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.