Economics 103

1. Economics 103 Lecture # 20 Economic Organization

2. The last lecture argued that PR systems were designed to mitigate TC problems. We can think of a spectrum of organizations. Today we’ll start at the left end of the spectrum and work our way over.

3. Why is production organized within a firm? Think of how differently is from In all cases, firms are designed to make the incentives of workers compatible with those of the owners of capital. Depending on what is being made, the firm might end up being complicated or simple.

4. The Family Farm - let’s consider a very simple industry. - at one time virtually everything was organized around the family. - now family production dominates only in farming and procreation. Why is it if you run a cow/calf operation, you do it as a family, but if you grow chickens you’re controlled by

5. The advantage of large scale, factory production, is the gains from specialization. On an assembly line you have to monitor workers. Often this isn’t too hard to do. When will workers be able to cheat/shirk the firm? When nature plays a large role.

6. The problem with farming, compared to other types of production, is it takes place outdoors. Nature plays a large role (good and bad). Thus wage workers can blame low crops on the weather. Which means workers can shirk a lot and get away with it. The result is that farms are owned by single farmers and their families in order to save on the TC of monitoring workers. This is why families still dominate in the Biological stages of farming, but not the other stages.

7. In the late 19th century factory farms, so called “Bonanza Farms” started in the Red River Valley. Some of the largest farms ever. Hailed as the new age of farming. Yet in 20 years they were taken over by -

8. The costs of monitoring farm hands turned out to be enormous. The gains from specialization turned out to be trivial. Why? When does farming become factory like?

9. 1. When you can eliminate the role of nature. These firms are enormous. 2. When the gains from specialization increase.

10. The combine provides an interesting example of how technology can influence TC, and therefore influence the organization of the farm. Before there were combines, grain was cut, bundled, stored, and then separated with a threshing machine.

11. Threshing required huge skills … lots of gains from specialization. As a result, there were “threshing firms”.

12. The Combine, literally “combined” all of these jobs, so that even an academic could run one.

13. Given the better roads, and the increasing size of combines, however, the gains from specialization have increased, and once again, we’re seeing this part of farming being organized by firms. -

14. So farming provides a nice example of the trade-off between transaction costs within a firm and the gains from specialization within. Let’s move from this one type of firm, to one of the most successful firms the world has ever seen.

15. The British Navy Rules • RN was extremely successful during the last 150 years of the Age of Sail.  Many theories why: -- Continental social upheaval -- better morale, diet, weapons, ships, etc. -- none of these fit all of the facts. • A better explanation is that they devised a better system of incentives relative to other navies, especially the French.

16. Why No Navy Should Have Functioned  Nature played a huge role. ¨ -Captains had only general orders: blockade, patrol, escort, engage enemy. ¨ - Ships were at the mercy of the wind. ¨ - Ships were mostly in unchartered waters.  Captains and Admirals had two strong incentives not to fight. -- They were the most likely on board to die in battle.

17. How was Admiral Nelson killed?

18. The second reason was -- They got rich taking valuable merchant vessels that were easy targets.

19. What Was The British Solution?  

20. The British Record  Killed or Wounded: ¨

21.  Ships: ¨ Yet the British had no technical or personnel advantage. What was the organizational solution that solved the major TC problem?

22. What Was the Incentive System? • Captains and Admirals were paid too much. • --pay was mostly in the form of prizes taken in battle. • -- -- given the large potential prize, unemployment was • costly.

23. However, the Prize System in the Navy created an Incompatible Incentive: • Payment by prizes encouraged the taking of easy, non-military, prizes. Hence monitoring was done and involved a strict series of rules. 1. Fighting in a line c

24. 2. The Weather gage The weather gage could reduce your fire power. -

25. 3. Articles of War.   -critical one: must engage the enemy if in the same class … or die. -Byng “an encouragement to all the others”. -ruled out excuses on the weather.

26. How Were Errors Detected? --- Discontinuous Promotion. -- one became a lieutenant through exams. -- once a captain promotion was automatic. --one could be stuck at lieutenant all one’s life. There had to be openings in the Captain’s list for promotion (a necessary condition not a sufficient one). --lieutenant’s job was to watch the captain and keep a separate log. He was the watchdog of the navy, every ship had at least one lieutenant. -- incentives to lie were kept in check by having more than one lieutenant, the master also kept an independent log, and patronage of the captain was important as well for promotion.

27. Evidence  Privateers: -- • Army: -- JPJ.  Steam: --

28. The French • The French were not as dependent on their Navy for national protection, and used their Navy mostly for protection of trade routes  Seemed to have a first-best prior of naval action. • They were biased with strong priors and by the time they extracted the proper signal it was too late.