Dabbawala : The organization and emerge of food systems
\n[NOVEMBER
\nThe Nature of the Firm
\nBy R. H. COASE
\nECONOMIC theory has suffered in the past from a failure
\nto state clearly its assumptions. Economists in building
\nup a theory have often omitted to examine the foundations
\non which it was erected. This examination is, however,
\nessential not only to prevent the misunderstanding and
\nneedless controversy which arise from a lack of knowledge
\nof the assumptions on which a theory is based, but also
\nbecause of the extreme importance for economics of good
\njudgment in choosing between rival sets of assumptions.
\nFor instance, it is suggested that the use of the word \u201c firm \u201d
\nin economics may be different from the use of the term
\nby the \u201cplain man.\u201dl Since there is apparently a trend
\nin economic theory towards starting analysis with the
\nindividual firm and not with the industry,2 it is all the
\nmore necessary not only that a clear definition of the word
\n\u201cfirm \u201d should be given but that its difference from a
\nfirm in the \u201c real world,\u201d if it exists, should be made clear.
\nMrs. Robinson has said that \u201cthe two questions to be
\nasked of a set of assumptions in economics are: Are they
\ntractable and : Do they correspond with the real world \u201d3
\nThough, as Mrs. Robinson points out, \u201c more often one set
\nwill be manageable and the other realistic,\u201d yet there may
\nwell be branches of theory where assumptions may be
\nboth manageable and realistic. It is hoped to show in
\nthe following paper that a definition of a firm may be obtained
\nwhich is not only realistic in that it corresponds to what
\nis meant by a firm in the real world, but is tractable by
\ntwo of the most powerful instruments of economic analysis
\ndeveloped by Marshall, the idea of the margin and that of
\nsubstitution, together giving the idea of substitution at
\n1 Joan Robinson, I~corro~rrzcs as a Serious Subjecr, p. 12.
\n2 See N. Kaldor, \u201cThe Equilibriuin of the Finn,\u201d hcommzc Jourml, March, 1934
\n3 Op. cit., p. 6.
\n386
\n387 THE NATURE OF THE FIRM 19371
\nthe margin.\u2019 Our definition must, of course, \u201crelate to
\nformal relations which are capable of being conceived
\nexactly.\u201d2
\nI
\nIt is convenient if, in searching for a definition of a firm,
\nwe first consider the economic system as it is normally
\ntreated by the economist. Let us consider the description
\nof the economic system given by Sir Arthur Salter.3 \u201c The
\nnormal economic system works itself. For its current
\noperation it is under no central control, it needs no central
\nsurvey. Over the whole range of human activity and human
\nneed, supply is adjusted to demand, and production to
\nconsumption, by a process that is automatic, elastic and
\nresponsive.\u201d An economist thinks of the economic system
\nas being co-ordinated by the price mechanism and society
\nbecomes not an organisation but an organism.4 The economic
\nsystem \u201cworks itself.\u201d This does not mean that there is
\nno planning by individuals. These exercise foresight and
\nchoose between alternatives. This is necessarily so if there
\nis to be order in the system. But this theory assumes that
\nthe direction of resources is dependent directly on the price
\nmechanism. Indeed, it is often considered to be an objection
\nto economic planning that it merely tries to do what is
\nalready done by the price me~hanism.~ Sir Arthur Salter\u2019s
\ndescription, however, gives a very incomplete picture of
\nour economic system. Within a firm, the description does
\nnot fit at all. For instance, in economic theory we find
\nthat the allocation of factors of production between different
\nuses is determined by the price mechanism. The price
\nof factor A becomes higher in X than in Y. As a result,
\nA moves from Y to X until the difference between the
\nprices in X and Y, except in so far as it compensates for
\nother differential advantages, disappears. Yet in the real
\nworld, we find that there are many areas where this does
\nnot apply. If a workman moves from department Y to
\ndepartment X, he does not go because of a change in relative
\nprices, but because he is ordered to do so. Those who
\n1 J. M. Keynes, Essays in Biography, pp. 223-4.
\n2 L. Robbins, Nazure and Signijcance of Eronorntc Science, p. 63.
\n3 This description is quoted with approval by D. H. Robertson, Control of IndustTy,
\np. 85, and by Professor Arnold Plant, \u201c Trends in Business Administration,\u201d ECONOMICA,
\nFebruary, 1932. It appears in Allied Shipping Control, pp. 16-17.
\n4 See F. A. Hayek. \u201cThe Trend of Economic Thinking,\u201d ECONOMICA, >lay, 1933.
\nSee F. .A. Hayek. op. cit.
\n388 ECONOMICA [NOVEMBER
\nobject to economic planning on the grounds that the problem
\nis solved by price movements can be answered by pointing
\nout that there is planning within our economic system
\nwhich is quite different from the individual planning
\nmentioned above and which is akin to what is normally
\ncalled economic planning. The example given above is
\ntypical of a large sphere in our modern economic system.
\nOf course, this fact has not been ignored by economists.
\nMarshall introduces organisation as a fourth factor of
\nproduction ; J. B. Clark gives the co-ordinating function
\nto the entrepreneur ; Professor Knight introduces managers
\nwho co-ordinate. As D. H. Robertson points out, we find
\nislands of conscious power in this ocean of unconscious
\nco-operation like lumps of butter coagulating in a pail of
\nbuttermilk.\u201dl But in view of the fact that it is usually
\nargued that co-ordination will be done by the price mechanism,
\nwhy is such organisation necessary Why are there these
\n\u201c islands of conscious power \u201d Outside the firm, price
\nmovements direct production, which is co-ordinated through
\na series of exchange transactions on the market. Within
\na firm, these market transactions are eliminated and in
\nplace of the complicated market structure with exchange
\ntransactions is substituted the entrepreneur-co-ordinator,
\nwho directs production.2 It is clear that these are alternative
\nmethods of co-ordinating production. Yet, having regard
\nto the fact that if production is regulated by price movements,
\nproduction could be carried on without any organisation
\nat all, well might we ask, why is there any organisation 7
\nOf course, the degree to which the price mechanism is
\nsuperseded varies greatly. In a department store, the
\nallocation of the different sections to the various locations
\nin the building may be done by the controlling authority
\nor it may be the result of competitive price bidding for
\nspace. In the Lancashire cotton industry, a weaver can
\nrent power and shop-room and can obtain looms and yarn
\non credit.3 This co-ordination of the various factors of
\nproduction is, however, normally carried out without the
\nintervention of the price mechanism. As is evident, the
\namount of \u201c vertical \u201d integration, involving as it does
\n66 *
\n1 Op. cit., p. 85. * In the rest of this paper I shall use the term entrepreneur to refer to the person Or
\npersons who, in a compehti;e system, take the place of the-price mechanism in &direction
\nof resources.
\nSurvey of Textile Idustries, p. 26.
\n19371 THE NATURE OF THE FIRM 389
\nthe supersession of the price mechanism, varies greatly
\nfrom industry to industry and from firm to firm.
\nIt can, I think, be assumed that the distinguishing mark
\nof the firm is the supersession of the price mechanism.
\nIt is, of course, as Professor Robbins points out, \u201c related
\nto an outside network of relative prices and costs,\u201d1 but
\nit is important to discover the exact nature of this relationship.
\nThis distinction between the allocation of resources
\nin a firm and the allocation in the economic system has
\nbeen very vividly described by Mr. Maurice Dobb when
\ndiscussing Adam Smith\u2019s conception of the capitalist :
\n\u201c It began to be seen that there was something more
\nimportant than the relations inside each factory or unit
\ncaptained by an undertaker; there were the relations of
\nthe undertaker with the rest of the economic world atside
\nhis immediate sphere . . . . the undertaker busies himself
\nwith the division of labour inside each firm and he plans
\nand organises consciously,\u201d but \u201che is related to the much
\nlarger economic specialisation, of which he himself is merely
\none specialised unit. Here, he plays his part as a single cell in a
\nlarger organism, mainly unconscious of the wider rale he fills.\u201d*
\nIn view of the fact that while economists treat the price
\nmechanism as a co-ordinating instrument, they also admit
\nthe co-ordinating function of the \u201c entrepreneur,\u201d it is
\nsurely important to enquire why co-ordination is the work
\nof the price mechanism in one case and of the entrepreneur
\nin another. The purpose of this paper is to bridge what
\nappears to be a gap in economic theory between the assumption
\n(made for some purposes) that resources are allocated
\nby means of the price mechanism and the assumption
\n(made for other purposes) that this allocation is dependent
\non the entrepreneur-co-ordinator. We have to explain
\nthe basis on which, in practice, this choice between alternatives
\nis effe~ted.~
\n1 Op. cit., p. 71. 2 Capiialisr Enterprise and Social Progress, p. 20. Cf., also, Henderson, Supply and Demand,
\nPP. 3-5. 3 It 1s easy to see when the State takes over the direction of an industry that, in planning
\nit, it is doing something which was previously done by the price mechanism. What is
\nusually not realised is that any business man in organising the relations between his departments
\nis also doing something which could be organised through the price mechanism. There
\nis therefore point in Mr. Durbin\u2019s answer to those who emphasise the problems involved
\nin economic planning that the same problems have to be solved by business men in the
\ncompetitive system. (See \u201c Economic Calculus in a Planned Economy,\u201d Economic Journal,
\nDecember, 1936.) The important difference between these two cases is that economic
\nplanning is imposed on industry while firms arise voluntarily because they represent a more
\nefficient method of organising production, In a competitive system, there is an \u201c optimum \u201d
\namount of planning !
\n390 EcONOMICA [ N OVEM BE R
\nI1
\nOur task is to attempt to discover why a firm emerges
\nat all in a specialised exchange economy. The price
\nmechanism (considered purely from the side of the direction
\nof resources) might be superseded if the relationship which
\nreplaced it was desired for its own sake. This would be
\nthe case, for example, if some people preferred to work
\nunder the direction of some other person. Such individuals
\nwould accept less in order to work under someone, and
\nfirms would arise naturally from this. But it would appear
\nthat this cannot be a very important reason, for it would
\nrather seem that the opposite tendency is operating if one
\njudges from the stress normally laid on the advantage of
\n\u201c being one\u2019s own ma~ter.\u201d~ Of course, if the desire was
\nnot to be controlled but to control, to exercise power over
\nothers, then people might be willing to give up something
\nin order to direct others ; that is, they would be willing
\nto pay others more than they could get under the price
\nmechanism in order to be able to direct them. But this
\nimplies that those who direct pay in order to be able to
\ndo this and are not paid to direct, which is clearly not true
\nin the majority of cases2 Firms might also exist if purchasers
\npreferred commodities which are produced by firms to
\nthose not so produced; but even in spheres where one
\nwould expect such preferences (if they exist) to be of negligible
\nimportance, firms are to be found in the real world.3
\nTherefore there must be other elements involved.
