are not necessarily valid. is similar in some respects to behavioral economics but differs in research design and testing protocols.

Edgeworth would be delighted to know that an emerging branch of economics, (descendants of the psychic physicists), employs MRIs and other brain scanning devices to measure people’s responses to choices. One neuroeconomist, Emory

Copernicus had done for the relationships of worlds in space. To his great credit Jevons acknowledged Gossen’s precedence in the second edition of his Theory of Political Economy noting, “…Gossen has completely anticipated me as regards the general principles and method of the theory of Economics. So far as I can gather, his treatment of the fundamental theory is even more general and thorough than what I was able to scheme out.” 21 See Paul A. Samuelson, “A Note on the Pure Theory of Consumer’s Behavior,” Economica, February 1938, p. 62. Reprinted in The Collected Scientific Papers of Paul A. Samuelson (Vol. 1) edited by , 1966, MIT Press, Cambridge, , p. 2. 22 H. S. Houthakker, “Revealed Preference and the Utility Function,” Economica, 1950 23 Paul A. Samuelson, “The Problem of Integrability in Utility Theory,” Economica, November 1950. Also reprinted in Collected Scientific Papers referenced above. 24 See for example D. Wade Hands, “Economics, Psychology and the History of Consumer Choice Theory,” 2009, for a slightly different interpretation of the psychological basis of choice theory. A working paper version of which is available on the web. Another discussion of the cycle is Esther-Mirjam Sent “Behavioral Economics: How Psychology Made Its (Limited) Way Back into Economics” History of Political Economy - Volume 36, No.4, Winter 2004, pp. 735-760

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University’s Gregory Berns has tried, with modest success, to predict the popularity of unreleased songs by scanning teen brains listening to demo records.25 An in-depth review of behavioral economics is beyond our scope but we will spend some time with some of the “old” school of behavioral economics, particularly Herbert Simon’s pioneering efforts to model and explore bounded rationality in “A Behavioral Model of Rational Choice.”26

In the end the concept of utility boils down to individuals being able to make decisions between alternatives based on the relative desirability of those alternatives - as they perceive them. The market, the aggregate of those individual decisions, then acts to create and convey information to consumers and producers so that, under the conditions necessary to make the problem tractable, it guides the allocations of resources to maximize the aggregate utility of all subject to their individual budget constraints.27 This is equivalent to the condition that the ratio of the marginal utility of each good to its is equal to that of every other good and equal to the marginal utility of .28

The Legend of Homo Economicus

An enduring and irritating shibboleth of critics of economics is that economists believe in and apply an absurdly hyper-rational, self-interested figure called economic man or Homo economicus. No economist we have ever read or met believes literally in Homo Economicus. Hearing this causes many economists to want to take Occam’s Razor to the speaker’s argument if not his person. What many economists do assert is that the neoclassical assumptions of perfect and rational behavior serve as an

25 Eric Felton, “Is There a Scientific Explanation for Justin Bieber?” , June 17, 2011, http://online.wsj.com/article/SB10001424052702304186404576389553396237510.html?mod=WSJ_Opinion_ MIDDLETopBucket 26 See Herbert Simon’s later “Bounded Rationality and Organizational Learning” for an early effort to connect limited cognitive capacity and expansion through learning. Also, D. Kahneman, “Maps of Bounded Rationality: Psychology for Behavioral Economics,” a modified version of his Nobel lecture, American Economic Review, Vol. 93, No. 5 (Dec., 2003), pp. 1449-1475, for an accessible discussion of the work he and Amos Tversky conducted. The title is an interesting nod to Simon and his colleague James March of the Carnegie school. The article is a fairly comprehensive introduction to and survey of behavioral economics. 27 We use the language maximization subject to the budget constraints rather than optimization in large part because there is no presumption that the income distribution and therefore budget constraint is optimal. Goods have income as well as price elasticities and preferences change with respect to income. is concerned with the income distribution that maximizes social welfare. The famous Pareto optimal condition posits that social welfare is maximized when no one can be made better off without someone else being adversely affected. Economists solved the equilibrium conditions for consumer and general welfare incrementally. Leon Walras introduced a model of simultaneous equations including linear production functions in his 1874 work Elements of Pure Economics, but it made little impact outside of the German school until Arrow and Debreau extended the concepts in the 1950s. The Russian economist Eugene E. Slutsky solved the consumer utility equilibrium conditions and proved their consistency with the behavior of consumer behavior with respect to changes in and incomes. See E.E. Slutsky, “On the Theory of the Budget of the Consumer,” Giornale degli Economisti, 1915, pp. 1-26. Reprinted with translation by Olga Ragusa in AEA Readings in Price Theory, Richard D. Irwin, Chicago, 1952, pp. 27-56. and Gerard Debreu set out a more general framework for in K. J. Arrow and G. Debreu, “Existence of An Equilibrium for a Competitive Economy,” Econometrica, 1954 Volume 22 pp265-290. Equilibrium (and there may be many) does not imply a state of perpetual rest. That would be no fun and obviate the need for economics. 28 Mathematically this is expressed as: u1/p1 = u2/p2 = … = un/pn = u where the set ui (i=1,2,…n) comprises the marginal utility of good i and u is the marginal utility of money.

9 Draft notes for Bob Wayland’s Economics of Business excellent model to explain a vast array of economic phenomena. Old H.e. is an abstraction or model that plays the role in economics that the frictionless surface plays in classical – a simplified framework within which to explain the direction and velocity of interacting forces. Many businessmen (and, alas, students) criticize economic reasoning as sterile, abstract, ivory tower thinking. Of course many economists view real businessmen as grasping Babbits who are unable to appreciate the elegance and power of their discipline.29 Both sides may have some basis for their beliefs.

29 A term connoting a bourgeois, striving, and conformist personality type based on the main character of Literature Nobel Laureate Sinclair Lewis’ 1922 novel Babbit. Babbit tries to break out of his conformist mindset and lifestyle but with damaging and pathetic consequences. Our favorite character, and one relevant to this topic, is Professor Joseph K. Pumphrey, owner of the Riteway Business College (apparently an early for-profit educational enterprise) who teaches Public Speaking, Business English, Scenario Writing, and Commercial Law. Lewis describes him as, “A bulbous man with pepper-and-salt cutaway and pipe-organ voice.” (Sinclair Lewis, Babbit, Penguin Books 1996 edition pp. 49-50).

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I. B. The Division of Labor, or Specialization, is a Primary Source of a Society’s Wealth

We tend to think of economics in terms of the price mechanism operating more-or-less automatically through , but Adam Smith began The Wealth of Nations at a much more fundamental level and provided a compelling argument for the power of the division of labor and its positive consequences for a society’s wealth and welfare. In fact, without specialization, there is very little, if any, need for markets or price discovery.30 A society of self-sufficient generalists has little need for any of the interesting elements of an economy such as markets, money, trade, commercial law, and regulation.31 Without a market to facilitate voluntary trade people acquire things by other means. Economic historian David Landes pointed out that hunter-gathers who were essentially generalists without developed property rights and institutions did not trade - they raided.32 Landes probably exaggerated, more recent research indicates significant Paleolithic trade.

Increases in a society’s wealth are due in large part to the division of labor.33 A person is compensated largely on the value of what they produce. To the extent that specialization increases their productivity and amount of value they produce, their rewards increase. Specialization, or the division of labor, is a necessary precursor to organization. The firm, a relatively late arrival, is one means of organizing specialized labor and other resources. The need for management (as we use that term today) arises in large part from the need to direct and coordinate specialized workers within the firm.

Early Western philosophers appreciated the importance of specialization among men and its role in fostering society and in fact saw society largely as a collection of occupational specialists. In The Republic (Part II) Plato,34 speaking through Socrates, notes,

30 Paleo-anthropologists use the extent of specialization or division of labor as an indicator of a group’s level of development. Interestingly, it is believed that Neanderthal’s practiced little or no division of labor, in part because they concentrated on big game hunting that required universal participation by generalist hunters. This lack of specialization may have cramped their technical development and contributed to their demise. See: Kate Wong, “Twilight of the Neandertals, (sic)” Scientific American, August 2009, p32-37. Some recent evidence found in Spain suggests that the Neanderthals were more sophisticated and complex thinkers than previously believed and made and wore jewelry likely to convey some image or rank. The findings by Joao Zilhao of the University of Bristol are published in the Proceedings of the National Academy of Sciences and summarized by NPR here: http://www.npr.org/templates/story/story.php?storyId=122466430&ft=1&f=1001&sc=YahooNews. Even more recently, evidence of mingling and interbreeding among Neanderthals and modern humans suggests that Europeans and Asians have a little Neanderthal DNA in their genome. One business model rarely supplants another instantly or without adopting some characteristics of the predecessor. 31 They may have need of government, or more specifically, an organization capable of organizing defense. 32 This is a bit of an exaggeration, some trade took place in the Paleolithic and Neolithic periods. 33 Perhaps the earliest example of technology-driven occupational specialization, cooking and the division of labor between sexes, appears to have arisen even before Homo sapiens. Cooking reduced greatly the time spent eating and freed time for hunting and other pursuits. See an accessible overview at: http://news.harvard.edu/gazette/?p=88047&utm_source=SilverpopMailing&utm_medium=email&utm_ca mpaign=08_25_11%2520(1)&utm_content= 34 Plato understood the benefits of specialization but advocated a comprehensive form of communism that included property and wives. Aristotle abhorred the notion of communal wives and thought of communism

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“Society originates, then, so far as I can see, because the individual is not self-sufficient, but has many needs which he can’t supply himself.” Then, after enumerating, the basic needs of a state, he goes on, “It will need a farmer, a builder, a weaver, and also, I think, a shoemaker and one or two others to provide for our bodily needs.” Which then brings Socrates to the matter of allocation of effort and reward, “Then should each of these men contribute the product of his labour for common use? For instance, should the farmer provide enough food for all four of them and devote enough time and labour to food production to provide for the needs of all four? Or alternatively, should he disregard the others, and devote a quarter of his time to producing a quarter of the amount of food, and the other three quarters one to building himself a house, one to making clothes, and another to making shoes? Should he, in other words, avoid the trouble of sharing with others and devote himself to providing for his own needs only?” To this question, Adeimantus replied in favor of specialization, “The first alternative is perhaps the simpler.”

