The Economics of Business

The Economics of Business Class 2 Notes Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

Revisit Class 1 • What are the four foundations of our foundation as found in Adam Smith’s Wealth of Nations? • What is the primary driver of economic wealth? • What is necessary to realize the benefits of specialization? • How are economic and biological systems similar? Outline incomplete without oral presentation

Revisit Class 1… • What distinguishes positive from normative economics? • What characteristic of using markets did Coase suggest stimulated the emergence of firms? • What change in the characteristics of the U.K. textile industry before and after the industrial revolution illustrate Coase’s argument? • What factors, ceteris paribus, tend to increase firm size? • What factors did Coase suggest lead eventually to constraints on the size and scale of firms? • What determines the ultimate limit to firm size, how does this relate to the concepts of variable proportion diminishing marginal returns? Outline incomplete without oral presentation

Alchian and Demsetz, Production, Information Costs, and Economic Organization • Alchian and Demsetz expounded on the importance of cooperation as an explanation of firms • Productivity increases through cooperative, team based production • Demand for organizations to facilitate that cooperation • More detailed picture than Coase, sought to: • Explain the conditions when cooperative specialization benefited from organization or market • Explain the structure of the organization Outline incomplete without oral presentation

Alchian and Demsetz, continued • Argued that Coase overstated power of hierarchy over market • Firms do not own all of their resources • Power to deploy and discipline no greater than through market • Fundamental basis for firms is superior ability to organize cooperative efforts • Cooperative activities (teams) are difficult and costly to meter (manage) • Joint, combined, simultaneous individual efforts • Specialized knowledge and careful observation required to meter joint or team effort Outline incomplete without oral presentation

Alchian and Demsetz • A team production function: z = f(x,y) is described mathematically by non-zero second cross partial derivatives: ∂f2/∂x∂y ≠ 0. • E.g. if z = f(x,y) = x3 + x2y3 -2y2 , then fx = 3x2 + 2xy3, and fxfy =∂/∂y (3x2 + 2xy3) = 6xy2 for all x,y ≠ 0 • But, if z = f(x,y) = x3 – 2y2 then fx = 3x2 , and fxfy = ∂/∂y (3x2) = 0 • Note: This is a little warm-up or warning shot exercise. If you find this incomprehensible your calculus is probably not up to dealing with some future articles such as Klepper Outline incomplete without oral presentation

Alchian and Demsetz, continued • Team production makes shirking difficult to observe • Person more prone to shirk as a team member than in task involving separable work • Shirker gains all of leisure • Shirker sacrifices 1/n of reward • Manager seeks to minimize shirking subject to costs of metering (optimal level of shirking) Outline incomplete without oral presentation

Alchian and Demsetz, continued • Firm (or principal) is the common contracting party for all team members • Manager has claim on the residual value created by the team • Centralized contracting is important characteristic of firm • Reduces re-contracting costs • Promotes familiarity and knowledge to better observe and counteract shirking Outline incomplete without oral presentation

Alchian and Demsetz, continued The classical firm* is defined as a contractual structure with: • Joint input production; • Several input owners; • One party who is common to all the contracts of the joint inputs who • Has rights to renegotiate any input's contract independently of contracts with other input owners; • Holds the residual claim; and • Who has the right to sell his central contractual residual status. The central agent (principal) is called the firm's owner and/or the employer *”Our exposition also suggests a definition of the classical firm –something crucial that was heretofore absent.” (p784) I am unclear on exactly how they can “retroactively” define a classical firm. Outline incomplete without oral presentation

Alchian and Demsetz, continued • Alchian and Demsetz see limits to scale of the firm consistent with Coase but more specific than simply a “generic” recourse to diminishing returns to management. • The greaterthe interdependencies among functions, 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. • Keep these points in mind when we discuss Simon and the limits to human cognitive powers Outline incomplete without oral presentation

Alchian and Demsetz, continued • Firm type defined by residual sharing arrangements • Profit Sharing Firms • Socialist Firms • The Corporation • Mutual and Non-profit Firms • Partnerships • Employee Unions (not firms but monitoring service) Outline incomplete without oral presentation

Alchian and Demsetz, continued • Profit sharing firms are generally found in small team size settings • Facilitates self-policing for small teams (non-specialized monitoring) • Under equal profit sharing schemes incentives to shirk directly related to the size of the team • Within large firms, equal sharing diffuses incentives of management Outline incomplete without oral presentation

Alchian and Demsetz, continued • Socialist firms often marked by broad sharing of residual value (if any) • Managers have no special claim on residual, lack incentive • Proxies for residual; e.g. goals, evaluations, etc. used • Worker evaluations, where used, may encourage tolerance of shirking Outline incomplete without oral presentation

Alchian and Demsetz, continued • Corporations are marked by diffuse ownership • Small shareholders have little incentive to meter • Liquidity limits risk • Managers are policed to some extent by • Internal competition • Potential change of ownership (raiders, LBOs, etc) • Perhaps better to view stockholders as investors, not owners (How would the SEC react to this?) Outline incomplete without oral presentation

Alchian and Demsetz, continued • Mutual and non-profit firms • No market valuation • Often compensated on “comparable” basis • Rewarded for “inputs’ Outline incomplete without oral presentation

Alchian and Demsetz, continued • Partnerships • Frequently for jointly produced artistic and intellectual productions • Small scale permits self-policing • Often formed among relatives or friends • Once common in “professional services” but replaced by LLCs to limit liability Outline incomplete without oral presentation