\nThe main reason why it is profitable to establish a firm
\nwould seem to be that there is a cost of using the price
\nmechanism. The most obvious cost of \u201c organising \u201d
\nproduction through the price mechanism is that of discovering
\nwhat the relevant prices are.4 This cost may be reduced
\nbut it will not be eliminated by the emergence of specialists
\nwho will sell this information. The costs of negotiating and 1 Cf. Harry Dawes, \u2018\u2019 Labour Mobility in the Steel Industry,\u201d Economic Journal, March,
\n1934, who instances \u201c the trek to retail shopkeeping and insurance work by the better paid
\nof skilled men due to the desire (often the main aim in life of a worker) to be independent \u201d
\n2 None the less, this is not altogether fanciful. Some small shopkeepers are said to earn
\nless than their Helpants.
\n3 G. F. Shove, \u2018\u2018 The Imperfection of the Market : a Further Note,\u201d Economic Journal,
\nMarch, 1933, p. 116, note I, points out that such preferences may exist, although the
\nexample he gives is almost the reverse of the instance given in the text.
\n4 According to N. Kaldor, \u201c A Classificatory Note of the Determinateness of Equilibrium,\u201d
\nRwim of Economic Studies, February, 1934, it is one of the assumptions of static theory
\nthat \u201cAll the relevant prices are known to all individuals.\u201d Rut this is clearly not true
\nof the real world.
\n(P. 86).
\n391
\nconcluding a separate contract for each exchange transaction
\nwhich takes place on a market must also be taken into
\nacc0unt.l Again, in certain markets, e.g., produce exchanges,
\na technique is devised for minimising these contract costs ;
\nbut they are not eliminated. It is true that contracts are
\nnot eliminated when there is a firm but they are greatly
\nreduced. A factor of production (or the owner thereof)
\ndoes not have to make a series of contracts with the factors
\nwith whom he is co-operating within the firm, as would be
\nnecessary, of course, if this co-operation were as a direct
\nresult of the working of the price mechanism. For this
\nseries of contracts is substituted one. At this stage, it is
\nimportant to note the character of the contract into which
\na factor enters that is employed within a firm. The contract
\nis one whereby the factor, for a certain remuneration (which
\nmay be fixed or fluctuating), agrees to obey the directions
\nof an entrepreneur within certain Zimits.2 The essence of
\nthe contract is that it should only state the limits to the
\npowers of the entrepreneur. Within these limits, he can
\ntherefore direct the other factors of production.
\nThere are, however, other disadvantages-or costsof
\nusing the price mechanism. It may be desired to make
\na long-term contract for the supply of some article or service.
\nThis may be due to the fact that if one contract is made
\nfor a longer period, instead of several shorter ones, then
\ncertain costs of making each contract will be avoided.
\nOr, owing to the risk attitude of the people concerned,
\nthey may prefer to make a long rather than a short-term
\ncontract. Now, owing to the difficulty of forecasting, the
\nlonger the period of the contract is for the supply of the
\ncommodity or service, the less possible, and indeed, the
\nless desirable it is for the person purchasing to specify what
\nthe other contracting party is expected to do. It may well
\nbe a matter of indifference to the person supplying the
\nservice or commodity which of several courses of action
\nis taken, but not to the purchaser of that service or commodity.
\nBut the purchaser will not know which of these
\nseveral courses he will want the supplier to take. Therefore,
\n19371 THE NATURE OF \u2019THE FIRM
\n1 This influence was noted by Professor Usher when discussing the development of capitalism.
\nHe says : \u201cThe successive buying and selling of partly finished products were sheer waste
\nof energy.\u201d (Introduction to the Industrial History of England, p. 13). But he does not
\ndevelop the idea nor consider why it is that buying and selling operations still exist.
\n9 It would be possible for no limits to the powers of the entrepreneur to be fixed. This
\nwould be voluntary slavery. According to Professor Batt, 7he Lazu of Master and Smant.
\np. 18, such a contract would be void and unenforceable.
\nECONOMICA [NOVEMBER 392
\nthe service which is being provided is expressed in general
\nterms, the exact details being left until a later date. All
\nthat is stated in the contract is the limits to what the persons
\nsupplying the commodity or service is expected to do.
\nThe details of what the supplier is expected to do is not
\nstated in the contract but is decided later by the purchaser,
\nWhen the direction of resources (within the limits of the
\ncontract) becomes dependent on the buyer in this way,
\nthat relationship which I term a ” firm ” may be obtained.’
\nA firm is likely therefore to emerge in those cases where a
\nvery short term contract would be unsatisfactory. It is
\nobviously of more importance in the case of serviceslabour-than
\nit is in the case of the buying of commodities.
\nIn the case of commodities, the main items can be stated
\nin advance and the details which will be decided later will
\nbe of minor significance.
\nWe may sum up this section of the argument by saying
\nthat the operation of a market costs something and by
\nforming an organisation and allowing some authority (an
\n” entrepreneur “) to direct the resources, certain marketing
\ncosts are saved. The entrepreneur has to carry out his
\nfunction at less cost, taking into account the fact that he
\nmay get factors of production at a lower price than the
\nmarket transactions which he supersedes, because it is
\nalways possible to revert to the open market if he fails
\nto do this.
\nThe question of uncertainty is one which is often considered
\nto be very relevant to the study of the equilibrium of the
\nfirm. It seems improbable that a firm would emerge without
\nthe existence of uncertainty. But those, for instance,
\nProfessor Knight, who make the mode of payment the
\ndistinguishing mark of the firm-fixed incomes being
\nguaranteed to some of those engaged in production by a
\nperson who takes the residual, and fluctuating, incomewould
\nappear to be introducing a point which is irrelevant
\nto the problem we are considering. One entrepreneur may
\nsell his services to another for a certain sum of money,
\nwhile the payment to his employees may be mainly or
\nwholly a share in profits.2 The significant question would
\n1 Of course, it is not possible to draw a hard and fast line which determines whether
\nthere is a firm or not. There may be more or less direction. It is similar to the legal
\nquestion of whether there is the relationship of master and servant or principal and agent.
\nSee the discussion of this problem below.
\n4 The views of Professor Knight are examined below in more detail.
\n19371 393 THE NATURE OF THE FIRM
\nappear to be why the allocation of resources is not done
\ndirectly by the price mechanism.
\nAnother factor that should be noted is that exchange
\ntransactions on a market and the same transactions organised
\nwithin a firm are often treated differently by Governments
\nor other bodies with regulatory powers. If we consider the
\noperation of a sales tax, it is clear that it is a tax on market
\ntransactions and not on the same transactions organised
\nwithin the firm. Now since these are alternative methods
\nof ” organisation “-by the price mechanism or by the
\nentrepreneur-such a regulation would bring into existence
\nfirms which otherwise would have no raison d’itre. It would
\nfurnish a reason for the emergence of a firm in a specialised
\nexchange economy. Of course, to the extent that firms
\nalready exist, such a measure as a sales tax would merely
\ntend to make them larger than they would otherwise be.
\nSimilarly, quota schemes, and methods of price control
\nwhich imply that there is rationing, and which do not apply
\nto firms producing such products for themselves, by allowing
\nadvantages to those who organise within the firm and not
\nthrough the market, necessarily encourage the growth of
\nfirms. But it is difficult to believe that it is measures such
\nas have been mentioned in this paragraph which have
\nbrought firms into existence. Such measures would, however,
\ntend to have this result if they did not exist for other
\nreasons.
\nThese, then, are the reasons why organisations such as
\nfirms exist in a specialised exchange economy in which it
\nis generally assumed that the distribution of resources is
\n” organised ” by the price mechanism. A firm, therefore,
\nconsists of the system of relationships which comes into
\nexistence when the direction of resources is dependent on
\nan entrepreneur.
\nThe approach which has just been sketched would appear
\nto offer an advantage in that it is possible to give a scientific
\nmeaning to what is meant by saying that a firm gets ‘larger
\nor smaller. A firm becomes larger as additional transactions
\n(which could be exchange transactions co-ordinated through
\nthe price mechanism) are organised by the entrepreneur
\nand becomes smaller as he abandons the organisation of
\nsuch transactions. The question which arises is whether
\nit is possible to study the forces which determine the size
\nof the firm. Why does the entrepreneur not organise one
\n394 E CO N 0 MICA [NOVEMBER
\nless transaction or one more It is interesting to note
\nthat Professor Knight considers that :
\n\u201c the relation between efficiency and size is one of the
\nmost serious problems of theory, being, in contrast with
\nthe relation for a plant, largely a matter of personality
\nand historical accident rather than of intelligible general
\nprinciples. But the question is peculiarly vital because
\nthe possibility of monopoly gain offers a powerful incentive
\nto continuous and unlimited expansion of the firm, which
\nforce must be offset by some equally powerful one making
\nfor decreased efficiency (in the production \u2018of money
\nincome) with growth in size, if even boundary competition
\nis to exist.\u201dl
\nProfessor Knight would appear to consider that it is impossible
\nto treat scientifically the determinants of the size of the
\nfirm. On the basis of the concept of the firm developed
\nabove, this task will now be attempted.
\nIt was suggested that the introduction of the firm was
\ndue primarily to the existence of marketing costs. A
\npertinent question to ask would appear to be (quite apart
\nfrom the monopoly considerations raised by Professor
\nKnight), why, if by organising one can eliminate certain
\ncosts and in fact reduce the cost of production, are there
\nany market transactions at all 2 Why is not all production
\ncarried on by one big firm There would appear to be
\ncertain possible explanations.