Another early reference to the division of labor is found in the Roman poet Virgil’s (70BC-19BC) long poem Georgics (On Working the Earth) Book IV: “The Nature and Qualities of Bees.” Virgil introduces the topic by describing how the Cyclopes worked together to produce thunderbolts for Jupiter:

“And like the Cyclopes when they forge lightning bolts quickly, from tough ore, and some make the air come and go with ox-hide bellows, others dip hissing bronze in the water: Etna groans with the anvils set on her: and they lift their arms together with great and measured force, and turn the metal with tenacious tongs…”35

Virgil then likens the division of labor among the Cyclopes to that of his Cecropian bees and observes how their desire for honey drives their efforts. The honeybee is the official insect of British economics. Virgil’s phrase amor urget habindi roughly, love of having spurs us on, together with a depiction of one of his famous bees serves as the seal of The Royal Economic Society, founded in 1890 by, among others, Alfred Marshall.

Division of labor enables people, Cyclopes, and bees to produce far more than they could if they had to perform more and broader tasks. Adam Smith estimated something on the order of a 240 to 4800 percent increase in productivity resulting from the division of more as a high form of sharing limited largely to the upper castes or classes. See for example, http://www.economictheories.org/2008/10/aristotle-and-plato-communism.html 35 This segment of the poem is from the translation at: http://www.poetryintranslation.com/PITBR/Latin/VirgilGeorgicsIV.htm#_Toc534524378 Clearly Virgil was familiar with the division of labor in producing bronze weaponry and imputed it to the Cyclopes’ efforts on behalf of Jupiter.

12 Draft notes for Bob Wayland’s Economics of Business labor in making the humble pin. The power of specialization is set out in one of the most famous passages in The Wealth of Nations, a passage that should be read and understood by everyone interested in the foundations of economics and the role of organized activity based on division of labor:

“To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. … One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations”

Specialization requires trade so that people can exchange their specialized products for the bundle of other that they need and want. Pin makers can’t eat or wear pins so they exchange them for food and clothing, either directly through barter or by using money. So we can think of specialization as giving rise to markets to organize trade and discover prices. Once we have markets that establish prices through trade we can have (but don’t necessarily need) firms.

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I. B.1. The division of labor (specialization) is limited by the extent of the market

One of Adam Smith’s most important insights was that the division of labor is limited by the extent of the market.36 When many students first encounter this notion they find it hard to appreciate that the more extensive the opportunities for trade, the more intensive and granular will be the division of labor among people. A larger market provides more opportunities for specialization; more specialization creates more wealth and so on in a virtuous spiral. A larger market also provides more opportunities for intellectual interaction, what Matthew Ridley calls “ideas having sex” and thus more .

Trade, , and things such as improved transportation and communication networks increase the effective size of the market. We’ll see the relationship between market size and firm-level specialization in more depth when we discuss George Stigler’s article, “The Division of Labor is Limited by the Extent of the Market,” the title of which borrows from Smith’s observation. Stigler introduces a life-cycle theory of firms and explains how the extent of specialization is determined by market size. Stigler’s framework helps to explain the incidence of outsourcing and the gains from abandoning certain decreasing cost production activities to the market.

I. B. 2. Specialization gives rise to complexity which in turn calls for organization

The relationship between size or the extent of exchange and division of labor is true inside firms as well as in the market. Generalists and jacks-of-all- are more common in small firms than in larger operations staffed primarily by specialists.37 The study of organizational design and development is largely about which specialists to employ, how best to group those specialists, and how to determine and reward their contributions.

As individuals and work units become ever more specialized, the economy becomes ever more complex and organized. As specialization increases, fewer people produce final goods and services. The specialized efforts of people and firms have to be coordinated, giving rise to organization. Organization may come through markets or firms. Assembling raw materials into intermediate goods and then into final goods can be achieved either through the market or within firms with the choice depending on which route involves lower costs.

As we’ll understand better upon reading Ronald Coase’s seminal article, ”The Nature of the Firm,” the firm and its system of hierarchy is a substitute for the market and its managers must decide which activities to perform inside the firm, which to buy from the market, how to design jobs, train workers to perform them, and organize the various

36 Adam Smith, An Inquiry Into the Nature and Causes of The Wealth of Nations, (New York, Random House, Modern Library edition, 1965) Chapter III, p17 37 Of course many small firms, especially professional partnerships or LLCs, comprise primarily specialists.

14 Draft notes for Bob Wayland’s Economics of Business functions within the firm. At bottom, all of these questions are about what are the economically attainable and sustainable degrees of specialization within the firm given the condition of the market. Productivity is essentially a function of the degree of specialization and the effectiveness of the organization supporting the specialists. Just as larger markets can support greater division of labor, so larger firms can achieve greater specialization in their workforces and processes.

In “Production, Information Costs, and Economic Organization” Alchian and Demsetz offer a slightly different perspective than Coase and argue that firms emerge to facilitate cooperation among resources. In their view control and hierarchy emerge to meter and reward the jointly made contributions of the cooperating agents. Businessmen often lose sight of the fundamental purposes of firms and are vulnerable to well- intentioned but often counterproductive theories. This redounds greatly to the benefit to the popular business press and the consultants that specialize in discerning and then distributing a steady stream of organizational . Most of these innovations are not tethered to economics as evidenced by their relatively short life cycle captured by the term, “silver bullet de jour” muttered by exasperated managers and employees.38

Coase explained the economic function of firms as economizing on transactions costs. That insight is the basis of transactions cost economics, developed largely by Oliver Williamson as discussed below. As noted above Alchian and Demsetz extended the basis for organizing resources in firms. These contributions do not however address the process by which firms come to exist. This is the province of the entrepreneur. The entrepreneur is the essential agent of action and change in a market economy. His role has been acknowledged since the first comprehensive overview of economics, Essai sur la Nature du Commerce en General, published in French in 1755 century by Richard Cantillon.39

One of the most fundamental divisions of labor is that between entrepreneurs and workers. Perhaps the most comprehensive treatment of the role of the entrepreneur is ’s 1921 classic, Risk, and Profit. In this work, Knight made his famous distinction between risk and uncertainty in which risk is a measurable factor while uncertainty is immeasurable. These phenomena can also be referred to respectively as objective and subjective probabilities. Risk, being measurable, can be priced by the market and insured against. In a world of perfect certainty and measurable risk there would be no need for economic profit since everyone could simply arrange resources in the most productive manner. Profit opportunities exist only in a world of uncertainty. The entrepreneur’s role is to identify or create profit opportunities and to make judgmental decisions under uncertainty. For bearing uncertainty and making those decisions, the entrepreneur is rewarded with profit or penalized with losses. The capacity to make

38 Students in previous editions of this course examined the relationship between internal terms and external terms of trade. Given the firm’s role as a substitute mechanism to organize specialists, the question arises of what influence market prices should have, if any, on internal or transfer prices. Jack Hirshleifer’s “On the Economics of Transfer Pricing” offers a framework for incorporating market information into internal decisions depending on the shape of markets for outputs and intermediate goods. 39 Still the best overview of the origins and rediscovery of Cantillon’s work is Stanley Jevons, 1881, “Richard Cantillon and the Nationality of Political Economy, Contemporary Review, January 1881, reprinted in Jevons’ Principles of Economics, London, 1905, edited by Henry Higgs.

15 Draft notes for Bob Wayland’s Economics of Business judgmental decisions is not distributed evenly among men. Some men will eschew bearing uncertainty and exchange their labor for a certain return from entrepreneurs.40 Entrepreneurs’ constant search for profit opportunities is the dynamic mechanism of a market economy and force moving resources to their most valuable applications.

We will discuss the function of the entrepreneur in two articles, Scott Shane’s critical position, “Why Encouraging More People to Become Entrepreneurs is Bad Public Policy” and an overview of the entrepreneurial role in Israel Kirzner’s, “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.”

The topic of vertical integration (make or buy) is one of the major issues in business strategy and the shape of industries. Vertical integration makes sense only if there is some market imperfection. In a perfectly competitive world it would not pay any firm to acquire either downstream or upstream operations. Why make what you can buy more cheaply or of higher quality? John Jewkes’ 1930 article, “Factors in Industrial Integration,” uses the competitive market template to examine how imperfections might stimulate more integration of firms. Oliver Williamson, the 2009 Nobel Laureate in Economics, built on Coase’s early insights and developed economics (TCE) to develop rules for the appropriate sort of governance and contractual structures to fit different degrees of idiosyncrasy (another form of specialization). His thoughts are represented in two articles we’ll explore; “The Economics of Organization: The Transaction Cost Approach” and “Transaction-Cost Economics, The Governance of Contractual Relations.” Williamson clarified the question of where the firm’s boundaries should lie and stressed the difference between relationships within firms and between firms. R. Gibbons notes in “Make, Buy or Cooperate” that there in practice three states of cooperative relationships and that the nature of inter-firm relationships depend greatly upon which party owns the relevant productive assets.

Some people see the enormous amount of variety in the marketplace as wasteful and argue for organizing product choices into more compact and homogeneous groups. Vermont Senator Bernie Sanders, an admitted socialist and a quixotic candidate for the 2016 presidential election said, You don't necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers when children are hungry in this country.” No one doubts Senator Sander’s sincerity – only his economic . Variety in product choice actually reflects higher information content and organization than do limited or generic goods. The more precise alignment of product characteristics with customer preferences increases welfare and efficiency. One-size-fits-all is actually an efficient way to use resources. Segmentation and product differentiation are the marketing counterparts of specialization and idiosyncrasy. Our reading of Kelvin Lancaster’s work “A New Approach to Consumer Theory” will give us an appreciation of how the proportions of product attributes can be varied and combined to tailor more closely products to groups of customers or even individuals - to make the goods more idiosyncratic and specialized.

40 Frank H. Knight, 1921, Risk, Uncertainty and Profit, University of Chicago Press. There have been many subsequent editions. A very inexpensive and useful one is the 2005 Kindle edition by Cosimo, Inc.

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We’ll connect this insight to Williamson’s that the degree of segmentation and differentiation determines to a large extent the nature of customer relationships and governance structures.

