Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Class 2 Notes: Alchian and Demsetz on Production, Information Costs, and Economic Organization

Recall from the previous class that organization begins with people specializing; first functionally and occupationally, later by organizing cooperatively around elements of work (e.g. pin making steps) and adopting more complex production functions. Trade emerges to coordinate specialists and leads to a price system or market. Transactions can be performed through the market, e.g. the putting out system, or through hierarchy within firms. There are costs to using the market or price system. Coase argued that firms emerge when hierarchy is more efficient than market transactions. In Coase’s model firm scale and scope limits on firms are determined by diminishing returns to management, the costs of organizing, the incidence of mistakes, and the nature of the markets for factors of production.

Objectives: To build on Coase’s notion of the firm through Alchian and Demsetz’ perspective and to take a closer look at the incentives to form firms. We will set the stage for discussing incentives by defining types of firms in light of the intensity of managers’ stakes in their firm’s results. We will touch, all too briefly, on Demsetz’ extension of the ideas contained in the earlier article he co-authored with Alchian. Then we’ll move on to examine George Stigler’s extension of Adam Smith’s theorem about the division of labor depending upon the size of the market to explain the division of labor within and across firms in terms of the shapes of production functions and their relationship to the size of the market. This provides a basis to explore the relationship(s) between the degree of sustainable vertical integration, the practice of outsourcing, and the emergence of new firms in decreasing cost industries. We will extend these principles to explain in part the emergence of clusters.

Increased efficiency Greater potential rewards

Cooperative, team-based production

Monitoring and metering Difficult to determine individual Familiarity with workers output Incentive system design Asymmetric information Contract design Agency costs Potential for shirking

Free rider problem

1 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Alchian and Demsetz and the Importance of Cooperation as an Explanation of Firms

Adam Smith emphasized the productivity enhancing power of specialization and the importance of exchange or trade to realizing its benefits. Dennis Robertson had observed that we find “islands of conscious power in the ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk.” Coase attributed the emergence and dominance of the firm to lower transactions costs within firms due the application of authority and hierarchy. In fact, the great majority of transactions in a market economy occur within firms rather than across firms or individual producers using the price system. Coase pulled economists away from the “black box” or production function conception of the firm and prompted them, eventually, to think more deeply about what firms were and how they functioned.

In 1972, Armen Alchian and Harold Demsetz published a very important paper, “Production, Information Costs and Economic Organization,” that extended both our understanding of how firms emerge and connected that understanding to how firms manage their internal transactions and relationships.1 Alchian and Demsetz expanded upon Coase’s narrow transactions cost explanation and focused on the firm’s role in managing cooperative teams in light of information costs and the consequent need for a central contracting authority.

“…Resource owners increase productivity through cooperative specialization and this leads to the demand for economic organizations which facilitate cooperation…”2

Where Coase implicitly assumed that market or firm production differed only with respect to transactions costs, Alchian and Demsetz noted that firms made a different sort of production possible. Cooperative, team-based production could be much more efficient than separable, additive market-based production. The firm still has transactions costs, especially for gathering and using information, but the key ones are directed to monitoring and measuring the performance of cooperating resources. On that foundation Alchian and Demsetz developed a systematic picture of the firm’s internal workings; how the role of managers emerged from the need to meter teams, how managers’ incentives to be productive are driven by sharing the residual created by the teams under their direction, and how the intensity of the connection between residual sharing and managerial effort helps to define types of firms.

Like Smith, Coase, and Stigler before them, Alchian and Demsetz recognized the importance of specialization in increasing wealth but they defined the problems facing a theory of economic organization a little differently. In their view the theory had two charges:

1 Armen Alchian, Harold Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review, 1972, Vol. 66, pp 777-95 2 Ibid, page 777 32 Ibid, page 777 4 Alchian and Demsetz, op cit, p778 5 See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76. Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it 2 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

… to explain the conditions that determine whether the gains from specialization and cooperative behavior can better be obtained within an organization like the firm, or across markets, and to explain the structure of the organization.3

Alchian and Demsetz offer a bit of a riposte to Coase’s emphasis on the relative power of hierarchy over markets by arguing that the firm really has no more authority or capacity to discipline resources than does the market. The firm does not own all of its inputs and has access to no disciplinary action more powerful than that between contracting parties in the market. Where Coase suggested that firms arose to perform those transactions that, due to the costs of using the market, could be conducted more efficiently within a firm; Alchian and Demsetz asserted that the fundamental rationale for firms was their superior capacity to foster cooperation among specialists. In their model the firm is the “centralized contractual agent in a team productive process.” 4

I. The Metering Problem Economic efficiency requires paying resources on the basis of their productivity (e.g. payments equal to value marginal product). This is relatively easy in competitive market transactions because the supply of the last unit will be priced at its marginal cost. This condition is harder to achieve within firms, especially when joint, team, or cooperative production methods are used and thus requires internal metering and information. The degree of productivity is directly related to the efficacy of metering. The roots of what Nicholas Kaldor (1908-1986) called “supervisory” management and the identification of its contribution are in the metering problem.5

II. Team Production Alchian and Demsetz identified the jointness of team or cooperative work that was inherently suited to being performed within a firm as the critical characteristic of a firm.