\nFirst, as a firm gets larger, there may be decreasing
\nreturns to the entrepreneur function, that is, the costs of
\norganising additional transactions within the firm may
\nrise.3 Naturally, a point must be reached where the costs
\nof organising an extra transaction within the firm are equal
\nto the costs involved in carrying out the transaction in
\nthe open market, or, to the costs of organising by another
\nentrepreneur. Secondly, it may be that as the transactions
\nwhich are organised increase, the entrepreneur fails to
\nplace the factors of production in the uses where their value
\n1 Risk, Uncertainty aiid Profit, Preface to the Re-issue, London School of Economics Series
\nof Reprints, No. 16, 1933.
\n2 There are certain marketing costs which could only be eliminated by the abolition of
\n\u2018. consumers\u2019 choice \u201d and these are the costs of retailing. It is conceivable that these costs
\nmight be so high that people nould be willing to accept rations because the extra product
\nobtained was worth the loss of their choice.
\n3 This argument assumes that exchange transactions on a market can be considered as
\nhomogeneous; This complication is taken into account
\nbelow.
\nwhich is clearly untrue in fact.
\n‘9371 THE NAI’UKE Oh’ THE FIRM 395
\nis greatest, that is, fails to make the best use of the factors
\nof production. Again, a point must be reached where the
\nloss through the waste of resources is equal to the marketing
\ncosts of the exchange transaction in the open market or
\nto the loss if the transaction was organised by- another
\nentrepreneur. Finally, the supply price of one or more of
\nthe factors of production may rise, because the ” other
\nadvantages ” of a small firm are greater than those of a
\nlarge firm.l Of course, the actual point where the expansion
\nof the firm ceases might be determined by a combination
\nof the factors mentioned above. The first two reasons
\ngiven most probably correspond to the economists’ phrase
\nof ” diminishing returns to management.”2
\nThe point has been made in the previous paragraph that
\na firm will tend to expand until the costs of organising an
\nextra transaction within the firm become equal to the costs
\nof carrying out the same transaction by means of an exchange
\non the open market or the costs of organising in another
\nfirm. But if the firm stops its expansion at a point below
\nthe costs of marketing in the open market and at a point
\nequal to the costs of organising in another firm, in most
\ncases (excluding the case of ” combination “9, this will
\nimply that there is a market transaction between these
\ntwo producers, each of whom could organise it at less than
\nthe actual marketing costs. How is the paradox to be
\nresolved If we consider an example the reason for this
\nwill become clear. Suppose ‘A is buying a product from
\nB and that both A and B could organise this marketing
\ntransaction at less than its present cost. B, we can assume,
\nis not organising one process or stage of production, but
\nseveral. If A therefore wishes to avoid a market transaction,
\nhe will have to take over all the processes of production
\ncontrolled by B. Unless A takes over all the processes of
\n1 For a discussion of the variation of the supply price of factors of production to firms
\nof varying size, see E. A. G. Robinson, The Structure of Comperitive Industry. It is sometimes
\nsaid that the supply price of organising ability increases as the size of the firm increases
\nbecause men prefer to be the heads of small independent businesses rather than thc heads
\nSee Jones, The Trust Problem, p. 531, and Macgregor,
\n],&strial Combination, p. 63. This is a common argument of those who advocate Rationalsation.
\nIt is said that larger units would he more eflicient. but owing to the individualistic
\nspirit of the smaller entrepreneurs, they prefer to remain independent, apparently in spite
\nof the higher income which their increased efficiency under Rationalisation makes possible.
\nFor a more thorough discussion
\nof this particular problem, see N. Kaldor, ” The Equilibrium of the Firm,” E~-uuomic Journal,
\nMarch, 1934, and E. A. G. Robinson. “The Problem of JIiins~cmcnt ;ind thc Sizc of the
\nFirm,” Economic journal^ June, 1934.
\ndepartments in a large, business.
\n2 This discussion is, of course, brief and incomplete.
\n3 Al definition of this term is given below.
\n3 90 EC o N 0 M t c A [NOVEMBER
\nproduction, a market transaction will still remain, although
\nit is a different product that is bought. But we have
\npreviously assumed that as each producer expands he
\nbecomes less efficient ; the additional costs of organising
\nextra transactions increase. It is probable that A\u2019s cost
\nof organising the transactions previously organised by
\nB will be greater than B\u2019s cost of doing the same thing.
\nA therefore will take over the whole of B\u2019s organisation
\nonly if his cost of organising B\u2019s work is not greater than
\nB\u2019s cost by an amount equal to the costs of carrying out
\nan exchange transaction on the open market. But once
\nit becomes economical to have a market transaction, it
\nalso pays to divide production in such a way that the cost
\nof organising an extra transaction in each firm is the same.
\nUp to now it has been assumed that the exchange transactions
\nwhich take place through the price mechanism are
\nhomogeneous. In fact, nothing could be more diverse
\nthan the actual transactions which take place in our modern
\nworld. This would seem to imply that the costs of carrying
\nout exchange transactions through the price mechanism
\nwill vary considerably as will also the costs of organising
\nthese transactions within the firm. It seems therefore
\npossible that quite apart from the question of diminishing
\nreturns the costs of organising certain transactions within
\nthe firm may be greater than the costs of carrying out the
\nexchange transactions in the open market. This would
\nnecessarily imply that there were exchange transactions
\ncarried out through the price mechanism, but would it
\nmean that there would have to be more than one firm
\nClearly not, for all those areas in the economic system
\nwhere the direction of resources was not dependent directly
\non the price mechanism could be organised within one
\nfirm. The factors which were discussed earlier would seem
\nto be the important ones, though it is difficult to say whether
\ndiminishing returns to management \u201d or the rising supply
\nprice of factors is likely to be the more important.
\nOther things being equal, therefore, a firm will tend
\nto be larger:
\n(a) the less the costs of organising and the slower these
\ncosts rise with an increase in the transactions organised.
\n(b) the less likely the entrepreneur is to make mistakes
\nand the smaller the increase in mistakes with an increase
\nin the transactions organised.
\n66
\n193 71 397 THE NATURE OF THE FIRM
\n(c) the greater the lowering (or the less the rise) in
\nthe supply price of factors of production to firms of larger
\nsize.
\nApart from variations in the supply price of factors of
\nproduction to firms of different sizes, it would appear that
\nthe costs of organising and the losses through mistakes will
\nincrease with an increase in the spatial distribution of the
\ntransactions organised, in the dissimilarity of the transactions,
\nand in the probability of changes in the relevant
\nprices.l As more transactions are organised by an entrepreneur,
\nit would appear that the transactions would tend
\nto be either different in kind or in different places. This
\nfurnishes an additional reason why efficiency will tend to
\ndecrease as the firm gets larger. Inventions which tend
\nto bring factors of production nearer together, by lessening
\nspatial distribution, tend to increase the size of the firm.2
\nChanges like the telephone and the telegraph which tend
\nto reduce the cost of organising spatially will tend to increase
\nthe size of the firm. All changes which improve managerial
\ntechnique will tend to increase the size of the firm.3-4
\nIt should be noted that the definition of a firm which
\nwas given above can be used to give more precise meanings
\nto the terms \u201c combination \u201d and \u201c integration.\u201dB There
\nis a combination when transactions which were previously
\nThis aspect of the problem is emphasised by N. Kaldor, op. cit. Its importance in
\nthis connection had been previously noted by E. A. G. Robinson, 7he Strucfure .f Comperztiae
\nIndustry, pp. 83-106. This assumes that an increase in the probability of price
\nmovements increases the costs of organising within a firm more than it increases the cost
\nof carrying out an exchange transaction on the market-which is probable.
\n2 This would appear to be the importance of the treatment of the technical unit by
\nE. A. G. Robinson, op. cit., pp. 27-33. The larger the technical unit, the greater the
\nconcentration of factors and therefore the firm is likely to be larger.
\n3 It should be noted that most inventions will change both the costs of organising and
\nthe costs of using the price mechanism. In such cases, whether the invention tends to
\nmake firms larger or smaller will depend on the relative effect on these two sets of costs.
\nFor instance, if the telephone reduces the costs of using the price mechanism more than
\nit reduces the costs of organising, then it will have the effect of reducing the size of the
\nfirm.
\n4 An illustration of these dynamic forces is furnished by Maurice Dobb, Russian Economic
\nDevelopment, p. 68. \u201cWith the passing of bonded labour the factory, as an establishment
\nwhere work was organised under the whip of the overseer, lost its raison d\u2019& until this
\nwas restored to it with the introduction of power machinery after 1846.\u201d It seems important
\nto realise that the passage from the domestic system to the factory system is not a mere
\nhistorical accident, but is conditioned by economic forces. This is shown by the fact that
\nit is possible to move from the factory system to the domestic system, as in the Russian
\nexample, as well as aicc O\u2018CTS(I. It is the essence of serfdom that the price mechanism is
\nnot allowed to operate. Therefore, there has to be direction from some organiser. When,
\nhowever, serfdom passed, the price mechanism was allowed to operate. It was not until
\nmachinery drew workers into one locality that it paid to supersede the price mechanism
\nand the firm again emerged. * This is often called \u201c vertical integration,\u201d combination being termed \u201c lateral integratbrr.\u201d
\n398 ECOMOMICA [NOVLMBEIC
\norganised by two or more entrepreneurs become organised
\nby one. This becomes integration when it involves the
\norganisation of transactions which were previously carried
\nout between the entrepreneurs on a market. A firm can
\nexpand in either or both of these two ways. The whole
\nof the \u201c structure of competitive industry \u201d becomes tractable
\nby the ordinary technique of economic analysis.
\nI11
\nThe problem which lias been investigated in the previous
\nsection has not been entirely neglected by economists and
\nit is now necessary to consider why the reasons given above
\nfor the emergence of a firm in a specialised exchange economy
\nare to be preferred to the other explanations which have
\nbeen offered.