I. B. 3. Some see specialization as evil

Specialization or the division of labor is a fundamental characteristic of economics with tremendous political and social implications. The modern business firm is a child of the division of labor or specialization and the selective forces of the market, social, and political systems that co-evolve over time. Specialization’s enormous economic benefits sometimes come with social and personal costs. It is fashionable in some quarters to advocate a return to less complex economies and to seek greater self-sufficiency. As Matt Ridley notes in his discussion of the fallacy of the “food miles” argument for more local produce to reduce fuel consumption, “self sufficiency is poverty.”41 The hold of ignorant and damaging unscientific beliefs about industrial food production, genetic modification and vaccination cause real harm.42 Specialization and the interdependence it entails is much more efficient and less risky than going it alone.

While appreciating the economic value of the division of labor, Frank Knight (1885- 1972), a great economist and supporter of free markets said, “Specialization itself is evil, measured by generally accepted human ideals.” The intellectually numbing routine of some hyper-specialized tasks (especially if organized around that icon of exploitative capitalism, the assembly line) is still a frequent lament.43 Knight observed that specialization: “Narrows personality, discourages well-roundedness; routine, monotonous work may ruin health and destroy spirit.” He felt also that, “Specialization of leadership means that the masses of people work under conditions which tend to suppress initiative and independence, to develop servility as well as narrowness and in general to dehumanize them.” These costs, to the extent that they are real and more noxious than the alternatives, are the result of achieving the benefits of specialization - not the form of ownership or political system. Ivan working in a state-owned Russian automobile plant was at least as numbed and tormented as John working in Detroit.

41 Matt Ridley, The Rational Optimist: How Prosperity Evolves, Harper, New York, 2010 pp. 41-42 42 Contrast Michael Pollan’s extremely popular 2006 book The Omnivore’s Dilemma: A Natural History of Four Meals with Pierre Desrochers and Hiroko Shimizu, 2012 work The Locovore’s Dilemma. 43 There have been repeated efforts to improve on the “Ford-ism” model including “Toyota-ism” or lean production, and the work-cell approach pioneered in the Swedish automobile industry. As differentiation becomes more significant, the inflexibility of the assembly line method based on “de-skilling” tasks to achieve rapid cycle time, sometimes gives way to more flexible and worker-centered processes. This is not a refutation of specialization’s power but an example of reducing the scope for specialization. Scale and specialization won out. Both major Swedish automakers were unable to survive as independent companies; Saab will likely cease to exist in 2010 and Ford has unloaded Volvo to a Chinese firm. See for example, Berggren, Christian, 1950- Alternatives to lean production: work organization in the Swedish auto industry, ILR Press, Ithaca, N.Y., c1992. A counter-argument is that many people like the freedom that not having to think about work after their shifts and prefer the higher income that specialization enables them to have so they can indulge their interests outside of work.

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The practical dimensions of division of labor can be examined in terms of Knight’s list of economic advantages that organized activity has over unorganized effort.44 Knight’s points follow closely those of Smith and are still valid today. Knight covered the good, the bad, and the ugly features of specialization. He noted first that specialization facilitated the utilization of natural aptitudes; especially those of leaders and followers and paid homage to management and executive talent: 45

“…undoubtedly the largest single source of the increased efficiency results from having work planned and directed by the exceptionally capable, while the mass of the people follow instructions.”

This is unfashionably blunt phrasing (discuss this at your next employee session) but in fact exceptionally capable people who can direct effectively others are very scarce. The importance of scarce leadership skills is reflected today in the enormous library of business literature devoted to recognizing and developing corporate leaders.46 One problem is that firms are not in business to make workers happy but are interested in employee happiness to the extent that it improves the value of the workers’ effort. Unfortunately, the business literature and much of the psychological literature treats employee happiness as being worthwhile in its own right and fails to discuss the trade offs involved. When Marissa Mayer curtailed at-home work at Yahoo! Many criticized her mean-spiritedness. We suspect she felt some workers were having too much fun relative to work and their low productivity endangered the prospects of other workers. We will discuss opportunistic behavior and its relationship to asymmetric information between the principal and the agent first in the Alchian and Demsetz article and later in the Akerlof examination of the lemon principle.

Knight stressed also the role of specialization in the development and utilization of acquired skill and acquired knowledge. Specialization, especially in highly granular tasks, makes the necessary knowledge and skill accessible to more people and, with instruction and practice, leads to highly efficient performance. We will encounter in Nelson and Winter’s overview of , “Evolutionary Theorizing in Economics” the related notions of the competence paradox and corporate routines that explain how people and firms can become exceptionally proficient at some highly complex tasks and fumble when required to exercise foresight and deal with novel situations when we discuss the evolutionary economics perspective.

A lot of people detest the assembly line mode of organizing work but as Knight noted, changing the piece of work is cheaper, within limits, than changing the activity

44 Frank H. Knight, “Social Economic Organization,” an excerpt from The Economic Organization, Harper and Row, 1951, pp3-30. Reprinted in William Breit, Harold M. Hochman, editors, Readings in , 2d edition, (Holt, Reinhart and Winston, 1975) pp3-22 45 Frank H. Knight, “Social Economic Organization,” an excerpt from The Economic Organization, Harper and Row, 1951, pp3-30. Reprinted in William Breit, Harold M. Hochman, editors, Readings in Microeconomics, 2d edition, (Holt, Reinhart and Winston, 1975) pp3-22. It is ironic that many think they can emulate a with little difficulty but recognize their inferiority relative to a Michael Jordan. 46 Smith made a provocative point that the differences among people are created in large part through the course of specialization that they pursue. Emile Durkheim made a similar point about the evolution of human capability and social structure.

18 Draft notes for Bob Wayland’s Economics of Business performed on the work. Moving a work piece from one specialist to another and eliminates their need to learn multiple tasks or to change tools.47 The previous system of piecework or putting out involved moving material greater distances and involved more expensive oversight and coordination costs. The extensive management focus on process reengineering that arose in the 1980’s was in many respects a rethinking of the various assembly lines or processes within firms to reflect new communication and information technologies.

Geographical specialization reflects locational advantages such as mineral deposits and protected harbors. As Knight observed there are “natural advantages in the case of natural resources.” Although U.S. coal deposits are widely distributed geographically, underground mine production tends to center in a smaller number of places where suitable workers and infrastructure are concentrated. More recently, market-driven clusters of specialized intellectual resources such as in Silicon Valley have emerged to support firms in related industries. Finally, in the retail industries, it was no accident that department stores tended to cluster near each other or that before the advent of auto megastores dealerships used to cluster near each other. Even here, there are cost minimizing (for the consumer) advantages to location.

Knight also called out the artificial specialization of material agents. The division of operations leads to the invention and use of specialized machinery a phenomenon that Oliver Williamson later called asset specificity and which explains much of the structure of governance and contracting within and among firms. As Knight remarked:

“… many things can be done with a hammer; only one with an automatic printing press… but that one thing is done with wonderful precision and speed.”

Finally, Knight observed the benefit of the minor technical gains that emerge from specialized workers who require fewer tools and those tools could be more finely tailored to the task. In addition, some tasks are most efficiently performed simultaneously or in parallel and that of course requires specialization.

Most economists don’t find specialization to be insufferably stultifying. Critics of specialization usually have in mind routine, repetitive, and boring tasks rather than the personal and professional focus that illuminates and furthers many disciplines. These types of jobs are declining in the U.S. and other developed countries. In advanced economies, mechanization and robotics are displacing people in many of the most dangerous and mind-numbing tasks. While industrial and agricultural labor conditions in emerging nations seem brutal and exploitative to some people, in many, if not most, cases the jobs are willingly embraced by people who find them superior to their alternative ways of making a living.

47 Many of us think of the heavy industrial assembly lines made infamous by Charlie Chaplin’s classic 1936 film Modern Times but the processing of light tangibles such as insurance claim forms or even intangibles such an electronic funds transfer are also typically organized as lines although network and parallel processing are making significant inroads.

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A narrow notion of specialization underlies much of scientific management developed by Frederick Taylor (1856-1915) in the late 19th and early 20th century. Taylor sought to optimize work processes by careful observation and analysis and to standardize routines to achieve maximum efficiency through better management practice and incentive compensations. Taylor recognized the principal-agent and asymmetric information problem and seems genuinely to have believed that labor and management could reconcile their differences if jobs and reward systems were only designed well enough. Although he was contemptuous of his subject workers, Taylor believed earnestly that his science would free workers from tyrannical management. His critics felt he was imposing another form of tyranny based on time studies. A 1913 Life magazine cartoon, showed a young couple in a workplace caught in an embrace by the “Efficiency Crank” who says, ”Young man, are you aware that you employed fifteen unnecessary motions in delivering that kiss?”48 An enhanced version of Taylorism, process reengineering, infected management practice in the 1980s and 90s and sought to extend the division of labor along the process dimension and integrate information technology with work design and measurement

The intellectually numbing routine of some hyper-specialized tasks, especially if organized around that icon of exploitative capitalism, the assembly line, is still a frequent lament.49 Not all economists find specialization to be insufferably stultifying. Critics of specialization usually have in mind routine, repetitive, and boring tasks rather than the personal and professional focus that illuminates and furthers many disciplines. Few people bemoan the specialists in law, , or science although they are just as representative of Smith’s point as is the pin-maker. In advanced economies, mechanization and robotics are displacing people in many of the most dangerous and mind-numbing tasks.

The course you are taking is produced and delivered using essentially the same division of labor as in Adam Smith’s day. The extended market size of distance learning has given rise to a few new specialists such as our videographer, but the general process would be recognizable to Smith. This old model is already under a lot of strain and it is certain that new models will emerge and with them a new set of specialists. The odd researcher- teacher combination of roles may be a leading candidate for extinction.

Smith observed that the principal-agent problem was endemic in education noting that the structure is designed for the agent (professors) rather than the putative principle (student).

48 Robert Kanigel, The One Best Way: Frederick Winslow Taylor and the Enigma of Efficiency, Penguin Books, 1997, New York, p514. 49 There have been repeated efforts to improve on the “Ford-ism” model including “Toyota-ism” or lean production, and the work-cell approach pioneered in the Swedish automobile industry. As differentiation becomes more significant, the inflexibility of the assembly line method based on “de-skilling” tasks to achieve rapid cycle time, sometimes gives way to more flexible and worker-centered processes. This is not a refutation of specialization’s power but an example of reducing the scope for specialization. Scale and specialization won out. Both major Swedish automakers were unable to survive as independent companies; Volvo is now owned by a Chinese concern and, as we write this Saab has changed hands and is currently unable to meet its obligations and faces liquidation. See for example, Berggren, Christian, 1950-Alternatives to lean production: work organization in the Swedish auto industry, ILR Press, Ithaca, N.Y., c1992.