3 Ibid, page 777 4 Alchian and Demsetz, op cit, p778 5 See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76. Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it was the latter which was fixed for the individual firm and hence the basis for ultimately diminishing returns to other resources. Kaldor built on Austin Robinson’s The Structure of Competitive Industry, and, like Coase, rejected Frank H. Knight’s notion of control resting with those who bear the ultimate risks (perhaps uncertainty would be the more accurate term here). Kaldor defined and explained the firm in terms that seem to anticipate the central contracting agent of Alchian and Demsetz and their emphasis on the residual value as a basis of management compensation, “…for theoretical purposes the most satisfactory definition of a firm is that of a ‘productive combination possessing a given unit of co-ordinating ability” which marks it off from ‘productive combinations’ (such as an industry) not possessing this distinguishing peculiarity. It is the one factor which in the long run is ‘rigidly attached to the firm’ which, so to speak, lives and dies with it; whose remuneration, therefore is always price-determined.” When he wrote this article, Kaldor was still in his neoclassical phase and had not moved on to his later emphasis on macroeconomic issues and the development of Keynesian models. Kaldor was very dismissive of monetarism and is famous for criticizing Milton Friedman’s analogy of increasing the money supply by dropping money from a helicopter (a theme later picked up by Ben Bernanke) and went so far as to discuss the different consequences should the helicopters release their manna over poor or rich parts of London.

3 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

In other words, the firm with its central contractor makes possible a more efficient type of production, a type that would be very difficult, if not impossible, to achieve working through the price system or market. Their notion of the firm as a vehicle for promoting cooperation through centralized contracting is significantly different than the classical view of the firm as a set of production functions but is perhaps not really so far from Coase’s notion of firms serving to economize on transactions costs. Today, transactions costs are often defined broadly to include information, search, contracting, and other similar costs associated with exchanges but not directly embodied in the product or service being exchanged.

Contracting (explicit or implicit) is the primary means of organizing sustained cooperative effort among people, either inside of outside of a firm. Take a moment and think about the “contract” as a device for cooperation and its relationship to property and property rights. There can be no free or voluntary contracting between people without property rights. Exercising our property rights to our own labor or other resources usually involves transactions costs. The person or firm contracting for our services also incurs transactions costs. These notions are central to the notion advanced by Jensen and Meckling that a firm is a “nexus of contracts.”6

The concepts of a team and team-based production are central to the Alchian and Demsetz model. Teams are a form of cooperative effort that may yield substantial economic gains but involve significant contracting and monitoring efforts. The value of contributions from individual resources in team-based production functions cannot be measured readily because the activity involves joint efforts of team members. Such joint effort may involve the simultaneous effort by team members (e.g.. cooperatively lifting a heavy box) or the use of a shared resource (e.g. shared access to a power supply or an assembly line) by team members. A team-based activity as a whole may be separated from others conducted by the firm in the same way as those discussed by Stigler (whose explanation of firm specialization and integration are discussed below).7

Jointness is a frequently encountered phenomenon in economics. Most students (at least those who took the prerequisite) are familiar with the problem of pricing joint outputs such as beef and hides that result from raising cattle. You may recall that despite the most ingenious, if logically strained, efforts of accountants to allocate joint inputs and their costs to the two outputs: it is impossible to determine separable production or cost functions for the two outputs: one cow, one carcass, and one hide.

6 Jensen, Michael C and William Meckling, 1976, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. 7 The concepts of production functions and production cost functions are essential to understanding how business firms allocate their resources and make choices about how to produce output given different technologies and factor prices. An accessible review of the production and cost functions by S.K. Mishra, “A Brief History of Production Functions” Working Paper for the Social Science Research Network is available free at http://www.scribd.com/doc/417083/A-Brief-History-of-Production- Functions#fullscreen:on

4 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Jointness arises also with inputs in production functions involving cooperative labor and resources. As Frank Knight observed, “In reality, of course, production is joint, almost without exception.”8 To illustrate joint production Alchian and Demsetz use the example of two men carrying a heavy box that neither alone could lift. We can measure how much the team lifts, but we really can’t say easily how much each team member lifts. This problem of non-separability of joint inputs has bedeviled economists for over a century but as Knight stated, “… it is inappropriate for economists to argue as to whether the separation of contributions to a joint product can or cannot be made; it is made; it is our business to explain the mechanism by which it is accomplished.”9 Alchian and Demsetz offer a solution to Knight’s problem.

The team-based box-carrying production function is a very different function than the separable one-man box-carrying models with which it competes. One-man models would, for example, likely require a redesign of the box packaging to make it smaller and lighter or involve breaking the contents into smaller quantities, increasing packaging costs, tracking costs, assembly costs, etc. The two-man box carrying production function will be chosen when its increase in efficiency over the one-man methods is sufficient to compensate the common resource and metering costs. In this simple case common or shared resource is the management activity that can direct the cooperative behavior. In other words there are three resources involved: two labor resources, and one management resource. The latter is justified by its contribution to the efficiency of the former two.10,11

The shared application of physical capital is probably the most important example of cooperative or joint output. When once relatively independently operating textile workers came together to work within mills and to share power sources, it quickly became evident that they could be managed more efficiently as a firm, i.e. through a central contracting agent. More efficient investments in capital assets were possible when a central contracting entity could plan for the full resource base and optimize inputs. This led to changes in the size and capacity of equipment and increased specialization among the workers. In almost all cases, the central contracting entity was the owner of the capital assets used jointly by the workers and other resources.

Team or cooperative production is characterized by three factors: 1. Several types of resources are used

8 Frank H. Knight, 1921, Risk Uncertainty and Profit, originally published by University of Chicago Press, quotes here are from the Kindle edition by Cosimo Classics, 2005 location 1175 of 4511. 9 Ibid, location 1270 of 4511 10 The workers do not have to be employees to work cooperatively or share a resource. For example, some independent cab drivers jointly operate or support a central dispatcher to provide efficient routing. 11 A team production function e.g. z = f (x,y) is described mathematically by the second cross partial derivatives of the function with respect to the variables: ∂f2/∂x∂y ≠ 0. For example If the production 3 2 3 2 2 3 function is z = f(x,y) = x + x y -2y then fx = 3x + 2xy , 2 3 2 3 2 and fxfy =∂/∂y (3x + 2xy ) = 6xy . But, if the production function is z = f(x,y) = x – 2y 2 2 Then fx = 3x and fxfy = ∂/∂y (3x ) = 0. In general at least one term of the production function’s has to contain a product of the variables – an indication of “jointness” and hence a team function.