\nIt is sometimes said that the reason for the existence
\nof a firm is to be found in the division of labour. This is
\nthe view of Professor Usher, a view which has been adopted
\nand expanded by Mr. Maurice Dobb. The firm becomes
\n\u201c the result of an increasing complexity of the division of
\nlabour . . . . The growth of this economic differentiation
\ncreates the need for some integrating force without which
\ndifferentiation would collapse into chaos ; and it is as the
\nintegrating force in a differentiated economy that industrial
\nforms are chiefly ~ignificant.\u2019~l The answer to this argument
\nis an obvious one. The \u201c integrating force in a differentiated
\neconomy \u201d already exists in the form of the price mechanism.
\nIt is perhaps the main achievement of economic science
\nthat it has shown that there is no reason to suppose that
\nspecialisation must lead to chaos.* The reason given by
\nMr. Maurice Dobb is therefore inadmissible. What has
\nto be explained is why one integrating force (the entrepreneur)
\nshould be substituted for another integrating force (the
\nprice mechanism).
\nThe most interesting reasons (and probably the most
\nwidely accepted) which have been given to explain this
\nfact are those to be found in Professor Knight\u2019s Risk,
\nUncertainty and Pro&. His views will be examined in
\nsome detail.
\n\u2018 Op. cit.,. p. 10. Professor Usher\u2019s viena .ire to Le found in his Iirlroducfron 10 ~bc
\n2 Cf. J. B. Clark, Disrnburzon of Wealth, p. 19, who speaks of the theory of e~change a5
\nIizdustrwl Ifaslory of England, pp. 1-18.
\nbeing the \u201c theory of the organisation of industrial society.\u201d
\n\u20189371 \u2018THE NATURE OF 1HE FIRM 399
\nProfessor Knight starts with a system in which there
\nacting as individuals under absolute freedom but
\nwithout collusion men are supposed to have organised
\neconomic life with the primary and secondary division
\nof labour, the use of capital, etc., developed to the point
\nfamiliar in present-day America. The principal fact
\nwhich calls for the exercise of the imagination is the
\ninternal organisation of the productive groups or establishments.
\nWith uncertainty entirely absent, every individual
\nbeing in possession of perfect knowledge of the situation,
\nthere would be no occasion for anything of the nature
\nof responsible management or control of productive
\nactivity. Even marketing transactions in any realistic
\nseiise would not be found. The flow of raw materials
\nand productive services to the consumer would be entirely
\nautomatic.\u201dl
\nProfessor Knight says that we can imagine this adjustment
\nas being \u201c the result of a long process of experimentation
\nworked out by trial-and-error methods alone,\u201d while it
\nis not necessary \u201cto imagine every worker doing exactly
\nthe right thing at the right time in a sort of \u2018 pre-established
\nharmony \u2019 with the work of others. There might be managers,
\nsuperintendents, etc., for the purpose of co-ordinating the
\nactivities of individuals,\u201d though these managers would
\nbe performing a purely routine function, \u201c without responsibility
\nof any sort.\u201d2
\nis no uncertainty : cc
\nProfessor Knight then continues :
\n\u201c With the introduction of uncertainty-the fact of
\nignorance and the necessity of acting upon opinion rather
\nthan knowledge-into this Eden-like situation, its character
\nis entirely changed . . . . With uncertainty present doing
\nthings, the actual execution of activity, becomes in a
\nreal sense a secondary part of life ; the primary problem
\nor function is deciding what to do and how to do it.\u201d5
\nThis fact of uncertainty brings about the two most
\n\u201cIn the first place, goods are produced for a market,
\non the basis of entirely impersonal prediction of wants,
\nnot for the satisfaction of the wants of the producers
\nthemselves. The producer takes the responsibility of
\nimportant characteristics of social organisation.
\n1 Risk, Uncerfainty and Profit, p. 267.
\n2 Op. cit., pp. 267-8. Op. cit., p. 268.
\nC
\n400 ECONOMICA [NOVEMBER
\nforecasting the consumers\u2019 wants. In the second place,
\nthe work of forecasting and at the same time a large
\npart of the technological direction and control of production
\nare still further concentrated upon a very narrow class
\nof the producers, and we meet with a new economic
\nfunctionary, the entrepreneur. . . . . When uncertainty
\nis present and the task of deciding what to do and how
\nto do it takes the ascendancy over that of execution the
\ninternal organisation of the productive groups is no
\nlonger a matter of indifference or a mechanical detail.
\nCentralisation of this deciding and controlling function
\nis imperative, a process of \u2018 cephalisation \u2019 is inevitable.\u201dl
\nThe most fundamental change is :
\n\u201c the system under which the confident and venturesome
\nassume the risk or insure the doubtful and timid by
\nguaranteeing to the latter a specified income in return
\nfor an assignment of the actual results. . . . With human
\nnature as we know it it would be impracticable or very
\nunusual for one man to guarantee to another a definite
\nresult of the latter\u2019s actions without being given power
\nto direct his work. And on the other hand the second
\nparty would not place himself under the direction of
\nthe first without such a guarantee. . . . The result of
\nthis manifold specialisation of function is the enterprise
\nand wage system of industry. Its existence in the world
\nis the direct result of the fact of ~ncertainty.\u201d~
\nThese quotations give the essence of Professor Knight\u2019s
\ntheory. The fact of uncertainty means that people have
\nto forecast future wants. Therefore, you get a special
\nclass springing up who direct the activities of others to
\nwhom they give guaranteed wages. It acts because good
\njudgment is generally associated with confidence in one\u2019s
\nj~dgrnent.~
\nProfessor Knight would appear to leave himself open
\nto criticism on several grounds. First of all, as he himself
\npoints out, the fact that certain people have better judgment
\nor better knowledge does not mean that they can only
\nget an income from it by themselves actively taking part
\nin production. They can sell advice or knowledge. Every
\nbusiness buys the services of a host of advisers. We can
\nimagine a system where all advice or knowledge was bought
\n1 Op. cit., pp. 268-95.
\n3 Op. cit., p. 270.
\na Op. cit., pp. 26970.
\n19371 THE NATURE OF THE FIRM 401
\nas required. Again, it is possible to get a reward from
\nbetter knowledge or judgment not by actively taking part
\nin production but by making contracts with people who
\nare producing. A merchant buying for future delivery
\nrepresents an example of this. But this merely illustrates
\nthe point that it is quite possible to give a guaranteed
\nreward providing that certain acts are performed without
\ndirecting the performance of those acts. Professor Knight
\nsays that \u201cwith human nature as we know it it would be
\nimpracticable or very unusual for one man to guarantee
\nto another a definite result of the latter\u2019s actions without
\nbeing given power to direct his work.\u201d This is surely
\nincorrect. A large proportion of jobs are done to contract,
\nthat is, the contractor is guaranteed a certain sum providing
\nhe performs certain acts. But this does not involve any
\ndirection. It does mean, however, that the system of
\nrelative prices has been changed and that there will be a
\nnew arrangement of the factors of production.1
\nthat Professor Knight mentions that the \u201c second party
\nwould not place himself under the direction of the first
\nwithout such a guarantee \u201d is irrelevant to the problem
\nwe are considering. Finally, it seems important to notice
\nthat even in the case of an economic system where there
\nis no uncertainty Professor Knight considers that there
\nwould be co-ordinators, though they would perform only
\na routine function. He immediately adds that they would
\nbe \u201c without responsibility of any sort,\u201d which raises the
\nquestion by whom are they paid and why I It seems that
\nnowhere does Professor Knight give a reason why the price
\nmechanism should be superseded.
\nIV
\nIt would seem important to examine one further point
\nand that is to consider the relevance of this discussion to
\nthe general question of the \u201c cost-curve of the firm.\u201d
\nIt has sometimes been assumed that a firm is limited
\nin size under perfect competition if its cost curve slopes
\nupward,B while under imperfect competition, it is limited
\nThe fact ,
\n1 This shows that it is possible to have a private enterprise system without the existence
\nof firms. Though, in practice, the two functions of enterprise, which actually influences
\nthe system of relative prices by forecasting wants and acting in accordance with such forecasts,
\nand management, which accepts the system of relative prices as being given, are
\nnormally carried out by the same persons, yet it seems important to keep them separate
\nin theory. This point is further discussed below.
\na See Kaldor, op. cit., and Robinson, The Problem of Management and the Size of the Firm.
\n402 ECONOMICA [NOVEMBER
\nin size because it will not pay to produce iiioie than the
\noutput at which marginal cost is equal to marginal revenue.\u2019
\nBut it is clear that a firm may produce more than one product
\nand, therefore, there appears to be no prima facie reason
\nwhy this upward slope of the cost curve in the case of perfect
\ncompetition or the fact: that marginal cost will not always
\nbe below marginal revenue in the case of imperfect competition
\nshould limit the size of the firm.2 Mrs. Robinson3
\nmakes the simplifying assumption that only one product
\nis being produced. But it is clearly important to investigate
\nhow the number of products produced by a firm is determined,
\nwhile no theory which assumes that only one product is
\nin fact produced can have very great practical significance.
\nIt might be replied that under perfect competition, since
\neverything that is produced can be sold at the prevailing
\nprice, then there is no need for any other product to be
\nproduced. But this argument ignores the fact that there
\nmay be a point where it is less costly to organise the exchange
\ntransactions of a new product than to organise further
\nexchange transactions of the old product. This point can
\nbe illustrated in the following way. Imagine, following
\nvon Thunen, that there is a town, the consuming centre,
\nand that industries are located around this central point
\nin rings. These conditions are illustrated in the following
\ndiagram in which A, B and C represent different industries.
\n1 Mr. Kobinson calls this the Imperfect Competition solution for the survival of the small firm.
\nJ Nr. Robinson\u2019s conclusion, op. cit., p. 249, note I, would appear to be definitely wrong.
\nHe is followed by Horace J. White, Jr., \u201c Monopolistic and Perfect Competition,\u201d American
\nEconomic Review, December, 1936, p. 6!5, note 27. Xr. White states \u201cIt is obvions that
\nthe size of the firm is limited in conditions of monopolistic competition.\u201d
\n3 Economics of Imperfect Competition.
\n19371 403 THE NATURE OF THE FIRM
\nImagine an entrepreneur who starts controlling exchange
\ntransactions from x. Now as he extends his activities in
\nthe same product (B), the cost of organising increases until
\nat some point it becomes equal to that of a dissimilar product
\nwhich is nearer. As the firm expands, it will therefore
\nfrom this point include more than one product (A and C).