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“The discipline of colleges and universities is in general contrived, not for the benefit of the students, but for the interest or, more properly speaking, for the ease of the masters.”50

I. C. The Importance of Freedom to Trade

At a fundamental level specialize and trade is what businesses do. Unwarranted restrictions on either process reduce the wealth that an economy can create.51 Adam Smith believed that people had an innate urge to trade.52

“The division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.”53

Smith saw that to achieve the greatest nations should allow the economic process to operate freely. This philosophy is often referred to as laissez faire and the term is frequently but inaccurately attributed to Smith who never used the words in his book nor would he likely have embraced the most literal versions of the philosophy.54

Trade is a very liberating force because it makes it easier for people to do what they do best and to acquire what they do not themselves make from people who are better able to

50 Smith, Wealth of Nations, Kindle free edition, p 451 of 570. 51 Of course restrictions on criminal activities and on some kinds of negative may increase overall wealth. 52 Smith’s ideas have staying power. Since we wrote the first edition of these notes, I have seen Matt Ridley use the quote below as the frontispiece to his recent book, The Rational Optimist: How Prosperity Evolves, Harper Collins, 2010. Ridley sees trade and specialization as prompting the emergence of a collective brain when, as he puts it delicately, “ideas have sex” giving rise to more ideas, more discovery, more technology, more specialization, more trade, and greater prosperity. Ridley, trained as a biologist, acknowledges his debt to Smith, to other economists, and to many evolutionary biologists. I would have liked him to acknowledge Emile Durkheim but his work is already intellectually expansive and he is practicing his thesis by establishing an ongoing and evolving website to invite others contribute to and to nurture his ideas. Reading him and his friend Richard Dawkins makes one consider seriously Alfred Marshall’s hypothesis that economics is a branch of biology. 53 Adam Smith, The Wealth of Nations, (original 1776, fifth edition 1789). Modern Library edition edited by Edwin Cannan, 1937, p13 54 A Google Books word search by the author was undertaken because I dimly recalled someone making this point but could not remember whom. In any event it did not originate with me. The phrase seems to have originated or at least surfaced, naturally enough for a French phrase meaning “let it be,” in an article by the mid- 18th century French Trade Minister and free trade advocate, René de Voyer, Marquis d'Argenson. It is not clear how many, if any, subsequent French trade ministers ever gave it a moment’s thought. James Mill, father of John Stuart, is credited with its popularization in English economic discourse.

21 Draft notes for Bob Wayland’s Economics of Business produce those goods making everyone better off. 55 Trade expands the size of the market and encourages greater division of labor or specialization, thus increasing economic productivity. The increased competition among suppliers prompted by trade leads to better goods and services and lower prices. No one is perfect: Smith’s most egregious lapse was supporting usury laws that capped allowable interest rates.56 In Smith’s time the notion of free trade conflicted directly with the prevailing zero sum theory of , which sought to assign trading roles and benefits to various countries and their inhabitants. Protectionism and mercantilism never seem to go away and continue to be instruments of preserving and extending the positions of a select group at the expense of consumers and, often, taxpayers.

Firms are not immune to the temptation to make their lives easier by hobbling rivals or customers and so a legal framework is essential to maintain the integrity of the market and to settle disputes. Smith appreciated the benefits of organized economic activity but recognized the rent seeking behavior of many businesses and firms:57

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Smith also recognized that businessmen and specialists soon learned to collude to blunt the market’s discipline and justified their efforts as consumer protections.58 The Candlemakers’ Petition written in 1845 by Frederic Bastiat, a French economist, eloquently presents the case for legislative action to curb the unfair competition from the sun (a foreign power) and to thus stimulate French industry and prestige.59 The arguments made by Bastiat would be familiar to any legislator today and, unfortunately, convincing to many of them.

Trade, beyond direct local barter, gives rise to specialists such as bankers and merchants and requires a law of contracts to define the nature of the transaction and to enforce its terms.60 Trade also involves risks and requires protection against opportunistic bad-faith behavior. Sea loans, fairly sophisticated risk and reward sharing arrangements to

55 This is not strictly true, , another great British economist, showed that trade benefited people even if the production advantages of one party were relative rather than absolute. This is known as comparative advantage and is still largely misunderstood by politicians. 56 Some think Smith later revised his views after considering arguments made by Jeremy Bentham in defense of usury contained in a famous letter to Smith. 57 Rent seeking is distinguished from profit seeking by the extraction of advantage and profits through conspiracy, government favor, and artificial barriers to competition, etc. Rent seeking is evident when, say, General Electric pushes for government support of wind power that would increase the value of GE’s wind turbine and electricity transmission businesses. Similarly, Archer Daniels Midland was a major proponent of corn-based ethanol - an incredibly stupid economic and social policy. 58 “The pretense that corporations (guilds) are necessary for the better governance of the trade, is without any foundation. The real and effectual discipline which is exercised over a workman, is not of his corporation but that of his customers.”58 (Parenthetical added) 59 Several audio and visual transcripts of Bastiat’s satirical works are available on-line and well worth the time to watch. One version of The Candlemakers’ Petition is at http://www.youtube.com/watch?v=T52w6dFM3T4 Schumpeter called Bastiat the greatest economic journalist. 60 Here “law” need not require government. Many early contracts reflected agreed-to conventions established through practice and maintained privately.

22 Draft notes for Bob Wayland’s Economics of Business facilitate early maritime trade are mentioned in Hammurabi’s Code as early as 2250BC. By the 15th century insurance and re-insurance contracts were well developed, particularly in Italy, and covered such defined risks such as risicum maris, (shipwreck by loss to the sea), and risicum gentium, (loss to pirates and privateers).

The ancient insurers understood well the concepts of moral hazard and opportunism and therefore policies did not cover malfeasance by the captain. Nevertheless, moral hazard is almost impossible to eliminate from insurance. Some of the inadvertent consequences of early maritime insurance included a propensity to risk more direct but hazardous routes, to insure the same load with multiple underwriters in multiple locations, to offload the cargo at a different port and then to intentionally wreck vessels, and other sharp practices.61 Most of these practices or their modern equivalent are still cheerfully employed by insured parties and explain the often-confrontational manner in which insurers deal with claims. Estimates of healthcare fraud in the range from 3 to 10 percent of claims; as many as 25 to 30 percent of automobile insurance claims may be fraudulent or inflated and there are even occasional fake life insurance claims.62

Trade benefits greatly from a commonly accepted unit of exchange or currency and the existence of currency and coinage is evidence of extensive trading and at least rudimentary financial systems. Currency not only facilitates trade but also makes further specialization by individuals easier by reducing transactions costs and enabling more granular transactions. The first coins appeared in Lydia, a part of modern Turkey, around the seventh century BC. Currency, especially the paper kind, depends upon trust. Someone, initially the guy whose image or seal appeared on the coins, later banks and governments, must vouch for the credibility of the currency. Adam Smith devotes several pages to the always-present problems of counterfeiting by criminals and the more serious problem of currency debasement by governments. Reducing the content of precious metals, a sort of qualitative easing, was a common deceit.

“For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins.”63

One of the problems with precious metals-based is that the quantity and hence relative value of the metals can change. The New World gold and silver brought back by Spain in the 16th century together with rich Central European silver deposits, population growth, and widespread debasement of coinage contributed to the “European Price Revolution” during the early 16th century to the mid 17th century when prices rose

61 Meir Kohn, Working Paper 99-07, “Risk Instruments in the Medieval and Early Modern Economy,” Department of Economics, Dartmouth College, February 1999. The sea loan or foenus nauticum had some equity-like risk sharing characteristics because they were forgiven if the ship or cargo were lost. 62 Wikipedia cites a number of organizations’ claims of insurance fraud at http://en.wikipedia.org/wiki/Insurance_fraud 63 Op cit. pp24-27

23 Draft notes for Bob Wayland’s Economics of Business by as much as 300 percent.64 Today most advanced economies rely on central banks with varying degrees of independence to maintain the integrity of their currencies. But, currencies can be (and usually are) managed to some extent and distort trade patterns and invite retaliatory actions (often misguided) that further damage trade flows.

I. D. An Autonomous, Self-Organizing System

One of Smith’s most profound insights was that the aggregate outcome of all people acting individually in their own interests usually advances the public good - the famous unseen or invisible hand that led men pursuing their own gain to promote an end (the public interest) that was not their intention.65

“By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”66

We are not sure we’d go as far as Kenneth Arrow and Frank Hahn do in crediting Smith with perceiving a tendency of to produce optimal economic solutions but we do believe that he sensed the dynamic interplay of economic actors produced unintended and unanticipated outcomes.67

An argument can be made that economies are an emergent property of biology. Indeed, Alfred Marshall (1842-1924), the British economist whose monumental 1890 Principles of Economics, cast economics into a mathematical framework, particularly those diagrammatic illustrations so beloved of students,68 wrote, “the Mecca of the economist lies in economic biology rather than in economic dynamics.” Adam Smith himself believed that man’s “propensity to truck, barter and exchange” is innate.

Economies are evolutionary phenomena. Specialists and businesses are subject to selection pressures and adopted or rejected by their environment. Changes and innovations follow the “descent with modification” pattern observed in all evolutionary systems. An appreciation for the random and impersonal dynamic of environmental

64 An excellent essay by John Munro, an economic historian at the , ostensibly on Earl Hamilton’s pioneering and much maligned history of the European Price Revolution but covering much of the debate over its causes can be found at http://eh.net/bookreviews/library/munro. 65 The origination of the terms “invisible hand” and “division of labor” is often attributed to Bernard de Mandeville (1670-1733) who’s exceptionally influential and controversial work, The Fable of the Bees: Private Vices, Publyck Benefits (1714, later expanded in 1723) certainly influenced Adam Smith. 66 Op cit., p 423 67 Kenneth Arrow, Frank Hahn, General Competitive Analysis, 1971, Holden-Day, San Francisco, pp1-2 68 in his eulogy to Marshall makes a similar point,” Marshall's mathematical and diagrammatic exercises in Economic Theory were of such a character in their grasp, comprehensiveness and scientific accuracy and went so far beyond the" bright ideas " of his predecessors, that we may justly claim him as the founder of modern diagrammatic economics-that elegant apparatus which generally exercises a powerful attraction on clever beginners, which all of us use as an inspirer of, and a check on, our intuitions and as a shorthand record of our results, but which generally falls into the background as we penetrate further into the recesses of the subject.” See John Maynard Keynes, “Alfred Marshall, 1842-1924, The Economic Journal, Sep 1924, p333-334. The entire article is a very worthwhile read that covers well Marshall, his time, and connects his personal development with the advances he made in the discipline.