5 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

2. The product is not the sum of separable outputs of each resource12 3. Not all of the resources belong to one person

Jensen and Meckling point out that the Alchian and Demsetz over-emphasize the role of technical jointness and that their argument holds where agency costs and multiple contracts are involved.

“Alchian and Demsetz (1972) object to the notion that activities within the firm are governed by authority, and correctly emphasize the role of contracts as a vehicle for voluntary exchange. They emphasize the role of monitoring in situations in which there is joint input or team production. We are sympathetic with the importance they attach to monitoring, but we believe the emphasis that Alchian and Demsetz place on joint input production is too narrow and therefore misleading. Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on. The problem of agency costs and monitoring exists for all of these contracts, independent of whether there is joint production in their sense; i.e., joint production can explain only a small fraction of the behavior of individuals associated with a firm.”

Jensen and Meckling’s insight is a valuable qualification to the original Alchian and Demsetz argument and was largely adopted by Demsetz in his follow-up article discussed below. Technical jointness is not necessary for a divergence between principal and agent objectives and for asymmetric information to emerge. Nothing is lost by thinking of team production in lieu of technically joint production.

The Insidious Temptation to Shirk

Alas, team members are human and some are inclined to exploit the difficulty of determining individual contributions in a joint or team production setting. The incentive to shirk (shirking is a form of moral hazard and similar to the free rider problem) is inversely related to the costs of detection and directly related to the value that the shirker places on his relief from effort. Recall that we emphasized that people seek to maximize their self-interest as reflected in their utility function. People will shirk and gain leisure when the value they place on it is less than the costs they expect to pay.

Economists note that each team member possesses asymmetric information; each knows how much he is shirking but it is difficult for others to be sure.13 The shirker gains all of the benefit arising from his indolence but pays only a share of the lost value. Team

12 Michael C. Jensen and William H. Meckling, Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. Reprinted in Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims and Organizational Forms, Harvard University Press, December 2000 available at http://hupress.harvard.edu/catalog/JENTHF.html Also published in Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998. 13 Even in the two-man box carry, one worker may suspect the other is shirking but unless they have worked together for some time, cannot really distinguish shirking from less strength or capability.

6 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, production makes it more difficult to detect shirking. A team member has therefore more incentive to shirk than the same person working in a non-cooperative or independent fashion where shirking is much easier to detect and the entire costs are more likely to fall on the shirker. Note that where (literal) teams are involved in producing an outcome as in sports, there are tremendous, almost obsessive, attempts to quantify contributions.14 A slightly lesser urge holds for business and is often the basis of incentive schemes. We will discuss the process of aligning effort, measuring and rewarding contribution when we cover compensation system design.

Managing teams (or any complex cooperative activity) calls for specialized monitoring skills and techniques. Since a team joint production function is not separable into the marginal value products of individual resources, it is impossible to measure the precise marginal value product of each member individually. Because of its jointness, we can’t divine exactly the individual contribution of each man lifting the box and there is thus an incentive for team members to shirk. Shirkers diminish the overall productivity of the team and hence its rewards but they incur only a share of the lost income. So, the shirk- inclined (aka lazy !#$%^&*) will relax up to the point where they perceive that the incremental expected utility they gain from additional leisure is equal to their share of the forgone team compensation.

14 Bill James, an economics major at the University of Kansas, was largely responsible for the founding of sabermetrics, the statistical analysis of baseball player performance and potential that has transformed baseball team management. His concepts have since spread to other major sports. James’ early adopter, Billy Beane, GM of the Oakland Athletics, was the subject of Michael Lewis’ book Moneyball which can be read profitably as a guide to information-based management in general.

7 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

III. The Classical Firm

The principal (often but not always the owner) is the centralized contractual agent that makes team production possible and efficient. He is a common party to the contracts of

! all of the agents and thus able to coordinate their efforts. He is rewarded in the form of residual (net) returns available after the Residual! agents (usually but not always employees) have been compensated. His role and objective is to manage the actions of !

$!!!Price!and! Cost the agents in a way that produces enough income net of other costs (the residual) to compensate the agents, pay for shared Team!!!Output! ! resources, and leave enough to compensate the principal.

Quid custodiet ipsos custodes?15 His stake in the residual is what keeps the principal or manager stimulated to perform and to resist shirking. Of course, as we’ll discuss more deeply later, the manager is human and will engage in shirking or the pursuit of other values up to point where the costs that he incurs will be just offset by the satisfaction or utility that he gains.

Centralized contracting is a distinguishing characteristic of firms and makes internal resource redeployment and utilization easier.16 Suppose our two box-carriers did not work for the firm. A principal could contract in the spot labor market with A (the man on the right) and then either the principal or A could in turn contract with B (the guy on the left). This form of spot labor market operates in the casual labor exchanges that are found in every city at locations where groups of men looking for work congregate and are 17 informally hired by employers for daily or hourly tasks. This ! arrangement could work well for the instant problem of moving the box. But, if there is a lull in the need for box moving, it might involve another round of contracting to redeploy A and B to, say, replacing evil, planet-destroying, soon-to-be-illegal incandescent light bulbs with energy-efficient LEDs.

15 Who shall watch the watchers? The phrase is attributed to the Roman poet Juvenal and the object variously translated as watchers, guards, or watchmen. It is the perennial problem of any hierarchical system and a major problem in corporate governance when, for example, directors are appointed by crony executives with whom they empathize more than they do with the shareholders. 16 Centralized here means that all contracts are with the firm. Such contracts may be made at different points within the firm. 17 Not all spot casual labor markets operate out of centralized locations; in some cases the spot market moves to the work site. Trucks are often loaded in the wee hours by casual laborers who line up outside the loading docks in the early morning to get a place. Since demand varies, the earlier the arrival the higher the chance of being selected for that morning’s shift. This leads to a certain amount of gaming and strategizing over the best arrival time. Unfortunately, the first few spots are not particularly desirable because the more thuggish members of the casual labor community like to arrive late and beat up or intimidate the first several workers into relinquishing their places. During my brief career in the causal labor sector I found that spots eight through fifteen were usually a good hedge against injury while preserving a high probability of selection.