\nThis treatment of the problem is obviously incomplete,l
\nbut it is necessary to show that merely proving that the
\ncost curve turns upwards does not give a limitation to the
\nsize of the firm. So far we have only considered the case
\nof perfect competition ; the case of imperfect competition
\nwould appear to be obvious.
\nTo determine the size of the firm, we have to consider
\nthe marketing costs (that is, the costs of\u2019using the price
\nmechanism), and the costs of organising of different entrepreneurs
\nand then we can determine how many products
\nwill be produced by each firm and how much of each it
\nwill produce. It would, therefore, appear that Mr. Shoves
\nin his article on \u201c Imperfect Competition \u201d was asking
\nquestions which Mrs. Robinson\u2019s cost curve apparatus
\ncannot answer. The factors mentioned above would seem
\nto be the relevant ones.
\nV
\nOnly one task now remains ; and that is, to see whether
\nthe concept of a firm which has been developed fits in with
\nthat existing in the real world. We can best approach the
\nquestion of what constitutes a firm in practice by considering
\nthe legal relationship normally called that of \u201c master and
\nservant \u201d or \u201c employer and em~loyee.\u201d~ The essentials
\nof this relationship have been given as follows :
\n\u201c (I) the servant must be under the duty of rendering
\npersonal services to the master or to others on behalf
\n1 As has been shown above, location is only one of the factors influencing the cost of
\norganising.
\n8 G. F. Shove, \u201cThe Imperfection of the Market,\u201d Economic Journal, March, 1933, p. 115.
\nIn connection with an increase in demand in the suburbs and the effect on the price charged
\nby suppliers, Mr. Shove asks I\u2018. . . . why do not the old firms open hranches in the
\nsuburbs \u201d If the argument in the test is correct, this is a question which Mrs. Robinson\u2019s
\napparatus cannot answer. a The legal concept of \u2018I employer and employee \u201d and the economic concept of a firm
\nare not identical, in that the firm may imply control over another person\u2019s property as well
\nas over their labour. But the identity of these two concepts is sufficiently close for an
\nexamination of the leaal concept to he of value in appraising the worth of the economic
\nconcept.
\nECONOMICA [NOVEMBER 404
\nof the master, otherwise the contract is a contract for
\nsale of goods or the like.
\n(2) The master must have the right to control the
\nservant\u2019s work, either personally or by another servant
\nor agent. It is this right of control or interference, of
\nbeing entitled to tell the servant when to work (within
\nthe hours of service) and when not to work, and what
\nwork to do and how to do it (within the terms of such
\nservice) which is the dominant characteristic in this
\nrelation and marks off the servant from an independent
\ncontractor, or from one employed merely to give to his
\nemployer the fruits of his labour. In the latter case,
\nthe contractor or performer is not under the employer\u2019s
\ncontrol in doing the work or effecting the service; he
\nhas to shape and manage his work so as to give the result
\nhe has contracted to effect.\u201dl
\nWe thus see that it is the fact of direction which is the
\nessence of the legal concept of \u201c employer and employee,\u201d
\njust as it was in the economic concept which was developed
\nabove. It is interesting to note that Professor Batt says
\nfurther :
\n\u201c That which distinguishes an agent from a servant is
\nnot the absence or presence of a fixed wage or the payment
\nonly of commission on business done, but rather the
\nfreedom with which an agent may carry out his employment
\n.\u201da
\nWe can therefore conclude that the definition we have given
\nis one which approximates closely to the firm as it is considered
\nin the real world.
\nIs it manageable
\nThis ought to be clear. When we are considering how
\nlarge a firm will be the principle of marginalism works
\nsmoothly. The question always is, will it pay to bring an
\nextra exchange transaction under the organising authority
\nAt the margin, the costs of organising within the firm
\nwill be equal either to the costs of organising in another
\nfirm or to the costs involved in leaving the transaction to
\nbe \u201c organised \u201d by the price mechanism. Business men
\nwill be constantly experimenting, controlling more or less,
\nand in this way, equilibrium will be maintained. This
\ngives the position of equilibrium for static analysis. But
\nOur definition is, therefore, realistic.
\nBatt, The Law of Master and Seroant, p. 6. * Op. cit., p. 7.
\n19371 THE NATURE OF THE FIRM 405
\nit is clear that the dynamic factors are also of considerable
\nimportance, and an investigation of the effect changes have
\non the cost of organising within the firm and on marketing
\ncosts generally will enable one to explain why firms get
\nlarger and smaller. We thus have a theory of moving
\nequilibrium. The above analysis would also appear to have
\nclarified the relationship between initiative or enterprise
\nand management. Initiative means forecasting and operates
\nthrough the price mechanism by the making of new contracts.
\nManagement proper merely reacts to price changes, rearranging
\nthe factors of production under its control. That the
\nbusiness marl normally combines both functions is an obvious
\nresult of the marketing costs which were discussed above.
\nFinally, this analysis enables us to state more exactly what
\nis meant by the ” marginal product ” of the entrepreneur.
\nBut an elaboration of this point would take us far from
\nour comparatively simple task of definition and clarification.<\/p>\n
American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic
\nReview.
\nhttps:\/\/monkessays.com\/write-my-essay\/jstor.org
\nAmerican Economic Association
\nMarkets and Hierarchies: Some Elementary Considerations
\nAuthor(s): Oliver E. Williamson
\nSource: The American Economic Review, Vol. 63, No. 2, Papers and Proceedings of the
\nEighty-fifth Annual Meeting of the American Economic Association (May, 1973), pp. 316-325
\nPublished by: American Economic Association
\nStable URL: https:\/\/monkessays.com\/write-my-essay\/jstor.org\/stable\/1817092
\nAccessed: 05-11-2015 13:21 UTC
\nYour use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https:\/\/monkessays.com\/write-my-essay\/jstor.org\/page\/
\ninfo\/about\/policies\/terms.jsp
\nJSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
\nin a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
\nFor more information about JSTOR, please contact support@jstor.org.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nORGANIZATIONAL FORMS AND
\nINTERNAL EFFICIENCY
\nMarkets and Hierarchies:
\nSome Elementary Considerations
\nBy OLIVER E. WILLIAMSON*
\nThe principal purposes of this paper are
\nto examine the factors which induce a
\nshift of transactions from market to internal
\norganization and, within internal
\norganization, to explain the types of
\nhierarchical relations that predictably
\nemerge. It is generally acknowledged that
\na prima facie case for the development of
\nnonmarket (or quasi-market) forms of
\neconomic organization can be said to exist
\nwhenever the market, if used to complete
\na set of transactions, experiences “frictions.”
\nBut this is only a rebuttable presumption.
\nAs R. Coase has emphasized
\nrepeatedly, the problems of efficient economic
\norganization need to be examined in
\na comparative-institutional way (1960, pp.
\n17-18; 1964, p. 195). Concern with the
\nstudy of market failures should thus be
\nexpanded to include “institutional failures”
\n(of internal organizational, political,
\nand judicial types) more generally.
\nAs compared with the study of market
\nfailures, the analysis of the sources and
\nconsequences of internal organizational
\nfailures is at a very primitive stage of
\ndevelopment. I submit, however, that
\nsubstantially the same factors that are
\nultimately responsible for market failures
\nalso explain failures of internal organization.
\nIf this contention is correct, the
\nstudy of alternative modes of economic
\norganization can proceed in a symmetrical
\nfashion. Rather than having to devise a
\nseparate apparatus for each organizing
\nmode, a common language and conceptual
\napparatus can be brought systematically
\nto bear across modes.
\nI. Markets and Market Failures
\nIt will be argued here that the interesting
\nproblems of economic organization are
\nmainly to be explained by reference to the
\nconjunction of a set of human attributes
\nwith a related set of (largely nontechnological)
\ntransactional factors. Inasmuch as
\neconomics is a social science concerned
\nwith exchange, this is perhaps unsurprising.
\nDiscussions of economic organization
\nnevertheless are frequently dominated by
\nreferences to technology.
\nTo be sure, technological indivisibilities
\nor nonseparabilities in production processes
\nsometimes exist and have important
\norganizational implications. Inasmuch,
\nhowever, as exclusive reliance on such
\nconsiderations would permit only relatively
\nsimple forms of economic organization
\nto be explained, whereas actual firms
\nand markets are often highly complex and
\nsubtle instruments, other (nontechnological)
\nfactors are presumably operative.
\nTo these we now turn.
\n* University of Pennsylvania. Research on this paper
\nhas been supported by a grant from the National Science
\nFoundation. Comments on the paper by Jeffrey
\nHarris and Hugh Davies are gratefully acknowledged.
\n316
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nVOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 317
\nA. Human Factors
\nBut for the existence of one or more of
\nthe following three factors, there would
\nappear to be little reason to supplant
\nmarket organization with some form of
\nnonmarket organization.
\n1. Bounded Rationality
\nBounded rationality refers to rate and
\nstorage limits on the capacities of individuals
\nto receive, store, retrieve, and
\nprocess information without error. The
\nreasons why the absence of unlimited
\ncomputational capacity prevents comprehensive
\ncontracting of the sort required
\nfor the standard theorems on the existence
\nand optimality of a competitive equilibrium
\nto go through have been examined by
\nR. Radner (1968). Certain specific problems
\nof interfirm (but, more generally, of
\nautonomous) contracting are also examined
\nin my discussion of vertical integration
\n(1971, pp. 115-18).
\n2. Opportunism
\nOpportunism is an effort to realize individual
\ngains through a lack of candor or
\nhonesty in transactions.’ It can take either
\nof two forms. The most commonly recognized
\nis the strategic disclosure of
\nasymmetrically distributed information by
\n(at least some) individuals to their advantage.
\nOriginal negotiations may be
\nimpaired on this account.
\nThe second type manifests itself during
\ncontract execution and renewal. The impossibility
\nof extracting what can be confidently
\nregarded as self-enforcing promises
\nto behave “responsibly” requires that
\nagreements be monitored and may pose
\nproblems, due to first-mover advantages,
\nat the contract renewal interval where
\nby a first-mover advantage I mean that
\nwinners of original bids acquire firmspecific
\nexperience which places them at a
\ncost advantage in relation to nonwinners
\non subsequent rounds of negotiation
\n(0. Williamson, 1971, p. 116). (The consequences
\nof this are discussed further in
\nconjunction with the small numbers issue
\nbelow.)