24 Draft notes for Bob Wayland’s Economics of Business adoption and selection is useful both to stimulate an appreciation of the importance of innovation in improving competitive fitness and a warning against executive hubris.69

The concept of evolution is central to this course. One of our early readings, Armen A. Alchian’s “Uncertainty, Evolution, and Economic Theory,” is a modern exposition of these notions and the resulting futility of decision-making based on notions of profit maximization and optimization. After we set the stage with articles by Coase, Alchian and Demsetz, Alchian and Stigler, we’ll look at a broader treatment of evolutionary economics in Richard R. Nelson and Sidney G. Winter’s “Evolutionary Theorizing in Economics.” Steven Klepper’s article, “Entry, Exit, Growth, and Innovation over the Product Life Cycle,” is an application of the ideas outlined in the Nelson and Winter article and illustrates how an evolutionary economist can model the ecology of an industry and explain how winners and losers emerge.70 One of the most powerful books of ideas written in this century, Rationality in Economics: Constructivist and Ecological Forms, by 2002 Nobel Memorial Prize winner Vernon L. Smith goes a long way to reconciling the roles of reason (constructivism) to provide variation and ecological forces to select the fitness needs of societies.

This notion of the market as an autonomous, dynamic, and self-directing system is just too much for many people to comprehend or accept. Failure to accept the notion of a generally positive, self-directed system supports efforts to impose planned systems. Biologists face similar resistance to the analogous concept of evolution as the product of random mutations and natural selection. The inability of apparently educated people to comprehend or accept the notion of efficient self-directed systems and to thus feel they

69 The evolutionary model, broadly defined as a system of incremental change based on intentional or unintentional (random in biology and most natural science applications) changes and combinations or variations of existing forms, tested and selected for within a larger environment, has been applied with great success not only in economics and biology but in law, some branches of cosmology, and recently, with W. Brian Arthur’s book, The Nature of Technology, What It Is and How it Evolves, 2009, Free Press, New York, to technology. Henry Petroski, a prolific historian of engineering and technology at Duke, provides many examples of the incremental, evolutionary nature of technological advances in several books, including The Evolution of Useful Things. The evolution of science seems also to be evolutionary but the most frequently cited work, Thomas Kuhn’s 1962 work The Structure of Scientific Revolutions, takes a more punctuated, discrete jump, or paradigm shift perspective. The distinction and implications between more-or-less continuous and punctuated, discrete shift models is important and observed in business debates between the home run and singles hitting approaches to development. There are many who advocate a leap ahead approach and cite Apple and Steve Jobs but Jobs himself seems to hold a more evolutionary view involving the careful tracking and assimilation of technology vectors. The “revolutionary” iPhone was in fact in development for years while various prototypes were tested and discarded. 70 Economics and biology share many dynamic characteristics but the analogy is often strained. See for example, Paul Ormerod’s, WHY MOST THINGS FAIL: Evolution, Extinction and Economics, (original Praeger hardcover 2005, Wiley paperback 2007) which is an accessible, thought-provoking, and entertaining effort that finally fails because, as the Financial Times’ Krishna Guha perceptively notes, “Talking about evolution as metaphor is one thing; using it as a model, another. Biological evolution is a random process that occurs through genetic mutation and sometimes copying errors occur when DNA is copied. In a Darwinian world a living being can do nothing to improve its fitness to survive.” (Guha seems to mean its species’ fitness to survive. Living beings do acquire abilities that serve their individual survival. The fallacy of Lamarck’s view was his belief in the heritability of acquired traits and capabilities.) Guha notes that companies continuously innovate and change with the intention of improving their competitiveness and ability to prosper.” These neo-Lamarkian efforts often reshape the firm’s routines, the elements that enable a firm to capture and transmit knowledge and are similar in some respects to genes. Guha’s review is at http://www.ft.com/cms/s/2/ad3c19a0-b7a6-11d9-8f87- 00000e2511c8,stream=FTSynd,s01=2.html.

25 Draft notes for Bob Wayland’s Economics of Business are qualified to support ignorant interventions or “expert” guidance are examples of Sir Peter Medawar’s trenchant observation that:

“…the spread of secondary and latterly of tertiary education has created a large population of people, often with well-developed literary and scholarly tastes, who have been educated far beyond their capacity to undertake analytical thought.”71

The notion of a self-directed, impersonal, dynamic and selective market system that “guided” behavior and “selected” outcomes was especially profound and contributed significantly to the intellectual debate that influenced Darwin’s thinking about a systematic framework for describing the origin of species. Curiously or perhaps ironically, it was while reading the same Malthus despised by Carlyle that Darwin grasped the outlines of his biological evolutionary model.

“…I happened to read for amusement Malthus on Population, and being well prepared to appreciate the struggle for existence which everywhere goes on from long-continued observations of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved and unfavourable ones to be destroyed. The result of this would be the formation of new species. Here, then, I had at last got a theory by which to work….”72

The evolution of the idea of evolution is interesting. The story might start with Mandeville’s Fable of the Bees, an early exposition of the emergence of outcomes separate from intent; Smith picked-up on this notion and saw an Invisible Hand guiding behavior; his student, Malthus, later worked out a pioneering model of the dynamic interplay of food production and population; Darwin read Malthus and had an epiphany about the contests among creatures and with their environment.73,74 Since the came first it is unfair and uninformed of critics to label intense commercial competition as “economic Darwinism.” It is misleading also to use Herbert Spencer’s term, “survival of the fittest” because today it connotes a misleading picture of competition and selection within both economic and biological systems.75 Most

71 Quoted with delight by the similarly acerbic Richard Dawkins in The Greatest Show on Earth, 2009, Free Press, New York, N.Y. page 158n. 72 We can’t help but contrast Darwin’s “read for amusement” and Carlyle’s pejorative “dismal” regarding Malthus. See Charles Darwin, The Autobiography of Charles Darwin, originally published in 1887, Barnes and Noble Publishing (paperback) 2005, p 45. 73 Technically, the creature is a genome or collection of genes and the competition is among the genes. Those genes that provide a reproductive advantage to their host genome tend to be selected for by the environment perpetuated. 74 We are glossing over the near simultaneous “discovery” of natural selection by Alfred Russell Wallace (also inspired in part by Malthus) and the antecedent theories of evolution, most prominently Lamarkianism which postulated a progressive evolutionary force augmented by heritable adaptations. I take Wallace’s titling his own book Darwinism as evidence of acceding to Darwin’s precedence. Darwin himself discussed the works of over thirty other scientists and naturalists in Origins. His own grandfather, Erasmus Darwin, was known to irritate the clergy with pronouncements that man was descended from lesser species. 75 Regrettably, Darwin adopted Spencer’s catchy formulation, survival of the fittest, in the fifth edition of On the Origin of Species because he thought it less suggestive of explicit choice than “natural selection” used in previous

26 Draft notes for Bob Wayland’s Economics of Business importantly, Smith and later Darwin recognized in the systems that they studied, the power of random events,76 environmental factors, and dynamic selective pressures in determining winners and losers. Both biological and economic environments are very complex, interconnected, dynamic, and to a large extent unpredictable so chance plays a very large role in both systems.77

The inability to respect the workings of self-directed systems leads to a great deal of attempted mischief in school science curricula, and worse, in the misguided resistance to free trade, especially with undeveloped countries. Of course market failures (when a market produces inefficient outcomes) do occur but they are often the consequence (usually, but not always, unintended) of government intervention. In some cases government intervention is appropriate to balance social and private costs but not always as we’ll see when discussing Ronald Coase’s counter-intuitive but path-breaking article, “The Problem of .”

The individual’s consumption decisions are based on information generated within the market system and continually revised as incomes, tastes, resources, technology, and populations change. Trade extracts information on the values placed on goods by buyers and sellers and in turn creates information in the form of relative prices and that information then provides signals to guide peoples’ decisions. Today’s assault on the neoclassical model, much of it under the rubric of behavioral economics discussed earlier, goes to the subjective heart of the model and questions the ability of individuals to make rational and consistent decisions across all goods.78

editions. Unfortunately, the term acquired a misleading connotation and is no longer applied by professional economists and biologists. This is only one case of poorly understood biological models taking root in popular discussions of economics. The popular use of “dinosaur” as a metaphor for slow moving companies is unfair to dinosaurs, many of whom were quite speedy and were successful for over 100 million years (not counting their progeny, birds, who continue to prosper). The dinosaurs did not become extinct because they were no longer fit for their environment; they were devastated by a random event, probably a large meteor, from outside their environment. By contrast, Homo erectus appeared less than two million years ago and Homo sapiens (us) emerged only within the past few hundred thousand years. Companies, slow moving or otherwise, are, as a species, probably less than 2500 years old. 76 This may be a good point to insert Frank Knight’s famous distinction between risk, a situation where the probability distribution of outcomes is known but the outcome itself is unknown and uncertainty where even the probabilities are unknown. Recent events, especially in financial markets, suggest that our knowledge of the probability distributions and especially of correlations among risks may be faulty or incomplete. This is especially important to firms seeking to manage risk, a process that depends on knowing the distribution of the risks faced and the ability to identify complementary risk patterns. 77 Jesuitical arguments over whether uncertainty and chance reflect a fundamental randomness based ultimately perhaps on the basic uncertainty and random behavior at the quantum level or whether they reflect the limits of our computational and analytical capability but remain solvable in principle are way beyond our capacity. By random and chance we mean that a person cannot anticipate with certainty that something will or will not happen. In some cases, given a history, she may have some notion of the probability distribution of certain events. In other cases stuff just happens. In Alchian’s “Uncertainty, Evolution, and Economic Theory,” we will discus the role of chance in firm survival and growth. 78 See the earlier discussion of the evolution of utility and consumer choice theory in the section on self-interest. If individual behavior is predictable we can in principle make generalized statements about the dynamics of the system. See Dan Ariely, with two PhDs., one in another in business administration, offers an interesting thesis that humans behave irrationally but predictably. See his amusing and accessible treatment in Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions, Harper Collins Publishers, New York, Perennial Edition, 2010. Ariely however sometimes re-discovers well known economic concepts and declares them novel.