8 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Another advantage of centralized contracting is the accumulation of knowledge by the principal. Over time, the principal acquires knowledge by observing A and B that he can apply to improve process design, hiring, or other aspects of the business. Experience is an important management and entrepreneurial characteristic. The broader the experience and knowledge about aspects of the business that a manager or entrepreneur has the more likely he or she is to be effective.18

Team production will be used when it yields a level of output sufficiently greater than the best alternative separable production function to cover the extra costs of monitoring and disciplining team members. Alchian and Demsetz summarize their model as:

“The essence of the classical firm is identified here as a contractual structure with: 1) joint input production; 2) several input owners; 3) one party who is common to all the contracts of the joint in- puts; 4) who has rights to renegotiate any input's contract independently of contracts with other input owners; 5) who holds the residual claim; and 6) who has the right to sell his central contractual residual status. The central agent is called the firm's owner and the employer.”19

The scale of the firm is limited in the Alchian and Demsetz model in a manner consistent with Coase but more richly drawn than simple internal transaction cost overload or diminishing returns to management.

• The greater the interdependencies among functions of the firm, and the needs for specialized knowledge to manage those interdependencies, the more important is centralized contracting.

• The larger a firm and the more different bodies of knowledge it must master to manage interdependencies, the more difficult and expensive it becomes to perform efficiently.20

Based in part on the thoughts of Alchian and Demsetz, economists have studied closely the nature and behavior of teams. For example, Jacob Marschak and Roy Radner took the concept of teams as introduced by Alchian and Demsetz to a much deeper level and addressed the questions of optimal decision-making rules for teams under various states of the world, range of actions, quality of information and other factors.21 There is also a

18 See Edward P. Lazear, 2005, “Entrepreneurship,” Journal of Labor Economics, October 2005, pp. 249- 280 for an explanation of the entrepreneurial value of broad know-how and experience and the characteristics shared with senior managers. 19 Op. cit. p 794 20 Harold Demsetz, The Economics of the Business Firm: Seven Critical Commentaries, 2d commentary, “Agency and Nonagency Explanations of the Firm’s Organization,” p 34. Demsetz builds on and clarifies some of the points made in the original article with Alchian 21 Jacob Marschak and Roy Radner, Economic Theory of Teams, Cowles Foundation for Research in Economics at Yale University, Yale University Press, 1972 (out of print but available from UMI Out-of- Print Books on Demand). This book is comprehensive and rigorous but nearly inaccessible to a non- specialist.

9 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, popular management literature that celebrates the benefits of collaboration including the magnification of individual intellects and efforts through teams without unduly burdening the reader with either economic theory or evidence.22 The popular team literature usually ignores or minimizes the shirking problem and often paints an unrealistic picture of enthusiastic collaborators. Those happy cases exist of course but many internal teams impose additional costs and strains on participants many of whom perceive that their individual expected rewards are meager but the costs significant.

Shirking is everwhere. The graduate project teams assembled for this course experience serious shirking problems in 10-20 percent of the cases. In some, thankfully few, cases student shirking takes the form of plagiarism. At a higher level of scholarship, a disturbing number of published journal articles are retracted due to falsification of data. A recent study that attempted to replicate published data found that about 75 percent of psychology studies (64 percent in the top journals) could not be replicated. Not all of these cases involve shirking or dishonest reporting but a strong case can be made that the journals’ incentive to publish striking new findings has reduced their metering efforts.23

IV Types of Firms

As noted above, Alchian and Demsetz find that managers’ compensation is linked to their contribution to the firm’s overall residual value or the residual value that the managers create. The intensity of that linkage can be used to characterize different sorts of firms.

Profit sharing firms are generally found in small team size settings where self-policing may be less costly than investing in specialized metering resources. Profit sharing (like partnership) is frequently effective with small teams of difficult-to-monitor specialists such as artists, lawyers, consultants, architects, etc. Larger firms often find that profit sharing dilutes the central manager’s disincentives to shirk and may in fact cause overall productivity to decline. The optimal size of the team under equal profit sharing schemes is directly related to the incentives to shirk. The less precisely individual reward is aligned with contribution, the less the incentive to perform efficiently.

Socialist firms are often marked by broad sharing of residual value (if any), which of course reduces its value as an incentive to efficient management or as a deterrent to shirking. For this reason, other disciplinary means such as workers committees must be used to keep the managers engaged. Some of these may involve quantitative output objectives while others may involve worker or agent evaluations. Agent evaluation of

22 Perhaps the most prominent is Jon R. Katzenbach and Douglas K. Smith, The Wisdom of Teams: Creating the High Performance Organization, 2003, Harper Paperbacks. Like most management books it treats teams for the most part as ad hoc, problem solving units rather than a fundamental means of cooperative production. The central metering and disciplinary role of the manager, central to the economic team concept is not stressed, in fact leadership in Katzenbach and Smith’s teams need not come from the senior manager in the group. A key word search for a selected group of academic experts and scholars on the subject of teams turns up 0 hits in the book. 23 See for example http://www.theguardian.com/science/2015/aug/27/study-delivers-bleak-verdict-on- validity-of-psychology-experiment-results

10 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, principals is problematical.24 Since workers place value on leisure (shirking) they likely consider the manager’s tolerance of shirking as well as other issues. The manager’s pursuit of “from each according to his ability” may not rank high on the list of socialist workers’ concerns.