\n3. A tmosphere
\nIndividuals are not (all) given to the
\nstrict maximization of expected pecuniary
\ngain but also consume “atmosphere.”
\nModes of organization or practices which
\nwould have superior productivity consequences
\nif implemented within, and thus
\nwould be adopted by, a group of expected
\npecuniary gain maximizers may be modified
\nor rejected by groups with different
\nvalues. For one thing, favorable productivity
\nconsequences may no longer obtain.
\nIn addition, preferences for atmosphere
\nmay induce individuals to forego material
\ngains for nonpecuniary satisfactions if the
\nmodes or practices are regarded as oppressive
\nor otherwise repugnant.
\nThis does not lead to a uniform preference
\nfor one mode of organization over
\nanother, however. Individuals who value
\nindependence highly may favor markets
\nover hierarchy, while others may favor internal
\norganization because of associational
\nsatisfactions which they derive. The
\ninstitutional design problem requires that
\nrequisite variety be supplied so as to permit
\nindividuals to allocate themselves appropriately
\namong alternative modes.
\nB. Transactional Factors
\nWhether markets experience contractual
\nproblems as a result of bounded rationality
\nand opportunism turns on a related set of
\ntransactional factors. Thus the consequences
\nof bounded rationality are less
\nsevere if the transactions in question are
\nuncomplicated and experience little un-
\n1 Returns attributable to productive advantages (e.g.,
\na unique location or differential skill) are not to be
\nregarded as opportunistic. Strategic representations are
\nrequired for opportunism to obtain.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\n318 AMERICAN ECONOMIC ASSOCIATION MAY 1973
\ncertainty. Similarly, opportunism is restricted
\nif competition reliably obtains or
\nif information asymmetries can be overcome
\nat little cost.
\n1. Uncertainty
\nThe effects of uncertainty on economic
\nbehavior are extensive and pervasive
\n(K. Arrow, 1969, 1971; Radner, 1968,
\n1970). Of particular interest to us here is
\nthat, inasmuch as a full set of contingent
\nclaim markets is infeasible (by reason of
\nbounded rationality), adaptive, sequential
\ndecision-making procedures need be devised.
\nVulnerable as market exchange is to
\nopportunism in these circumstances, hierarchical
\nforms of organization are apt
\noften to be favored.
\n2. Small Numbers
\nIf a large number of traders are roughly
\nequally qualified to supply the good or
\nservice in question-not merely at the
\noutset but also (inasmuch as environmental
\nuncertainty and bounded rationality
\nrender once-for-all contracts uneconomical)
\nat contract renewal intervalscompetition
\nwill obtain, trading ranges
\nwill be narrowly restricted, and market
\nexchange will be attractive. But while
\nfrequently a large numbers condition will
\nseem to obtain at the outset, this may be
\nillusory or may not continue into contract
\nrenewal stages.
\nThe illusion is that implicit homogeneity
\nassumptions may not be satisfied. Nonhomogeneity
\ncoupled with information
\nimpactedness and opportunism pose serious
\ndisclosure problems. Not only can
\nmarkets shrink on this account, but they
\nmay vanish altogether (see G. Ackerlof).
\nIn addition, although large numbers
\nhomogeneity conditions may obtain at the
\noutset, this may no longer hold at the
\ncontract renewal interval. If parity among
\nsuppliers is upset by first-mover advantages,
\nso that winners of original bids
\nsubsequently enjoy nontrivial cost advantages
\nover nonwinners, the joining of
\nusers and suppliers under a sales relationship
\nwill predictably give rise to small
\nnumbers haggling and associated maladaptations.<\/p>\n
The argument has relevance not only
\nfor examining when separable components
\nwill be made internally rather than purchased,
\nbut also when the work flow between
\nsuccessive individuals will be exchanged
\nunder an employment rather than
\na sales relationship. Transaction-specific
\nhuman capital is not all that uncommon
\n(P. Doeringer and M. Piore) and favors
\nhierarchy.
\n3. Information Impactedness
\nInformation impactedness is partly an
\ninformation asymmetry condition: one of
\nthe agents to a contract has deeper knowledge
\nthan does the other (Arrow 1969,
\np. 55). But more than asymmetry is implied
\nby our use of the term impactedness.
\nIt is also costly for the party with less information
\nto achieve information parity.
\nTo the extent that it is difficult to distinguish
\nbetween agents who disclose the
\nimpacted information to which they
\nhave access in an opportunistic (selective
\nor distorted) manner from those who make
\ngood faith representations, agents of the
\nlatter type may be induced to withdraw
\nfrom the market.
\nC. An Example
\nAlthough most of the problems of markets
\n(including public goods, externalities,
\nmarkets for information (including invention),
\netc.) can be traced to the conjunction
\nof the human and transactional factors
\ndescribed above (in that, absent these, the
\nproblems would vanish), it is beyond the
\nscope of this paper to attempt such a
\nshowing here. Insurance, however, offers a
\nsimple illustration. Risk aversion will be
\nassumed and the question is whether a
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nVOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 319
\ngroup of individuals who are exposed to
\nindependent risks will be able to pool
\nthese successfully with an insurer.
\nAssume that the members of the group
\nare uniformly distributed over the risk
\ninterval p, to P2, where pl < P2 and p
\ndenotes the probability for a particular individual
\nthat the contingency to be insured
\nwill eventuate. (Since this probability
\nwill vary depending on the riskmitigating
\nactions taken by an individual,
\nassume that p reflects efficient risk mitigation.)
\nWhereas individuals will be assumed
\nto know their risk characteristics exactly,
\nthe insurer is unable, at low cost, to distinguish
\none member of the group from
\nanother. Information impactedness thus
\nobtains. Assume also that the highest
\npremium that an individual of risk class p
\nwill pay is (p+E)D, where E <(P2-P1)\/2,
\nand D is the (common) damage that will be
\nincurred if the contingency obtains.
\nIn the absence of other information, and
\nassuming transaction costs to be negligible,
\ninsurers would break even if they could
\nsell insurance to all members of this group
\nat a premium of [(pl+p2)\/2]D, which is
\nthe mean loss. Such a premium will be
\nregarded as excessive, however, by those
\nrisk types for whom p+E < (Pl+P2)\/2. Inasmuch
\nas these preferred risks cannot
\neasily establish that they are honestly entitled
\nto a lower premium-since (opportunistic)
\npoor risk types can make the
\nsame representations and insurers are unable
\n(except at great cost) to distinguish
\nbetween them-they will withdraw. Breakeven
\nthen requires that remaining parties
\nbe charged a higher premium; the system
\nwill stabilize eventually at a premium of
\n(p2-E)D. Information impactedness and
\nopportunism thus result in what is commonly
\nreferred to as the “adverse selection”
\nproblem.
\nMoreover, the matter does not end here
\nif the extent of the losses incurred is influenced
\nby the degree to which insured
\nparties take steps designed to mitigate
\nlosses. If promises were self-enforcing, insurers
\nneed merely extract a promise from
\ninsureds that, once insured, they will behave
\nresponsibly. Alternatively, if it could
\neasily be discerned ex post whether efficient
\ncontingency mitigating practices had or
\nhad not been followed, insurers could supply
\ninsureds with appropriate incentives
\nto behave responsibly by paying only
\nthose claims that fell within the terms of
\nthe agreement. If, however, such determinations
\ncan only be made at great cost
\nand (some) insureds exploit ex post information
\nimpactedness opportunistically,
\nthe problem referred to in the insurance
\nliterature as “moral hazard” obtains
\n(Arrow, 1971, pp. 142, 202, 243). Premiums
\nwill be increased on this account
\nalso. Note finally that responsible parties
\nwho otherwise would be prepared to selfenforce
\npromises to take efficient lossmitigating
\nactions may find that such behavior
\nis not competitively viable and will
\nconsequently be induced to imitate opportunistic
\ntypes by underinvesting in loss
\nmitigation as well.2
\nD. A dministrative Expense
\nAlthough information asymmetries may
\ninitially be great, so that estimates of the
\ntrue characteristics of economic agents are
\n2 It is furthermore relevant in this connection to distinguish
\nbetween insurance claims attributable to excessive
\nexposure to hazard, for failure to take appropriate
\nprotective actions, and the “over-utilizatioA” of insured
\nservices (e.g., health care) because, given insurance, the
\neffective price is less than the market price. M. Pauly
\ncontends that only the former and not the latter reflects
\nmoral hazard, and describes the price responsiveness as
\na result “not of moral perfidy, but of rational economic
\nbehavior” (p. 535). Clearly, however, behavior of both
\ntypes could and would be eliminated if insurers could
\nextract self-enforcing promises from insureds not to
\nexploit ex post information impactedness opportunistically.
\nInasmuch as ex post behavior of both types is
\nattributable to the impossibility of extracting such
\nguarantees, it seems artificial that one type should be
\nregarded as moral perfidy but not the other (Arrow
\n1971, pp. 220-21).
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\n320 AMERICAN ECONOMIC ASSOCIATION MAY 1973
\nsubject to considerable uncertainty, these
\ncan be reduced in a variety of ways. One is
\nto infer true characteristics from experience.
\nA simple performance record can be
\nmaintained and a priori probabilities successively
\nrevised. TIhis can often usefully
\nbe supplemented by both precontract and
\nperformance auditing. Performance audits
\nare especially important where outcomes
\nare jointly dependent on the state of
\nnature that obtains and the behavior of
\nthe economic agent. Arrow refers to this
\ncondition as the “confounding of risks and
\ndecisions” (1969, p. 55). Absent a performance
\naudit, the true explanation for
\nthe outcomes observed in these circumstances
\ncannot be accurately established.
\nRevising the terms of a contract to reflect
\nthe additional information gleaned
\nfrom experience may be referred to as
\nexperience rating. Ihe prospect that this
\nwill be done serves to curb opportunism in
\ncontract execution. Inferior agents will
\nnevertheless be able to exploit information
\nimpactedness, however, unless original
\nterms are relatively severe (i.e., no
\nbargains are to be had on joining) or
\nparties are unable easily to opt out when
\nterms are adjusted adversely against them.