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The price system usually performs its information creating and signaling functions automatically and efficiently but there are some frictions and search costs in finding a relatively low quote among a set of dispersed prices as we’ll see in George Stigler’s classic, “The Economics of Information,” a seminal contribution to modern information theory.

Sometimes market prices and signals are so distorted by buyer uncertainty, asymmetric information, and ignorance that the market itself is threatened and trade is constrained as George Akerlof described in “The Market for Lemons: Quality, Uncertainty and the Market Mechanism” (recommended but not required). Even worse perhaps, some trades between producers and buyers impose costs on third parties, which, if significant, may call for a reworking of the rules governing liability as Ronald Coase explained in his article on social costs noted above.

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II. The Supreme Myths of the Industrial Revolution

Some of the most resistant barriers to understanding the economics of business are the erroneous impressions of the Industrial Revolution students acquire through literature and some popular schools of history. Today’s social justice movement traces much of its view that capitalism had a pernicious influence on society to the real and imagined injustices preceding and supporting the Industrial Revolution.79 F. A. Hayek, the 1974 Nobel Laureate in Economics, deplored the misinformation and misinterpretations of the Industrial Revolution:

“There is, however, one supreme myth which more than any other has served to discredit the economic systems to which we owe our present-day civilization … It is the legend of the deterioration of the position of the working classes in consequence of the rise of ‘capitalism’ (or of the ‘manufacturing’ or ‘industrial’ system).”

The rapid industrialization of 19th century Great Britain was achieved in large part by ever-increasing division of labor. This led to a much more urban and complex society with very different relationships among people and within lower class families than existed in the pre-industrial period. Of course an increase in general welfare does not preclude the suffering of some. Industrialization made the poor more visible. matter and many of the most persuasive voices decried the conditions of workers without noting that in most cases those conditions represented an improvement over the less visible agony of rural poverty. Many scholars see the origins of the modern class system and the associated political spectrum in the strains caused by the industrial division of labor.

It would be hard to overestimate the effect that the transition from a largely agrarian to industrial society had on culture, social science, and literature. Many thoughtful but incompletely informed people contested Adam Smith’s positive view of the consequences of the division of labor. In a sort of Third Law of Political Motion, modern socialism and communism were created in reaction to the Industrial Revolution. It is a cruel irony that the growing pains of market economies provoked well meaning (at least initially) but horribly ineffective economic systems that kept hundreds of millions of people impoverished long after market economies evolved into kinder, gentler systems. In his1847 Principles of Communism Frederick Engels’ explicitly connected the ever- more-granular division of labor with a diminution of individuality and saw it as precursor to the factory system.

79 One thread of the social justice movement goes further and claims that slavery, by reducing labor costs, was an important factor in the accumulation of British wealth and the rise of American capitalism. A brief, sympathetic overview of slavery’s contribution to American capitalism is at http://www.huffingtonpost.com/2014/02/24/slavery_n_4847105.html. An overview of the importance of slavery, particularly as employed in the sugar trade, to the development of the British economy is David Eltis and Stanley L. Engerman, “The Importance of Slavery and the Slave Trade to Industrializing Britain: The Journal of , Vol. 60, No. 1 (Mar., 2000), pp. 123-144. They conclude that the slave-based sugar industry was a factor but not an especially large factor.

29 Draft notes for Bob Wayland’s Economics of Business

“Labor was more and more divided among the individual workers so that the worker who previously had done a complete piece of work now did only a part of that piece. This division of labor made it possible to produce things faster and cheaper. It reduced the activity of the individual worker to simple, endlessly repeated mechanical motions that could be performed not only as well but also much better by a machine. In this way, all these industries fell, one after another, under the dominance of steam, machinery, and the factory system, just as spinning and weaving had already done.”80

Many other people, including the authors Charles Dickens, William Blake, and of course the Luddites saw industrialization as a force that alienated people and desecrated nature. Their views resonated within and shaped western popular culture and are still on display on the streets outside any , G7, or G20 conference. Dickens’s himself suffered a bout of child labor when he was sent briefly to work in a blacking factory and warehouse during a family financial crisis. Oliver Twist’s journey from workhouse to crime and, finally a genteel life was shaped by Dickens’ factory experience and sympathy for the perceived economic casualties of the period.

Charles Dickens was so appalled by the industrial revolution and the concept of utilitarianism that he wrote a novel, Hard Times, to both caricature and discredit the concept and capitalists. In the book Dickens created a number of unattractive businessmen most notably Josiah Bounderby and his employee, the teacher Mr. Gradgrind. The two are apostles of utilitarianism and the unsentimental, hardheaded analysis that Dickens felt defined economists such as John Stuart Mill but enervated the souls of people and denied to them the romantic and childish delights of life. Consistent with his habit of stereotyping names, Dickens names two of Gradgrind’s children, Adam Smith and Thomas Malthus. About the only businessman Dickens showed any compassion for was Ebenezer Scrooge and that only after visits from ghosts who surveyed his romantic failure, cheap conduct, and offered him visions of an unlamented death. About a century later the philosopher and novelist Ayn Rand (1905-1982) wrote a series of novels almost diametrically opposed to Dickens’ perspective and celebrated a sharply drawn form of self-interest that she called Objectivism.81 Rand (to complete this non-obvious circle) was influential in shaping the early thought of Alan Greenspan, former professional jazz saxophonist, economist, and long-serving Chairman of the Federal Reserve.82

80 Engels’ Principles of Communism is a straightforward tract organized around 25 questions. It is available on- line at many locations including: http://www.marxists.org/archive/marx/works/1847/11/prin-com.htm. This short work is much more accessible than Marx’s more ambitious but often opaque theorizing. As we will see when we discuss evolutionary economics, the early communists didn’t reject the basic principles of market- based economics or contest the evolutionary nature of the system; they just believed that the forces acting to select survivors along the evolutionary path were different (especially the role of inter-class struggle) and the outcomes therefore would be much different than it turned out. 81 Rand’s work and philosophy is outlined in http://plato.stanford.edu/entries/ayn-rand/ 82 A fairly light but revealing interview with Greenspan is at: http://www.businessweek.com/articles/2012-08- 09/alan-greenspan-on-his-fed-legacy-and-the-economy#p1

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William Blake’s 1804 poem, And did those feet in ancient time, which became a popular hymn, Jerusalem,83 bemoans the loss of England’s pastoral world to the “satanic mills” of industrialization. Blake and other romantics influenced succeeding generation’s perceptions of industrialization and still inspire those who want to spare people in undeveloped countries the pains of economic growth through exposure to Nike’s dark satanic mills.

And did those feet in ancient time, Walk upon Englands mountains green: And was the holy Lamb of God, On Englands pleasant pastures seen!

And did the Countenance Divine, Shine forth upon our clouded hills? And was Jerusalem builded here, Among these dark Satanic Mills?

Bring me my Bow of burning gold; Bring me my Arrows of desire: Bring me my Spear: O clouds unfold: Bring me my Chariot of fire!

I will not cease from Mental Fight, Nor shall my Sword sleep in my hand: Till we have built Jerusalem, In Englands green & pleasant Land.

For many, the Industrial Revolution is defined by an image of children laboring under inhumane conditions and cruel overseers. Child labor was in fact very common in 19th century cotton mills but one reason seems to be that adults were not particularly productive in the early years of the industry. This may have reflected the unsuitable agrarian skills and orientation of the adult workforce. Or it might be a case of the division of labor gone bad: “since the machines had reduced many procedures to simple one-step tasks, unskilled workers could replace skilled workers…nimble fingers, small stature and suppleness of children were especially suited to the new machinery and work situations …children had a comparative advantage with the machines that were small and built low to the ground as well as in the narrow underground tunnels of coal and metal mines.”84

Arguments still rage over whether the children were exploited by the industrialists and their parents or simply caught in an unfortunate situation. It is clear that young children, even in those times, did not voluntarily enter the workforce. Most economists would argue that involuntary work is a form of exploitation and the British state agreed, to an extent, by setting the minimum age of workers at ten and later limiting them to ten hours per day. The exploitation of children, as awful as it was, was not as absolute as found in

83 “Jerusalem” is used as a metaphor for heaven on earth, the putative condition of pre-industrial England and the paradise destroyed by the evil proprietors of satanic mills. It was especially popular in communist and socialist quarter in the U.K. 84 Excerpt from Carolyn Tuttle, Lake Forest College, “Child Labor during the British Industrial Revolution” at http://eh.net/encyclopedia/article/tuttle.labor.child.britain

31 Draft notes for Bob Wayland’s Economics of Business slavery or serfdom.85 Eventually a relatively competitive labor market evolved. Even in the early days, productivity was recognized and reflected in wages. As the original cohort of children grew older and more accomplished, their wages increased substantially. As more adults with suitable skills became available, the mills reduced significantly the proportion of children in their workforce and typically did so in advance of the child labor laws.86

Anyone who thinks this reform was motivated by anything other than cold self-interested calculation should read the story of Ellen Hooten, a ten year old Lancashire girl who rebelled against her employment in the cotton mills and was punished severely enough to become the subject of an investigation that has left us with a detailed record of her misery.87 Competitive employers do not have to be saints, they simply have to make job offers that employees will accept, given their options. If an employer underpays his employees and somehow earns exceptional returns by doing so, another entrepreneur has an incentive to enter and outbid the incumbent for labor. One objection of this argument is the possible power of employers. There may have been some of that but the concentration of industry in urban areas provided many workers with choices. Workers also demonstrated the ability and willingness to relocate to where jobs were as can be seen in the rapid growth of cities.