Corporations typically raise capital by selling promises of future payment to relatively large groups of people who collectively own the firm. Although, the shareholders have claims on the residual value produced by the firm, it is too costly for most individual shareholders to invest the time and effort to be effective overseers of the firm and so they delegate that role to a board of directors. Given the difficulty of effective individual shareholder oversight of management shirking and the ease by which a shareholder can simply sell and eliminate his exposure, Alchian and Demsetz (and many economists) suggest it is perhaps better to view shareholders as investors rather than owners.25

Mutual companies and nonprofits. The ability to sell shares, which capitalize expected future earnings, provides a market-based evaluation of corporations. Mutual companies and non-profits do not expose themselves to this sort of scrutiny and hence we expect to find higher levels of shirking among their executives relative to their corporate counterparts. The heads of many large non-profits receive compensation that approaches that of corporate officers based on the argument that their organizations are of comparable scale. This amounts often to rewarding people for inputs rather than outputs. It is remarkable how many charity and foundation trustees buy this argument and seem oblivious to the managerial behavior it promotes.

Partnerships are a frequently preferred organization for team based artistic and intellectual productions. Partnerships are closer to market-organized rather than principal- agent contracts. Partnerships are usually self-policing (there is no manager between the partners) and frequently organized among relatives or friends in part because they are familiar with the others’ tendency to shirk.

24 The use of student evaluations of professors and instructors is a case where principal behavior may be unduly influenced by agent “feed-back.” It is often difficult to distinguish the disgruntled from the insightful and candid. Anonymity makes detection of the agent almost impossible and thus reduces the cost in terms of anxiety over retribution for criticism and leads to more than would be the case if the critic was identified. 25 Aggressive professional stockholders, sometimes referred to as corporate raiders, were an important but misunderstood force for good corporate management. People like Irwin Jacobs, Carl Icahn, and T. Boone Pickens (before his gas crusading days) identified untapped shareholder value in many companies and worked to get management to realize it. The leveraged buyout (LBO) phenomenon of that emerged in the 1980s was epitomized by Kohlberg, Kravis and Roberts (KKR) who specialized in buying, rehabilitating, and selling companies that had failed to aggressively pursue profits in favor of size or revenues. The late, over-rated management guru Peter Drucker objected to corporate raiders as short-term focused strippers of value and blamed the acquisition of large stockholding by pension funds for making takeovers easier. This is not Drucker’s only erroneous criticism of free market economics. In contrast, scholars such as Amar Bhide examined a large number of contested tender offers and found them to be “capitalism at its best.” Unfortunately, many states enacted legislation making it easier for shirking executives and boards to defend their sinecures. Fortunately, some private equity funds and some hedge funds continue the good work of shaking up management.

11 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Employee unions are not firms but do serve as a monitoring service for members to reduce management shirking and management of retirement and insurance funds. In some cases unions perform transaction management functions for insurance and pension plans and then are subject to shirking and self-interested behavior. This accounts in part for the government regulation of union activities.

V. Team Spirit and Loyalty

Some institutions such as the military and sports teams exhibit a great deal of team spirit and believe that it is nearly as important as pecuniary incentives. Managers and executives have long tried to improve cooperation by fostering an identity with the firm. Chester Barnard, an influential and pioneering management thinker, felt that:

“The most important single contribution required of the executive, certainly the most universal qualification, is loyalty, domination by the organization personality.”26

This notion of “domination by the organization personality” has always struck us as creepy. Unfortunately, institutions from corporations to colleges do seek to manufacture, instill, and enforce a notion of shared goals and objective. Apparently the selection value or fitness of uniformity outweighs, or is believed to outweigh, the benefits of diverse personalities. But wait, the same organizations that seek to inculcate a shared sense of values and culture will often proclaim also their devotion to diverse opinion and perspective. Go figure.

Firms often reveal their assessment of employee intelligence by attempting to decrease shirking by promoting codes of conduct and a team- building ethos. These efforts are often supported by a lot of inane industrial poster art encouraging teamwork and shared values.27 As we’ll see later, incentive systems often also work counter to team spirit. Real cultures are evolutionary phenomena that emerge as various behaviors are selected for within the community or corporation (the Marines really do practice what they preach). People know the difference between the real culture and the fantasies promoted by management and consultants. One of the recent buzzwords is “employee

26We have always found this statement off-putting, especially the “domination by the organization personality” part. It seems to suggest a sort of Borg-like suppression of individuality. At best, Barnard may have been awkwardly referring to something akin to corporate culture. See Chester I. Barnard, The Functions of the Executive, originally published in 1938, 30th Anniversary Edition, 1968, Harvard University Press, Cambridge, MA. 27 Despair Incorporated, a firm dedicated to “increasing success by lowering expectations,” has built on the tradition of industrial poster art by creating their “demotivator” series. One of which is shown above. 27 One of my favorites is a full color photo of the great pyramids with the caption, “You can do anything you set your mind to when you have vision, determination, and an endless supply of expendable labor.”

12 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, engagement” which is probably a worthy goal and sometimes a real condition but the material strikes us as largely repackaged pieces of earlier campaigns such as “empowering employees,” “open book management,” etc. 28

VI. Kinds of Inputs Owned by the Firm

Asset ownership tends to reside where the greatest net value can be realized. Employee ownership of productive assets is one way to assert a claim on any residual value produced through their use and to reduce asset abuse (a form of shirking of care and maintenance). Observing physical asset use and care is often expensive. If possible the firm may require individuals to own the physical assets such as tools that they use.

In some cases, such as independent cabs, individuals own their own vehicles and contract for dispatch services and joint maintenance facilities. Most mechanics and many technicians own their own tools and jealously guard them from careless or acquisitive colleagues. Similar divisions of asset ownership and risk taking will be encountered later when we look at risk sharing and crop-sharing models of incentive contracting. In later sessions we look at Oliver Williamson’s argument that the degree of asset specificity is an important factor in deciding which party owns an asset and the Klein, Crawford and Alchian discussion of opportunistic behaviors such as hold-up in the determination of governance.

