The Information and Services Economy a.k.a. Business Architecture and Services Science

1. The Information and Services Economya.k.a.Business Architecture and Services Science IS210, Week 3 Profs Bob Glushko & Anno Saxenian UC Berkeley School of Information Fall 2006

2. The view from the 1960s: fun facts • All but two of the world’s largest companies based in US • US cos. produced 50% of world output • US cos. produced more manufactured output than next 9 industrial nations collectively • General Motors earned as much in profits as ten biggest cos. from France, UK, Germany combined (30 cos. total)

3. Theoretical foundations: the classics • Economics: Organize in firm v. market • Adam Smith • Ronald Coase • Oliver Williamson • Production: How to maximize output • Karl Marx • Henry Ford • Frederick Taylor • Alfred Chandler

4. Adam Smith & the wealth of nations • An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 • The magnum opus of Scottish economist, Adam Smith • The founding work of “modern” economics and political economy • Written on the eve of industrial revolution in Britain • Smith’s main theoretical contributions: • the specialized “division of labor” • the “invisible hand” of self-interest/ the market

5. Smith on the division of labor • Book 1, Chapter 1:“Of the division of labour” • “The greatest improvement in the productive powers of labour…seem to have been the effects of the division of labour.” • The division of labor in pin manufacture • Pin making can be divided into some18 distinct operations • If tasks performed by ten individuals, can make over 48,000 pins/day • If tasks all performed by the same individual, might only make 20

6. Sources of productivity growth • Division of labor at two scales • Specialization of tasks within the firm (e.g. pins) • Separation of tasks between firms/industries in the economy (e.g. philosophers) • Sources of productivity growth • Increased dexterity when working on single task • Time savings due to passing from one sort of work to another • Machinery that increases individual productivity

7. . . . the extent of the market • Book 1, chapter 3: “That the division of labor is limited by the extent of the market” • The greater the demand that a firm, industry, or economy faces, the more that firm, industry, or economy can deepen the division of labor. • The more specialized the division of labor, the greater the productive powers of workers • In a well-governed society, with division of labor and multiplication of the productive arts, we find “universal opulence that extends itself to the lowest ranks of the people”

8. Smith and the “invisible hand” • Book 1, chapter 2: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.” • Individuals/households acting solely in their own self-interest generate collective good/ general interest • The proper functioning of the free market, even though it appears chaotic, maximizes economic benefit overall • Book 4, chapter 2.”... by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

9. Ronald Coase “The nature of the firm” • Coase’s question: Why is there any economic organization? Why is economic activity organized into firms rather than by individual proprietors? • D. H. Roberston: We find “islands of conscious power in this ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk” • For mainstream economists, prices and markets are exclusive mechanisms for allocating resources and coordinating economic activity • When do organizations/ firms supercede the price mechanism, eliminate market, and allow “entrepreneur” to coordinate economic activity

10. The costs of using the price mechanism • The cost of discovering the relevant prices (imperfect information) • The cost of negotiating and concluding contracts for each exchange • Firm will expand until costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm.

11. Why isn’t all production in one big firm? • Decreasing returns to “entrepreneur” (managerial) function: rising costs to organizing transactions within firm • As transactions organized internally, misallocation of resources raises costs • Rising “supply price” of factors of production • “Diminishing returns to management”

12. Ronald Coase ”The nature of the firm” Firm will expand until costs of organizing an extra transaction within the firm becomes equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm. Why? There are costs associated with using the market • Cost of discovering prices (imperfect information) • Costs of negotiating and concluding contracts for each transaction

13. Theory of the firm: Oliver Williamson Markets and Hierarchies: Analysis and Antitrust Implications (1975) The Economic Institutions of Capitalism (1985) • Develops insight from Coase that firm boundaries can be explained by efficiency considerations • Identifies more precisely the nature and sources of transaction costs in differing circumstances • Focus on role of firm boundaries in providing incentives (less than coordination problems)

14. Transaction cost economics • Williamson identifies key dimensions of individual transactions and maps every transaction to a most efficient institutional arrangement (market or firm) • Assumptions • In the beginning there were (efficient) markets • Bounded rationality: human behavior intentionally rational but only limitedly (Simon) • Opportunism: “self-interest seeking with guile” (economic agents use strategic behavior to gain self-interest)

15. Opportunism: the “hold-up problem” Classic version: Klein, Crawford, Alchian (1978) One party makes a relation-specific investment to transact with another (value is lower, or zero, to other uses than transaction between those parties) Impossible to draw a complete contract that will cover all possible issues that might arise in transaction – might affect returns on investment • e.g. Very expensive dies used to shape steel into specific forms needed for sections of body of a particular car model, paid for and owned by supplier Supplier vulnerable to hold-up; the efficient solution is vertical integration

16. Williamson’s conditions BOUNDED RATIONALITY UNCERTAINTY/COMPLEXITY INFORMATION IMPACTEDNESS OPPORTUNISM SMALL NUMBERS ADVANTAGES OF INTERNAL ORGANIZATION IN RELN TO MARKETS

17. Later developments, Williamson Three crucial transaction characteristics • Frequency • Uncertainty • Asset specificity (foregone benefits of discontinuing relationship) Higher levels of uncertainty, higher degrees of asset specificity (esp in combination) result in complex contracting relationship with need for ongoing adjustments. Better resolved within firm than market (easier to resolve disputes)

18. Firm and hierarchy Advantage of firm for Williamson: Hierarchical relationships in which one party has control over both sides of the transaction and power to resolve disputes. A Hobbesian solution to opportunism: Market for Williamson is like Hobbes’s state of nature, and only possible resolution is through internalization of transactions within hierarchical structure Hierarchy: originally, rule by priesthood, heavenly beings; today, rule by single ruler with control over organization, authority passed through a series of subordinate rules, and so on through a pyramid.

19. Challenges to transactions cost model • Overlooks extent to which economic or “market” relations are intertwined in social relationships, both within and between firms and at all levels • Vastly overstates efficacy of “fiat” within organizations (internal conflict, cheating, etc.) • Observation of multiple forms of firms, not pure market or hierarchy: hybrids, LT subcontracting • Alternative models exist even in same industries e.g. Japanese v. U.S. auto industries • Depends upon relatively stable environments