Scholars disagreed about the consequences of the division of labor and the Industrial Revolution. John Clapham, a pioneering economic historian was one of the first to actually study the data and found evidence of a growing and increasingly prosperous middle class, especially in the latter stages of the period, and concluded that the broader picture was not entirely consistent with the dominant Dickensian narrative. Marxist historians such as E. J. Hobsbawm 88 linked the French and Industrial revolutions as “twin craters of a volcano” and the seeds of the ultimate decline of Great Britain. Emile Durkheim, a prominent French sociologist of the late 19th and early 20th centuries, entitled his dissertation, which is still in print, The Division of Labor in Society, and applied economic and biological evolutionary concepts to the emergence and development of societies and culture.

“…If science, art and economic activity develop, it is as the result of a necessity imposed upon men. It is because there is no other way to live, in the new condition in which they are placed. As soon as the number of individuals between whom social relationships are established is greater, men can only assume their position by specializing more, working harder,

85 Some argue that the children’s industrial work was no more appalling than the agricultural work in which their parents would have enlisted them otherwise. 86 See for example Douglas A. Galbi, Research Associate, Centre for History and Economics, “Child Labor and the Division of Labor in the Early English Cotton Mills,” King's College, Cambridge CB2 1ST, 13 June 1994 (A PDF version is available for download at: www.galbithink.org/fw.htm) 87 Douglas A. Galbi, “Through Eyes in the Storm: Aspects of the Personal History of Women Workers in the Industrial Revolution,” Social History, v 21 no. 2 (may 1996) pp142-159. (PDF of pre-publication draft available at www.galbithink.org) 88 Hobsbawm, E. J. Industry and Empire, New York: Random House, 1968

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and stimulating their facilities to excess. From this general stimulation there inevitably arises a higher level of culture…”89

We don’t have too many dark satanic mills today but one reason many people are still uncomfortable with corporate life and, in some cases extend their discomfort to capitalism, is the widespread feeling that the corporate life is a narrow, unfulfilling, soul- deadening existence in which people are pigeon-holed and spend their days in dreary, repetitive tasks. Unfortunately, specialization does sometimes lead to boring jobs and there is some truth to these concerns. But, the real question is how this picture of corporate life, when true, stacks up against the alternatives.

89 Emile Durkheim, The Division of Labor in Society, (Translated by W. D. Halls), New York, Free Press, paperback edition 1997, p 276

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II B. Second Industrial Revolution?

Some, including the eminent Harvard business historian Alfred E. Chandler, suggest that a new form of industrial firm emerged in the last decades of the 19th century as the network industries including rail and telegraph emerged to shrink distances and communication. Firms that were able to more fully exploit and scope became very different industrial organisms than their ancestors.

“A new type of industrial enterprise appeared suddenly in the last two decades of the 19th century. Throughout the 20th century, these firms were created and continued to grow in much the same manner, and they continued to cluster in industries with the same characteristics. These industrial firms first appeared as modern transportation and communication networks were completed - networks that themselves were built, operated, enlarged and coordinated by large hierarchical firms. By the 1880s, the new railroad, telegraph, steamship and cable systems made possible the steady and regularly scheduled flow of goods and information, at unprecedented high volume, through the national and international economies. Never before could manufacturers order large amounts of supplies and expect their delivery within, say, a week; nor could they promise their customers comparable large-scale deliveries on some specific date. The potential for greatly increased speed and volume of production of goods generated a wave of technological innovations that swept through western Europe and the United States during the last decades of the 19th century, creating what historians have properly called the Second Industrial Revolution (to differentiate it from the "first" that occurred in Britain at the end of the 18th century, through the application of coal produced steam- powered machinery to mining and the production of textiles, metals and metal products).”90

The shape of business firms today largely reflects the requirements and opportunities created in that second industrial revolution. The challenges of managing in that environment stimulated the development of management as a distinct area of study. Frederick Taylor and his disciples developed scientific management as a means to improve efficiency and, he hoped, to more fairly reward workers. While Taylorism acquired an inhumane odor, it’s emphasis on analysis, data gathering and performance measurement influenced all subsequent management and administrative science. Peter Drucker, perhaps the most famous (and overrated) management guru of all time even declared that Taylor’s ideas were America’s greatest contribution to western thought

90 See Alfred D. Chandler, “Organizational Capabilities and the Economic History of the Industrial Enterprise,” The Journal of Economic Perspectives, Vol. 6, No. 3 (Summer, 1992), pp. 79-100, published by the American Economic Association for a fascinating overview of the development of the modern business firm. Chandler’s survey of business history suggests to him that the evolutionary model of business development best fits the historical facts and data. Chandler (pp. 86-87) outlines a useful taxonomy of the various economic approaches to defining and analyzing the firm; the neoclassical, the principal-agent, the transactions cost, and the evolutionary models. He leans, as do we, toward the last. In practice, all four illuminate the subject and share many characteristics and tools with one another.

34 Draft notes for Bob Wayland’s Economics of Business since the Federalist Papers. They weren’t but that gives you some idea of how influential was Taylor and how prone to hyperbole was Drucker. It is possible that Drucker never even read Taylor’s intolerant and racist portrayals of workers.

Some people see a third industrial revolution emerging from current and new technologies especially in communications, information science, and biology. Technology has a huge influence on the economics of business but whether it favors transactions executed through the market or through firms depends on many factors. Some of the new technologies extend the network effect and may expand the boundaries of economies of scale and scope as did their 19th century ancestors. On the other hand, some of them also promote and enable more transactions to be conducted through the market. Whether or not these new technologies will ignite another true revolution and, if so, its final shape is not yet clear. This doesn’t stop some observers of management from combining a shallow understanding of economics with a string of anecdotes to predict dramatic changes.91

As this is written, there is a debate about the rate and scope of innovation and invention. Some people argue that major invention has slowed or stalled, the sort of “Post-it” incremental advances. Other observers cite the long gestation period between the conceptual or scientific breakthrough and suggest it is too early to predict a slowing of innovation and invention.92

91 See for example, Alan Murray, “The End of Management” Wall Street Journal, August 21, 2010, on the web at: http://online.wsj.com/article/SB10001424052748704476104575439723695579664.html?mod=WSJ_mgmt_Le ftTopNews 92 The Economist devoted its January 12th, 2013 issue cover and special report to the growing debate about dwindling innovation.

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Class 1 Notes, Part 2: Ronald Coase and the Nature of the Firm

Objectives. The objectives of the next several classes are to provide an understanding of the origin of the firm, its evolution, the roles and relationships of principals and agents within the firm and across firms, how decisions on output and investment affect the value of the firm. The Coase article that started much of the discussion about the nature of the firm and its boundaries is discussed below.

Required Readings. Coase 1937

The Firm

The modern business firm is the basis of our economy. By far most goods and services are produced within business firms and a huge majority of workers are employed by them. In 2004 the U.S. Census Bureau counted nearly 5.9 million firms employing about 115 million people, with receipts of something over $23 trillion, and payroll of about $4.3 trillion. Of these nearly six million firms, only about 11 per cent had more than twenty employees, less than two per cent had 100 or more employees and .3 per cent employed 500 people or more. These are the numbers people refer to when they discuss the importance of small and medium sized firms. But the behemoths, while a small percentage of the population, produce a disproportionate amount of the U.S. output. The 891 largest firms (by sales) accounted for 23 per cent of U.S. employment, almost 30 percent of payroll, and a whopping 42 percent of sales or receipts.93 On average over the past 20 years or so, about eight to nine percent of firms fail each year and are offset by the birth of new firms equal to about ten percent of the total firm population.

Over time, almost all firms fail or disappear. Many are absorbed into other firms. U.S. merger and acquisition activity in 2010 was valued at about $820 billion, about half that of worldwide M&A. The average acquisition premium, a measure of the acquiring company’s optimism, for U.S. deals was a little over 40 per cent, about ten points higher than the worldwide average.94

Economists didn’t give much thought to the phenomena of firms until the early 20th century. There were commercial censuses of businesses and some comment on the course of industry. J.H. Clapham reported in his 1926 book, An Economic History of Modern Britain, that the 1851 Census Commissioners counted 677 British “engine and machine makers,” 457 of which employed less than 10 men.95 But the formal study of the origin and evolution of firms was relatively neglected until Ronald Coase’s 1937 article. Since Coase, economists have asked and begun to find answers to important questions such as:

93 2004 U.S. Census Data, most recent available, http://www.census.gov/epcd/www/smallbus.html 94 These figures are still preliminary but are probably fairly accurate. See http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/ 95 Op cit. p 448

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• Why are there firms • What factors determine the scope of firms • What limits, if any, exist on the scale of firms • What are the efficient boundaries of firms • How do firms interact with other firms and the market

We can only address the major outlines of the economics of the firm in this course but that should enable students to approach many practical business problems and issues in a more critical manner.

Where Do Firms Come From?

Recall from our discussion of Adam Smith that specialization, trade and the market are means of creating wealth. Smith was clearly aware of firms but discussed them largely in terms of entrepreneurs, conflating the principal and the organization. The market’s invisible hand guided the decisions of entrepreneurs. But as anyone who has worked in a corporation knows, there are many visible hands directing resources within the walls of the firm. Society has many ways of organizing resources starting perhaps within families and clans and eventually markets and firms. As with any other “resource” economists seek to determine what are the optimal means of organizing resources and production and what factors bear on choices among competing organizational forms.

We take the existence of the firm for granted but the firm as we know it and its prominence in our lives is a fairly recent development in human history96 and it is not entirely obvious why it should be such an important factor in our economic lives. In the next few sections we will look at the work of five distinguished economists to gain insight into the factors that explain the origin and development of the firm. This provides a basis for analyzing and exploring the firm’s behavior, its boundaries, and the limits to its scale and scope. If we understand what really shapes a firm and the factors that govern its growth and survival we can better assess strategies and examine critically theories and prescriptions for success.

96 As we discussed in the previous section organized commercial activity has of course been around a long time. See for example, Karl Moore and David Lewis, Birth of the Multinational: 2000 Years of Ancient Business History-- From Ashur to Augustus, Handelshojskolens Forlag, illustrated edition (September 1, 1999) which traces multinational activities back to Assyrian times and into the Roman Empire.