VII. Firms as Specialized Markets for Collecting, Collating and Selling Input Information

Coase saw the firm as a substitute for the market writ large – the price system. But the firm can also be thought of as a surrogate market. Familiarity breeds knowledge of internal resources.29 Resources compete within firms for rewards. Superior combinations of inputs can often be more economically identified and joined with resources already inside the firm rather than outside. Efficient production with heterogeneous resources is not always having better resources but in knowing better the productivity of the resources and having the capacity to adjust payments accordingly.

Alchian and Demsetz close with a provocative thought on the relationship between firms and markets. Rather than a replacement for the market and means of suppressing the prices as Coase proposed, could it be better to think of the firm as a form of market that competes with other forms?

“Conceiving competition as the revelation and exchange of information about qualities, potential uses of different inputs…the firm is a device for

28 A brief overview of open book management is at http://www.economist.com/node/13809344 29 Employers are often willing to live with a moderately sub-par employee – the devil they know – rather than invest the time and search costs in finding a another employee of uncertain quality – the devil they don’t know.

13 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

enhancing competition among sets of input resources…In contrast to markets and cities which can be viewed as publicly or non-owned markets, the firm can be viewed as a privately owned market… could consider the firm and ordinary market as competing types of markets…Could it be that the market suffers from the defects of communal property rights in organizing and influencing uses of valuable resources?”

In a similar vein, Bengt Holmstrom, an economist at MIT, has suggested that the firm is a subeconomy. Holmstrom notes that employees rarely own significant physical capital and generally supply only human capital and asks why capital asset ownership is almost exclusively within firms. His analysis suggests that the firm can be viewed as a sort of island economy and that owning physical assets conveys the right to determine the rules of the game on the island.30

*********

30 Bengt Holmstrom, “The Firm as a Subeconomy,” Journal of Law, Economics, and Organization, Vol. 15, (1999) no.1

14 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Harold Demsetz, 1988, “The Theory of the Firm Revisited”

About 16 years after collaborating with Alchian on the basis of economic organization, Demsetz returned to the topic and extended their earlier analysis.31 He also developed a more complete critique of transaction cost economics and offered extensive thoughts on the significance and role of information. If time permitted, this article too would be on our reading list but for now we will limit our discussion to the famous phrase he used to define (and to extend) the boundaries of the firm:

“The firm properly viewed is a “nexus” of contracts.”32

Demsetz explored three key questions about the contracts: (1) the persistence of certain types of contracts found in this nexus, (2) the variation observed in other types of contracts that are “more-or-less” included in this nexus, and (3) the (horizontal and vertical) scope of activities covered by these contracts.

Demsetz, though he doesn’t use the jargon, had identified the broader concept we now call an “enterprise” to encompass the firm and its suppliers, and in some cases, its customers. By focusing on contracts and their nexus Demsetz was able to “brush aside the questions of absolutes – “When is a nexus of contracts a firm?” and substitute instead a question of relatives –“When is a nexus of contracts more firm-like?”33Recently, it has become popular to refer to a firm’s ecosystem – the set of firms linked by a common platform or system as with Apple, the iTunes Store, and the thousands of apps in the App Store. Like many biological analogies used in business, the ecosystem concept is suggestive of food chains and host-parasite relationships but is often handled sloppily.

The adoption of a contract-based definition of the firm is useful because it (a) allows us to envision the spectrum of both inter- and intra- organizational arrangements and to understand better their origin and structure, (b) provides a basis for estimating the value of components of the firm as the asset-equivalent of the contract, and (c) assess the relative contribution to firm value and provide management a means of focusing their information gathering and processing efforts.

********

31 See Harold Demsetz, “The Theory of the Firm Revisited,” Journal of Law and Economics, Spring 1988, pp.141-183. 32 Ibid, p 176 We have quoted the Demsetz’ formulation through which we became familiar with the “nexus” concept which was likely derived from an earlier paper by Jensen and Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. On page 8 J&M state, after referring to Alchian and Demsetz’ emphasis on contracts and central contracting, “It is important to recognize that most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals.” 33 Demsetz, op cit. p177

15 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

George Stigler’s Life Cycle Theory of Market Scale and Firm Scope

Stigler, the 1982 Nobel Laureate in Economics, adds to our understanding of the emergence and boundaries of firms by pointing out that transactions are sometimes performed within firms before migrating to the market, that the production costs – not just transactions costs – matter, and that the locus of production results from the dynamic interplay of output market size, resource costs, and production function characteristics.

In 1951, George J. Stigler, published one of his many influential papers, “The Division of Labor is Limited by the Extent of the Market.”34 In this article he built on Adam Smith’s original observation and Ronald Coase’s insights into the evolution of the firm and extended the theory to more explicitly address the scope of firms and the organization of industries. Stigler showed that the shape of production cost functions and the level of a firm’s output relative to the size of the market often determined which functions were best performed within an integrated firm and which functions could stand alone and be produced by specialist firms.

Coase explained that firms coagulated from buttermilk to perform those transactions that could be conducted in a hierarchical setting at less cost than through the market or price system. This transaction cost minimizing process could continue until diminishing returns to management set in. Stigler, while accepting diminishing returns to management as a constraint to firm size and scope, expanded the analysis of the boundaries of the firm by looking more closely at the nature of the functions performed inside of the firm. Stigler retained the neoclassical position that firms are essentially a set of production functions but he recognized that there is a logic to what functions can be performed best within the firm and best outside in the market (“outside” may mean being performed by another firm).

The fit between the cost minimizing scale of production for a firm and the extent of the market is a powerful evolutionary force in the life of organizations and their markets especially in the early days of an industry. Stigler built on the fact that most finished products are composed of intermediate products with separate and separable production functions. These intermediate stages and products correspond roughly to the popular notion of a value-added chain.