\nOne way to accomplish the latter is for
\nmarkets to pool their experience so that
\nopportunistic types cannot secure better
\nterms by “quitting” and turning elsewhere.3
\nThis requires that a common language
\nbe devised for describing agent characteristics,
\nwhich will be greatly facilitated
\nif the behavior in question can be easily
\nquantified. Where instead the judgments
\nto be made are highly subjective, the costs
\nof communication needed to support a
\ncollective experience rating system are
\napt to become prohibitive. Internal organization
\nmay be favored instead because
\nit affords economies of communication.4<\/p>\n
II. Internal Organization and Hierarchy
\nlTo describe the transformation of internal
\norganization from simple peer
\ngroups through intermediate hierarchical
\nstages to include eventually complex,
\nadaptive organization of the sort described
\nby S. Beer, in his cybernetic account of the
\nenterprise, is beyond the scope of this
\npaper. Ihe discussion here is accordingly
\nrestricted to hierarchies of a comparatively
\nprimitive sort. The shift from peer groups
\nto simple hierarchies, for bounded rationality
\nand experience rating reasons, and
\nthence to multistage hierarchies, for transactional
\nreasons, is all that will be attempted.<\/p>\n
Inasmuch as individuals derive nonpecuniary
\nsatisfactions from a wide variety
\nof nonwork group affiliations, while the
\nwork group is distinguished by its productivity
\nattributes, the discussion proceeds
\nmainly along productivity lines. But
\nwhile this delimits the inquiry, it does not
\nimply that workers are schizophrenic with
\nrespect to their economic and noneconomic
\nidentities. Those social psychologists
\nwho have been concerned with the
\n“human side of enterprise” have counseled
\nagainst this for years. Thus, although an
\nemphasis on productivity will be maintained,
\nan attempt will be made to display
\nsensitivity to the potentially oppressive
\nconsequences of alternative modes of
\norganization by reference to on-the-job
\natmosphere.
\nI This should not be read as a rationale for anticompetitive
\ncollusion.
\nI To the extent that supervisors and experience raters
\nare one and the same individual, the need to rationalize
\nsubjective assessments that are confidently held but difficult
\nto articulate is reduced. Thus the occasion to communicate
\nis less. In addition, interorganizational communication
\non complex matters is often more costly
\nthan is intraorganizational. Full-time membership in an
\norganization involves common training and experience
\nas well as recurrent interpersonal contacts. Informal
\ncoding economies are realized naturally and subtle
\nnuances come across easily as a result.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nVOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 321
\nA. Peer Group A ssociations
\nSo as to avoid imputing benefits to
\nhierarchy that can be had, in some degree,
\nby simple nonhierarchical associations of
\nworkers, it will be useful to begin with an
\nexamination of worker peer groups. I’hese
\ninvolve collective and usually cooperative
\nactivity, provide for some type of income
\nsharing arrangement, but do not entail
\nsubordination.
\n1. A dvantages
\nPeer group organization (possibly in the
\nnature of a cooperative) for which loose
\nmetering has been expressly provided may
\narise on account of indivisibilities, for
\nassociational reasons, or because of riskbearing
\nadvantages. Inasmuch as the
\nrationale for shifting from individual to
\ncollective organization to reach requisite
\nsize consistent with indivisibilities is
\nfamiliar, consider the associational and
\nrisk-bearing issues.5
\n‘IThe associational gains of peer groups in
\nrelation to markets are attributable to the
\ntransformation of “involvement” relations
\n(in the sense of A. Etzioni) from a
\ncalculative to a more nearly quasi-moral
\nmode. Such an affiliation may incur productivity
\nlosses but nevertheless be valued
\nfor itself. But it may also, for pure associational
\nreasons, yield productivity gains
\nby mobilizing energies which, even if they
\ncould be monitored costlessly and priced
\naccordingly, could not be exacted in the
\nmarket by the assured prospect of pecuniary
\nreward. Vulnerable, however, as
\nloose-metering structures are to free-rider
\nabuses, membership restrictions designed
\nto cull out those who would exploit average
\ngroup productivity are to be expected.
\nGroup affiliation may also be sought for
\ninsurance purposes if membership can
\nprovide income guarantees to buffer the
\neffects of unanticipated contingencies on
\nterms superior to that which market insurance
\ncan provide. The advantage of the
\ngroup over the market here is presumably
\ndue to its capacity to (1) limit membership
\nin a discriminating way, thus mitigating
\nproblems of adverse selection attributable
\nto ex ante information impactedness and
\nopportunism on the part of insurance
\npurchasers, and (2) check malingering and
\nother ex post manifestations of moral
\nhazard. Lacking hierarchy, however, the
\nargument has only small group implications.<\/p>\n
2. Limitations
\nWhether peer groups can fully realize
\neconomies attributable to indivisibilities
\nturns partly on utilization. Consider, for
\nexample, the problem of devising access
\nrules for an indivisible physical asset for
\nwhich simultaneous utilization is not
\npossible. Any of a number of rules may be
\nefficacious, but agreement on one must be
\nreached. While a full group discussion
\nmay permit one of the efficient rules eventually
\nto be selected, how much simpler if
\ninstrumental rules were to be “imposed”
\nauthoritatively. Resort to hierarchy may
\nthus be favored on this account though
\nthe “leader” in these circumstances may
\nmerely be the first among equals.
\nMore serious, probably, is the vulnerability
\nof peer groups to free-rider abuseswhere
\nthese are due to the conjunction of
\ninformation impactedness and opportunism.
\nSuch free-rider abuses can take either
\nof two forms: ex ante nondisclosure (disguise)
\nof true productivity attributes, and
\nex post malingering. The parallel with the
\ninsurance example should be noted.6
\nThus let p in the insurance example now
\nrefer to the potential productivity of an
\nindividual. If members of the peer group I Indivisibilities can take either physical or informational
\nforms. Indivisibilities of the former type are
\nfamiliar. On the latter, see Radner 1970, p. 457. i This was called to my attention by Jeffrey Harris.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\n322 AMERICAN ECONOMIC ASSOCIATION MAY 1973
\nare all rewarded by average group productivity
\n(fi) and if no individual is prepared
\nto accept less than a p-E return, the
\npeer group can be viable only if it can successfully
\nscreen out low productivity applicants.
\nTIo the extent that the cost of ex
\nante screening is high in relation to ex post
\nexperience rating, where the latter involves
\nhierarchy, peer group organization is perforce
\nlimited.
\nThere is the further problem in the peer
\ngroup of checking malingering, which is an
\nemployment manifestation of moral hazard.
\nAlthough informal peer group pressures
\nmay be mobilized to discourage
\nmalingering, supplementing these by experience
\nrating is apt often to be even more
\nefficacious.7 A shift to hierarchy is favored
\non this account as well. Thus, although
\npeer groups afford associational gains, may
\nbe efficient risk-bearing instruments, and
\npotentially permit economies attributable
\nto indivisibilities to be realized, the costs
\nof communicating and reaching joint decisions
\nare apt to be high and, by design,
\npeer groups lack a formal auditing and
\nexperience rating capability.
\nB. Simple Hierarchies
\n1. A dvantages
\nThe advantages of hierarchy for communicating
\npurposes are reasonably obvious
\nand have been developed elsewhere.
\nConsider, therefore, the auditing and experience
\nrating properties of simple hierarchies.<\/p>\n
Often the most efficient way to discover
\nan individual’s true potential productivity
\n(p) is by observing his work product
\nrather than by preadmission audits. Accordingly,
\nthe peer group can usefully be
\nsupplanted by hierarchy. Not only can
\neasier admission standards be allowed if
\none is confident that he can discern true
\nproductivity ex post and pay the appropriate
\ndiscriminating wage, but the
\nprospect of being audited and experience
\nrated discourages malingering as well.
\nHigh productivity types and\/or those who
\nwould be prepared to self-enforce promises
\nnot to malinger can thus be induced to
\naffiliate at a low wage by the assurance
\nthat this condition will be rectified as
\ninformation accumulates and more discriminating
\nwage assignments can be
\nmade. Correspondingly, those with low
\nproductivity and\/or high proclivities to
\nmalinger will be unable long to exploit the
\nsystem. The leader who is charged with
\nauditing and experience rating, however,
\nis no longer merely first among equals; a
\ngenuine supervisor-subordinate relation
\nnow obtains.8
\n2. Limitations
\nThe ideal manager in this model is one
\nwho has talents for discovering and extinguishing
\nopportunistic behavior.9 Nothing
\nhas been said about his risk-bearing
\naptitudes, innovative characteristics, leadership
\nqualities, or differential decisionmaking
\nskills. Neither has the bounded
\n7 D. Hampton, C. Summer, and R. Webber describe
\nthe group disciplinary effects of informal organization
\nin four stages (p. 283). The most casual involves cajoling
\nor ribbing. This failing, rational appeals to persuade the
\ndeviant to conform are employed. The group then
\nresorts to penalties by withdrawing the social benefits
\nthat affiliation affords. Finally overt coercion and ostracism
\nare employed.
\nI The issue here is similar to that examined by A.
\nAlchian and H. Demsetz in their interesting treatment
\nof what they refer to as the “classical capitalist firm.”
\nAs they see it, technological nonseparabilities in production
\nare responsible for the emergence of hierarchy. As
\nthe above discussion reveals, however, nonseparability
\nis not a necessary condition for hierarchy to evolve.
\nI That hierarchy of a supervisor-subordinate sort
\nfacilitates auditing and experience rating does not, however,
\nimply that all such hierarchies need meter productivity
\nin the same degree. Differing attitudes among
\nworkers toward metering intensity will permit enterprises
\nto specialize accordingly. Some will meter closely
\nand appeal to those who favor very tight correspondence
\nbetween rewards and deeds. Others will meter less
\nclosely in support of a less calculative associational relationship.
\nBoth types, given that workers allocate themselves
\nappropriately, can be fully viable.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nVOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 323
\nrationality problem been faced. Although
\na complete theory of the firm must eventually
\naddress all of these issues, such an
\neffort is beyond the scope of this paper.