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Ronald H. Coase and the Nature of the Firm as an Alternative to the Market

Ronald H. Coase (1910-2013) was one of the greatest economists of his time. He was especially influential in the development of transactions cost economics, economics of property rights, and the intersection of economics and law. His most famous articles include this essay on the origin of firms and the classic, “The Problem of Social Cost,” which we will discuss in a future session. Coase was, as Peter Klein noted, extremely successful despite (or because of) not having a PhD in economics, eschewing math and statistics, and practicing for much of his career outside of an economics department (he was a faculty member of the Chicago Law School). Coase was the acknowledged founder of new . He was working on a book on the emergence of China at the time of his death at 102.

Until Ronald H. Coase’s classic 1937 article, “The Nature of the Firm,”97 economists didn’t much discuss the inconsistency between their assumptions that some resource decisions were made more or less automatically by the price system and that others were made consciously and apart from the price system by people within firms. Coase grasped earlier than almost anyone else that the firm was an alternative to the market mechanism for organizing transactions. The dichotomy between firms and markets has a significant evolutionary implication. Once it is created a firm becomes a generator of variation in ways to satisfy the fitness requirements of the market. Those firms that generate the most fit solutions for customers are rewarded with profit and enabled to continue in the game. As we saw in the previous section, each year, hundreds of thousands of new firms are created. At the same time, hundreds of thousands of other firms are found wanting in meeting the fitness requirements of the market and fail.

Coase addressed two fundamental questions: why are there firms and what, if any, are the constraints on their size and scope of activity? In principle individuals could rely completely on the market and the price mechanism to direct resources. In fact many industries such as the putting out system in early fabric making were organized largely through market transactions among independent or semi-independent producers. But, in the evocative phrase of British economist Sir Dennis H. Robertson we find:

“… islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”

What causes the lumps? Coase’s most profound insight was that there are costs to using the price mechanism and that in some cases it is less costly to perform those transaction inside a firm rather than through the market.

Coase identified several costs of using the market. Most immediately, organizing activities through the market involves

97 Ronald H. Coase, “The Nature of the Firm,” Economica 1937

38 Draft notes for Bob Wayland’s Economics of Business discovering what the prices of relevant goods are. As George Stigler later showed in his work on the economics of information, the costs of price discovery are often significant and an important constraint on the market reach of firms.

The costs of price discovery do not disappear within firms although internally they are often called allocated expenses and overheads - the estimation and allocation of which employs legions of bookkeepers and accountants seemingly obsessed with obscuring their economic content. Other costs of using the market include negotiating, contracting and all the other expenses we lump together and call transactions costs today. (A bit confusingly, given current idiom, Coase used the term marketing costs to refer to the costs of using the price system or market.)

Coase held that the distinguishing feature of the firm was the “suppression of the price mechanism” and the use of hierarchy to direct resources. For Coase, the firm is an entity that performs those activities or transactions that can be conducted more efficiently internally (through hierarchy) than externally (through the market). The firm is thus an organism to acquire and organize resources and to use technological recipes, aka production functions, for converting those resources into more valuable goods and services.

Coase cites the flexibility of not having to develop continually contracts within a firm:

“A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is cooperating within the firm, as would be necessary, of course, if this cooperation were as a direct result of the price mechanism. For this series of contracts is substituted one.”98

Clearly, it is often less costly for the entrepreneur to contact for a service, say labor, once rather than repeatedly. Matching the demand and supply of labor results in a spectrum of labor transactions from spot-market to long-term employment contracts. Firms or entrepreneurs may mix some spot labor purchased directly from the market, or temporary services purchased from an agency, with full time employees. In each case the costs of transactions must be considered. O.E. Williamson built on Coase’s insights and developed transaction cost economics (TCE) that considers not only the acquisition transaction but also the governance costs and contractual frameworks appropriate to various types of transactions and relationships.

Factors Bearing on Scale

If there are some activities or transactions that are best done by a firm, what is to prevent a firm from continuing to grow until it performed all of those activities? Why can’t a single large firm gather together and perform the transactions conducted by many small firms? Coase reasoned that the size of the firm was determined (constrained) by its ability to handle additional functions at costs superior to the market price plus the applicable

98 Op cit. p391

39 Draft notes for Bob Wayland’s Economics of Business transactions costs. At some point diminishing returns to management or entrepreneurial capability would set in and the firm would be unable to maintain its advantage relative to the market or other firms.

In his invocation of entrepreneurial capability as the limiting factor to long term firm growth, Coase echoed Nicholas Kaldor (1908-1986) who had argued in 1934 that, in the absence of some limiting factor of which the firm could possess one and only one, (and hence a truly fixed factor), the firm could simply acquire additional units of the limiting resource and go on growing. Kaldor noted that only entrepreneurial capacity met this requirement and therefore served as a fixed and limiting factor.

“It has been suggested that there is such a “fixed factor” for the individual firm even under long-run assumptions – namely, the factor alternatively termed “management” or “entrepreneurship.” As it follows from the nature of the entrepreneurial function that a firm cannot have two entrepreneurs, and as the ability of any one entrepreneur is limited, the costs of the individual firm must be rising owing to the diminishing returns to the other factors when applied in increasing amounts to the same unit of entrepreneurial ability. The fact that the firm is a productive combination under a single unit of control, explains, therefore, by itself why it cannot expand beyond a certain limit without encountering increasing costs.”99

Entrepreneurial capacity, as the uniquely and inherently fixed factor of production, is the ultimate limit to the firm’s long run size relative to its market. This is not intuitive and economists came relatively late to this insight. Many texts and courses do not stress the importance of this fact and often obscure it by devoting a great deal of attention to the classical derivation of long run marginal and curves which suggest a uniform and optimal equilibrium firm size in a perfectly competitive industry subject to either constant or increasing long run average costs. (The case of long run decreasing costs is incompatible with competition and is usually finessed in introductory courses.) This analysis has artistic merit but few useful applications. Most people believe, understandably, given the standard pedagogy, that the ultimate limits to growth are imposed by cost or technical considerations. In fact, those factors do constrain output, but only in the short run. That’s what the short run is – the period over which some factors are fixed. And those factors are fixed in the short term due to previous entrepreneurial decisions.

Coase identified three specific limits to firm growth, two of which are managerial or entrepreneurial factors, the third a consequence of scale relative to supply markets:

“Other things being equal, therefore, a firm will tend to be larger:

99 Kaldor, Nicholas, “The Equilibrium of the Firm,” Economic Journal, March 1934, p 67. Coase cites this article but not as inspiration for his adoption of entrepreneurial capacity as a limiting factor. Rather, he notes and credits Kaldor with moving theory to the examination of firms directly rather than distilling their putative characteristics from a theoretical consideration of industrial equilibrium.

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a) The less the costs of organizing and the slower these costs rise with an increase in the transactions organized. b) The less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organized. c) The greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size”

Coase noted also that technological change affects the potential scale and scope of firms. Technologies that increase management efficiency (or reduce what Armen Alchian and Harold Demsetz call metering costs) will tend to increase firm size. Technologies that reduce the costs of spatial separation will also tend to increase firm size. Of course as Coase notes, some technologies reduce both the costs of using the market and the operation of the firm. In these cases, there will usually be a net advantage in one direction or the other.

Coase also anticipates but does not develop the notion of smaller firms enjoying some sort of “other advantages” that offset the advantages of larger firms. Today, there is a great deal of discussion about the potential for small firms to out-hustle their larger rivals. This might be the case if at least some small firms enjoyed lower internal transaction costs that offset the lower external transaction costs (e.g. supply prices) enjoyed by larger firms. But, our earlier discussion of the relationship between the division of labor and the size of the market (external or internal) suggests that those functions susceptible to out- hustling are likely to display increasing costs and limited opportunities to achieve large scale. It is likely that large firms become slower and vulnerable to being outhustled because they expanded beyond the point where their internal transactions costs are lower than those in the market.

Measuring Relative Internal and External Efficiency

Even if the firm has an initial advantage over the market, conditions may change so the firm must be continually aware of the relative cost of the market option. Internal transfer prices and their relationship, if any, to external market prices are a major issue at many vertically integrated firms. Coase does not address this directly, leaving it to Hirshleifer in his “On the Economics of Transfer Prices” and others to explore the relationship of internal transfer prices and external or market prices. Many of the hybrid forms of corporate governance such as joint ventures are devised in large part to reduce external transactions costs and often fail when they don’t.

It follows from Coase that since the firm evolved as a substitute for the market, its value and efficiency should be measured against what the market can provide. He suggests as much by noting that firm-market borders will be found by management experimentation and trial-and-error – a process later given more formal shape by Oliver E. Williamson who worked out the conditions for determining whether transactions would be inside or outside the firm’s borders. In a sense, the firm makes it possible to ask the question

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“make or buy?” Today’s concept of managed supply chains involves closely related questions about the content and extent of the firm and its relationships with other firms.

In distinguishing between decisions made by an internal hierarchy (e.g. managers, executives, and owners) and external market forces, we encounter the question of how similar the decision criteria used by internal managers are or should be to those reflected in markets. Of course, suppressing the price mechanism totally makes it impossible to determine whether the firm does or continues to outperform the market. Firms spend a fair amount of time puzzling over this question and have developed elaborate internal transfer pricing schemes to guide internal resource use. Coase doesn’t say anything about the relative production costs, sans transactions costs, of market versus firm production. Williamson later corrects this omission.

Technological change affects the potential scale and scope of firms. Technologies that increase management efficiency (or reduce what Alchian and Demsetz call metering costs) will tend to increase firm size. Technologies that reduce the costs of spatial separation will also tend to increase firm size. Of course as Coase notes, some technologies reduce both the costs of using the market and the operation of the firm. In these cases, there will usually be a net advantage in one direction or the other.

Coase’s work was seminal but incomplete. He kicked the profession out of its torpor regarding the means of organizing production, founded the school of transactions cost economics (populated primarily by Oliver Williamson and acolytes), and stimulated a number of other leading economists to look more closely at the nature and role of the firm.

In our next session we’ll see that Alchian and Demsetz disputed Coase’s emphasis on the contrast between hierarchy and the price system or at least tempered it by emphasizing the importance of team-based cooperation as a rationale for establishing firms. The emphasis by Alchian and Demsetz on facilitating cooperation is broadly consistent with the stress placed on leadership by many executives and consultants.

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