Stigler asked, “What production processes do firms conduct internally and why?” He found that the shape of production functions relative to the scale of the market explained the economic degree of vertical integration in many cases. Adam Smith’s insight about

34 George J. Stigler, “The Division of Labor is limited by the Extent of the Market”, Journal of Political Economy, Vol. LIX, No. 3 (June 1951); reprinted in George J. Stigler, The Organization of Industry, (1968, Richard D. Irwin, Homewood Illinois) pp129-141

16 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

the division of labor applied to firms as well as workers. As the market gets larger, firms often specialize more.

Stigler’s model is sometimes referred to as an “industry life cycle” theory of the firm. Firms often go through a cycle of early vertical integration, a period of industry and firm growth, and then at some point, a period of sloughing off functions and “outsourcing” as the markets for intermediate goods matures and specialized firms emerge. During an industry’s decline, shrinking markets for intermediate goods may cause the remaining firms to re-acquire the means of producing them. There is thus a dynamic interaction between firms’ scale and degree of vertical integration and their habitat or market environment.

Early U.S. cotton textile mills often built and maintained almost all of their machinery, produced the cloth, and conducted direct marketing activities. As the market expanded, specialists in textile machinery emerged to serve the industry. As the textile industry declined, some of those machinery specialists moved horizontally into other types of machinery such as paper mills, textile equipment for other fabrics, and such things as oil burners and refrigerators. The growth of the market led to the creation of specialized firms to which the previously fully integrated companies looked for intermediate goods or, in today’s terms - “outsourced” those functions.

Stigler’s analysis opened up the classical “black box” model of the firm and peered inside, laying the groundwork for the examination of why firms performed certain tasks and not others. A vertically integrated firm conducts two or more of the steps necessary ! AC! to produce a good or service. The figure illustrates $" ! a vertically integrated firm that conducts internally AC1! three processes: a continuously decreasing cost

Y3! function Y1, a continuously increasing cost P2!

P1! function Y3, and a U-shaped cost function Y2. Assuming that the rates of output for all functions Y2! are fixed relative to one another, we can add up the

PY1! Y1! costs at each output level to determine the integrated firm’s average cost function at each rate 0" Q1! Q2! of output as shown by the heavier curve at the top Output" of the graph.

Now, if the industry grows it may become feasible for a specialized firm to conduct the decreasing cost function Y1 independently and to sell that factor to the other firms, the originally vertically integrated firms will buy the factor Y1 at a price lower than they Previously produced it.

The cost of the “outsourced” resource is shown by the dashed straight line that replaces Y1. By acquiring resource Y1 from an outside supplier our average cost curve is lowered over the relevant range of production. The change in the total average cost curve, also shown as a dashed segment, illustrates the new lower costs of the final output. As the

17 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

market grows, this process can occur over and over if the function Y1 (or for that matter any of the cost functions) is found to have separable decreasing cost components.

In some cases, an otherwise increasing cost function, such as Y3 above, may have separable sub-functions subject to economies of scale and can be produced by specialists when the market grows large enough.

Stigler’s explanation of the Industry Life Cycle sheds a great deal of light on why firms integrate vertically and disintegrate and why vertical integration for “strategic” reasons is so hard to pursue profitably if some functions exhibit decreasing costs beyond the firm’s level of output. The ILC also helps to explain why many firms in small and developing countries that do not have ready access to larger markets are overly vertically integrated and inefficient relative to peers in larger markets. While some politicians prefer to shield such “infant” industries from competition, they are unlikely to achieve the scale or economies of firms able to specialize in various production functions. ! P" Stigler discusses briefly how market ! MC! imperfections either from government- ! T! induced distortions or monopoly power B! are important force for vertical S! integration. He notes the spate of vertical A! integration during and succeeding World MVP! R! War II prompted by price controls and allocations. The regulated price (OA) resulted in output OM which was valued 0" M! N! Q" at OB by buyers who received their allocated inputs on a non-price basis. The combined value to sellers and buyers from a market-clearing price would be the shaded sort-of triangle RST. Vertical integration was one way to obtain the value and circumvent the price control system. Similar incentives to vertically integrate may arise under cartels and monopoly power in one of the pertinent markets.

18 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Division of labor and outsourcing (an aside)

We can synthesize some of the points made by Coase, Alchian and Demsetz, and Stigler to understand better the phenomenon of “outsourcing.” Coase didn’t explicitly state but suggests that transactions are initially performed within markets and later migrate to firms as their ability to economize on transactions costs provides them an advantage. Alchian and Demsetz extended the notion of firm creation by noting that firms facilitated a different, more productive, form of production involving team-based cooperation. Stigler pointed out that a function or process may originate within a firm and later migrate to the market.

“Outsourcing” is reviled by many but it need not lead to loss of employment. In Stigler’s model, the activity moves outside the original firm but not necessarily outside the domestic market. In part this is because the outsourcing company is often founded and staffed by people from the original vertically integrated firms and in part because the increased economic efficiency and lower prices in the sector doing the outsourcing may increase demand in that sector and others. The lower prices that the outsourcing firms can offer by exploiting increasing returns stimulates their growth and attracts more customers. A common error of politicians is to bemoan the shrinking of firms through outsourcing without recognizing the growth of the outsourcers and the gains from increased efficiency and trade.

The clustering of specialized firms producing intermediate goods is partly a result of the division of labor and reflects the fact that many companies in some industries trace their origins to a common ancestor. Some of that division into separate offspring results from specialization in various production cost functions. Clustering is also a function of transportation, inventory, and communication costs. Paul Krugman resuscitated economic geography and location theory by emphasizing the importance of increasing returns in determining the emergence of clusters.

Industrial clusters are, in effect, large local marketplaces for specialized resources. New firms in these areas do not need to be vertically integrated. Industrial clusters (a sort of commercial habitat) are one reason new firms are able to be up and running very fast. Experienced people, specialized equipment, and established distribution channels can be assembled or tapped into quickly. But in some industries, information and communications technology make it possible to assemble teams from widely separated geographies.