Alchian and Demsetz, continued • Employee unions • Not firms, usually don’t create tradable products and services • Do provide monitoring services for members • Some provide training, hiring hall, and insurance services • Serious agency problems with respect to members in some cases Outline incomplete without oral presentation

Alchian and Demsetz, continued • Input ownership • Ownership resides where expected returns are greatest • Asset ownership arrangements are very similar to share-cropping contracts – basic form of risk-sharing contracting • Costs of asset use include depreciation and loss of service due to carelessness Outline incomplete without oral presentation

Alchian and Demsetz, continued • Firms will own those assets they can economically apply and monitor (owner absorbs financial and physical depreciation) • Centralized monitoring of abuse worthwhile for expensive physical assets • Typically owned by company • May be rented if cost, including premium for expected abuse, is lower than ownership costs • Later, asset ownership was viewed as a means to avoid “hold-up” and to exercise control over users Outline incomplete without oral presentation

Alchian and Demsetz, continued Employees will own assets if best able to realize the value of their service and protect them from abuse Workman can more easily monitor abuse of his tools Dedicated assets, even trucks, often employee owned Specialized tools of the trade, frequently owned by workers Outline incomplete without oral presentation

Alchian and Demsetz, continued Firm as a Specialized Market Institution for Collecting, Collating, and Selling Information • Firm can be considered a “private market” • Nuanced contrast to Coase “substitute” • Firm is in position to evaluate and direct resources better than those resources could on their own • Resources may find it better to work (sell their services) within a private market (firm) than through the public markets • Analogous to the private market of a department store • Efficient production with heterogeneous inputs • Not always better resources • Better knowledge about those resources • Combinations of resources • Adjustments in prices Do public markets suffer from communal ownership? Outline incomplete without oral presentation

Harold Demsetz, The Theory of the Firm Revisited • Follow-up to earlier work with Alchian • Observes need for greater emphasis on information in explaining firms • Describes the failure of “perfect decentralization” model to explain firms • Discusses some problems with TCE • Identifies the need to consider both transactions and production cost across internal and external options (later addressed by Williamson) • Notes that output or the producing firm may be purchased, need to clarify the relevant transactions costs • Traces confusion to lingering notion of free information Outline incomplete without oral presentation

Harold Demsetz, Revisited… • Moral Hazard, Shirking and Opportunism • Attention turned to incentive alignment • Dealing with moral hazard involves costs • Close ties between asset specificity and opportunism • Firm-like production results in a special form of productivity Outline incomplete without oral presentation

Harold Demsetz, Revisited… • Firm-Like Organization • “The firm properly viewed is a ‘nexus’ of contracts.” • Questions involve: • The persistence of certain types of contracts • The variation in other types of contracts that are “more-or-less” included in the nexus • The (horizontal and vertical) scope of activities covered by these contracts • We have now the tensions among forces shaping relationships • Specialization (idiosyncrasy) increases productivity but also vulnerability • Cooperative, team-based output (through either firm or contract) to achieve benefits of specialization • Human nature gives rise to moral hazard, opportunism, shirking, etc. and requires management Outline incomplete without oral presentation

George Stigler, The Division of Labor is Limited by the Extent of the Market Title is borrowed from Adam Smith’s observation Ricardo, Senior, and J.S. Mill observed the phenomenon of industrial increasing returns Dilemma: If further division of labor continuously lowers costs for larger outputs entrepreneurs would expand and monopolize industries Decreasing cost functions and increasing returns to scale were troublesome concepts and neglected In 1928 Allyn Young re-emphasized Smith’s theorem but couldn’t successfully integrate into the theory of the firm Outline incomplete without oral presentation

George Stigler, The Division of Labor is Limited by the Extent of the Market… • Stigler observed the “life cycle” of firms from fully vertically integrated to more focused entities and then re-integrating as the industry declined • An evolutionary concept analogous to species interacting with their environment or habitat (not stated as such by Stigler) • Firms may be seen as performing a series of distinct (separable) operations • These operations can be defined in terms of common rates of output and therefore summed vertically • Highly vertically integrated firms typically engage in operations with various cost curve shapes Outline incomplete without oral presentation

George Stigler, The Division of Labor is Limited by the Extent of the Market… Outline incomplete without oral presentation

George Stigler, The Division of Labor is Limited by the Extent of the Market… Vertical integration occurs also when the market or price system does not clear at MC of the product and Marginal-Value Product. Outline incomplete without oral presentation

George Stigler, The Division of Labor is Limited by the Extent of the Market… • Outsourcing – think of it as vertical de-integration • Outsourcing is simply buying rather than making – the original Coasian choice • Stigler’s life cycle or evolutionary model can explain some outsourcing • Much (most?) outsourcing is compelled by market forces and not particularly discretionary • Society’s overall wealth increases with the increase in specialization • Some particular people may be hurt • In some “clusters” the existence of a commonly accessible source for decreasing cost operations makes it much easier to start new specialized firms. Outline incomplete without oral presentation

Next Week • Uncertainty, evolutionary economics, firm selection and survival • Alchian, “Uncertainty, Evolution, and Economic Theory” • Nelson and Winter, “Evolutionary Theorizing in Economics” ******************** Outline incomplete without oral presentation

The Economics of Business