In some cases a new firm may find that nearly all of the specialized productive capabilities exist in competitive markets and is able to assemble what is often but misleadingly called a “virtual firm.” 35 Nike is frequently cited as an example of a virtual

35 The notion of a “virtual” firm, while catchy can be misleading. A firm is a real firm if it does something real, as Nike clearly does, the firms that conduct the functions that Nike purchases are also real firms. The appellation virtual for the coordinated production of the firms seems to place an exalted role on Nike’s use of and coordination of other people’s skills and assets - thus avoiding capital investments – something we all do every day. The term may suggest also that it is an inherently better form of organization or a structure

19 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, firm that focuses on product design and marketing while relying on a network of independent contract manufacturers to actually produce the products. In many respects, Nike demonstrates Coase’s point about the firm existing to perform what it can execute more efficiently than the market but in this case the transactions costs of working through the market in many cases is less than internal organization through hierarchy. Nike also exploits the vertical disintegration of production activities described by Stigler. Elements of Nike’s overall production function is apparently additive and separable and it appears that it performs internally only those functions which require close cooperative, joint, or team production as predicted by Alchian and Demsetz. Nike is also a good exemplar of Jensen and Meckling and Demsetz’ later observation that a firm is a “nexus of contracts” and helps us visualize the broader production concept of “enterprise.” Employee welfare activists and unions do not recognize the separation of production functions and seek to hold Nike and other firms responsible for the conduct of their suppliers.

We expect that most of the functions outsourced exhibit decreasing costs per unit over a significant range of output. In other words, at some point, entrepreneurs realize that a particular function could be done more efficiently at a scale beyond that attainable by the vertically integrated firms. This is consistent with the observed popularity of outsourcing administrative and support functions such as human resources; billing and collections, information technology management, etc. Once their central management and related systems are established, these firms can expand output at incremental costs consisting largely of additional specialists.

Firms in rapidly growing industries should be prone to spinning off functions and relying on specialist suppliers. This is consistent with the evolution of the computer and health care sectors. Early computer makers produced internally much of the electronic components in their machine, but now all rely on a worldwide network of specialized chip, drive, and screen makers.36

Of course, another stimulant to outsourcing arises when any of the intermediate cost functions can be produced at a lower cost by another firm either at home or in another country because the costs of inputs, say, labor are lower. Using the increasing cost function Y3 from the graph above as an example, this is equivalent to a downward shift of the Y3 curve and hence the total average cost curve. This is a matter of comparative advantage and not a consequence of Stigler’s notion of the subdivision of functions stimulated by increases in market size.

Economists view outsourcing (even to foreign countries) as a rational competitive response to the relative costs of performing a function. Just as we’ll see that Alchian argued that the evolutionary pressure of positive profits shaped and selected for firms, shedding internal functions isn’t really an entirely discretionary choice dependent on

worth pursuing in its own right, ignoring the underlying economic foundations of firm scope and scale. We prefer the term network manager to describe this sort of distributed operation. 36 Chip makers a la Intel and AMD are specialist firms with modest diversification. In other cases such as screens, the parent may be diversified but the producing entities are specialized.

20 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600, management’s personal preferences as made clear in Jack Welch’s explanation as relayed by Steven Kerr:37

“He (Welch) said let me give you some facts of life. We build washing machines, dryers, refrigerators, and things like that in Louisville, Kentucky. There are very aggressive unions and they get employees high wages. So let us say our employees get $25 an hour in Kentucky. It takes 5 hours of labor to build a box. …We build a box that costs $75. I get the same job done; same quality box in Mexico at $4 an hour that would make the box cost $20. Hence, I am spending $55 more to buy that box. Now, why don't I go to Mexico? Because the public opinion reaction would cost me more than $55 a box. I do not want to move the work to Mexico. Nevertheless, how can I afford not to go? Because Whirlpool and Maytag look at the same costs and they do not go either. It is not worth the bad publicity to them. However, the Japanese and Korean producers are making the box in the lower cost country. Their appliances will be just as good as ours will. They will sell for $55 less. Consumer magazines, who would be yelling if we were going offshore, will now recommend that people buy the Korean machine because it is a lot cheaper and just as good. They are right. Jack Welch would say, "It's not up to us." In other words, you cannot decide not to send jobs to where cheaper labor is unless the society wants to put in protective laws against it so you will be able to do it and still be competitive. However, with the protective laws, there will be fewer imports. You are protecting the employees who are working but now everybody in America is spending much more to buy the same product. … Congratulations, you have now made the cost of going to Mexico higher than the cost of making it in Louisville, and now we will not go. If you are a politician, you can say you saved jobs and tell your constituency you have just increased the cost of the product by $55. Anybody can do that. That is not skillful.”

Stigler pointed out also that protectionists' fears of undeveloped countries leapfrogging developed economies by adopting current technology and methods are probably overblown. The developing country’s educational system may not be able to produce enough employees with the skills necessary to staff complex functions. Developing countries, especially those that are restricted from trading freely with large markets, usually experience difficulty nurturing large vertically integrated firms. Their comparative advantage most often lies in labor-intensive activities, hence the frequent charge of labor exploitation. Without access to larger markets, entrepreneurs will be unable to specialize in the decreasing cost functions in which they might otherwise be competitive. Globalization, especially the spread of tariff-free trading blocs, increases the effective size of markets, reduces the costs of external sourcing, and promotes specialization by both domestic and international organizations.

37 Kenneth R, Thompson, “A conversation with Steven Kerr: a rational approach to understanding and teaching ethics. (Interview),” Journal of Leadership & Organizational Studies, December 22, 2006. Also available on-line at http://www.accessmylibrary.com/coms2/summary_0286-29101977_ITM

21