\nConsider instead the following delimited
\nproblem: What organizational relations
\nare to be expected if a set of technologically
\nseparable work groups (each, say, organized
\nas a simple hierarchy) is engaged in
\nrecurring exchange of a small numbers sort
\nfor which suiccessive adaptations to uncertainty
\nare required10
\nFor reasons that can be traced ultimately
\nto the human and transactional
\nfactors described in Section 1, neither long
\nterm nor short-term interfirm contracts
\nhave attractive properties in these circumstances
\n(Williamson 1971, pp. 115-
\n21). Consider therefore two hierarchical
\nalternatives: extend the span of control of
\na single manager over the entire set of
\ntransactionally-related activities; and inside
\ncontracting, which is a hierarchical
\nvariant (involving two or more stages) on
\nthe manager as monitor model.
\nThe first possibility can be dismissed on
\nbounded rationality grounds. Spans of control
\ncan be progressively extended only by
\nsacrificing attention to detail. Neither
\ntransactional economies nor effective monitoring
\ncan be achieved if capacity limits
\nare exceeded. Thus suppose that inside
\ncontracting were employed.
\nJ. Buttrick has described the inside contracting
\nsystem as follows:
\nUnder the system of inside cQntracting,
\nthe management of a firm provided floor
\nspace and machinery, supplied raw material
\nand working capital, and arranged
\nfor the sale of the final product. The gap
\nbetween raw material and finished product,
\nhowever, was filled not by paid employees
\narranged in [a] descending hierarchy
\n. .. but by [inside] contractors, to
\nwhom the production job was delegated.
\nThey hired their own employees, supervised
\nthe work process, and received a
\n[negotiated] piece rate from the company.
\n[pp. 201-02]
\nThe system developed among New England
\nmanufacturing plants at the time of
\nthe Civil War and was continued in many
\nof them until World War 1.
\nThe inside contracting system had the
\nattractive attributes that it (1) provided
\nfor the aggregation at a single location of a
\nseries of primary work groups that were
\ninvolved in successive manufacturing processes,
\nthereby reducing transportation expense
\nand assuring that a cheek-by-jowl
\nassociation would develop, with corresponding
\neconomies of communication;
\n(2) permitted the capitalist with relatively
\nlittle technical knowledge to employ his
\ncapital productively while limiting his
\ninvolvement to negotiating contracts with
\nthe inside department heads, inspecting
\nand coordinating the output of the various
\ndepartments, and taking responsibility for
\nfinal sales; and (3) provided the inside contractors
\n(first level monitors) with incentives
\nfor efficient labor performance, in
\nboth supervisory and process innovation
\nrespects. In addition, although neither is
\nmentioned by Buttrick, (4) the monopoly
\npowers of the various inside contractors
\nwere, in relation to supply by an exclusive
\noutside supplier, presumably limited by
\nthe capitalist’s ownership of plant and
\nequipment, and (5) problems of information
\nimpactedness, which might otherwise
\ninhibit new investment, were avoided.
\nThe system nevertheless experienced numerous
\ndifficulties (Buttrick, pp. 210-15):
\n(1) a bilateral monopoly position, albeit
\nrestrained, developed between
\nthe parties;
\n(2) the periodic renegotiation of rates
\ninduced the contractor to hoard information
\nand strategically delay
\ninnovations;
\n(3) the flow of components was difficult
\nto regulate;
\n10 Two work groups will be considered to be separable
\nif a buffer inventory would sever the interdependence
\nrelation, between them. Most large groups can be decomposed
\ninto a series of small groups in this way.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\n324 AMERICAN ECONOMIC ASSOCIATION MAY 1973
\n(4) work-in-process inventories were excessive
\nand, since each stage incurred
\nonly its own direct labor
\ncosts, later stage processes were
\nwasteful of components on which
\nearly stage work was completed;
\nand
\n(5) contractor incomes were sometimes
\nexcessive in relation to those of the
\ncapitalist, endangering the status of
\ncompany officials.
\nThe system moreover was beset by defective
\nincentives in that:
\n(6) equipment was not utilized and
\nmaintained with appropriate care;
\n(7) process innovations were biased in
\nfavor of labor saving, as against materials
\nsaving, innovations; and
\n(8) the incentives for product innovation
\nwere insufficient.
\nAlthough some of these defects-namely,
\n4 and 7-might have been remedied by
\nmaking simple changes in the internal
\npricing system, the other disabilities of
\ninside contracting appear really to be
\nimmanent. Given uncertainty, whence the
\noccasion to make coordinated adaptations
\nbetween successive parts, and bounded
\nrationality, whence the infeasibility of a
\nflat (single stage) hierarchy, the defects
\nlisted are manifestations of small numbers
\nbargaining relations in which opportunism
\nand information impactedness conditions
\nobtain.” Thus, the disabilities of yet another
\norganizational mode, this time inside
\ncontracting, are explained in terms of the
\nhuman and transactional factors described
\nin Section 1.
\nC. Subordination of Functional
\nDepartments
\nThe reasons, I submit, why inside contracting
\nwas displaced by a hierarchical
\nsystem in which department managers
\nwere no longer semiautonomous contractors,
\nbut were made to accept employee
\nstatus instead, are that this harmonized
\ninterests, permitted fiat to be employed to
\nsettle instrumental disputes that might
\notherwise occasion costly haggling, and
\nallowed auditing and experience rating to
\nbe brought more sytematically to bear. The
\nresulting transactional economies are examined
\nin my treatment of vertical integration
\n(1971). (For a discussion of the
\nhuman and transactional difficulties which
\nsuch functionally organized enterprizes
\neventually encounter as firm size is progressively
\nscaled up, see Williamson,
\n1970.)
\nIII. Concluding Remarks
\nThe discussion of internal organization
\nin this paper deals with only elementary
\nforms of hierarchy and relatively simple
\ntypes of adaptive behavior. The management
\nof a complex firm, however, must
\ndeal with such issues as the redeployment
\nof internal resources in response to environmental
\ndisturbances in kind, strategic
\nplanning, including innovation, and preserving
\n(or not degrading) intrafirm atmosphere
\nas firm size is scaled up. In addition,
\nthe eventual limits of complex hierarchies
\nneed to be assessed. While these
\nmatters are beyond the scope of this
\npaper, my contention that the interesting
\nproblems of organization in complex hierarchies
\nare likewise to be understood in
\nterms of the framework proposed in Section’
\nI is surely, at this stage, unsurprising.
\n11 Defect number 5 involves, in addition, a strain on
\natmosphere. Upsetting the normal correspondence between
\nhierarchical position and income apparently poses
\npersonal and functional status threats of a potentially
\ndisruptive sort.
\nREFERENCES
\nG. Ackerlof, “The Market for ‘Lemons’,”
\nQuart. J. Econ., Aug. 1970, 74, 488-500.
\nA. Alchian and H. Demsetz, “Production, Information
\nCosts, and Economic Organization,”
\nAmer. Econ. Rev., Dec. 1972, 62,
\n777-95.
\nK. Arrow, “The Organization of Economic
\nActivity,” in The Analysis and Assessment
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions
\nVOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 325
\nof Public Expenditure: The PPB System, 1,
\nJoint Economic Committee, 91st Congress,
\nWashington 1969, 59-73.
\nEssays in The Theory of Risk-Bearing,
\nChicago 1971.
\nS. Beer, “The Aborting Corporate Plan: A
\nCybernetic Account of the Interface between
\nPlanning and Action,” in E. Jantsch, ed.,
\nPerspectives of Planning, Paris 1969, 397-
\n422.
\nJ. Buttrick, “The Inside Contracting System,”
\nJ. Econ. Hist., Summer 1952, 12, 205-21.
\nR. Coase, “The Problem of Social Cost,” J.
\nLaw and Econ., Oct. 1960, 3, 1-44.
\n, “The Regulated Industries: Discussion,”
\nAmer. Econ. Rev., May 1964, 54,
\n194-97.
\nP. Doeringer and M. Piore, Internal Labor
\nMarkets and Manpower Analysis, Lexington,
\nMass. 1971.
\nA. Etzioni, A Comparative Analysis of Complex
\nOrganizations, New York 1961.
\nD. Hampton, C. Summer, and R. Webber,
\nOrganizational Behavior and The Practice
\nof Management, Glenview, Ill. 1968.
\nM. Pauly, “The Economics of Moral Hazard,”
\nAmer. Econ. Rev., June 1968, 58,
\n531-37.
\nR. Radner, “Competitive Equilibrium under
\nUncertainty,” Econometrica, Jan. 1968, 36,
\n31-58.
\n“Problems in the Theory of Markets
\nunder Uncertainty,” Amer. Econ. Rev., May
\n1970, 60, 454-60.
\n0. Williamson, Corporate Control and Business
\nBehavior, Englewood Cliffs 1970.
\n, “The Vertical Integration of Production:
\nMarket Failure Considerations,”
\nAmer. Econ. Rev., May 1971, 61, 112-23.
\nThis content downloaded from 134.176.160.187 on Thu, 05 Nov 2015 13:21:31 UTC
\nAll use subject to JSTOR Terms and Conditions<\/p>\n","protected":false},"excerpt":{"rendered":"
Dabbawala : The organization and emerge of food systems [NOVEMBER The Nature of the Firm By R. H. COASE ECONOMIC theory has suffered in the\u2026<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[8827,10099,10540,10536,10892,10538,10539,10537,10891],"tags":[10549,10616,10615,7687,10627,8857,10552,10295,10548,10622,8907],"class_list":["post-130053","post","type-post","status-publish","format-standard","hentry","category-australia-essays","category-buy-essay","category-cheap-essay-writers","category-get-assignments-done","category-page-paper","category-phd-essay-writers","category-research-paper-writing-service-for-any-topic","category-study-bay-essay","category-write-my-assignment-ireland","tag-ai-plagiarism-free-essay-writing-tool","tag-australian-best-tutors","tag-best-trans-tutors","tag-buy-essay-uk","tag-cheap-dissertation-writer","tag-help-with-writing-an-essay","tag-help-write-my-paper-ai-free","tag-homework-for-you","tag-online-essay-writers","tag-phd-essays","tag-write-my-essay-for-me"],"_links":{"self":[{"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/posts\/130053","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/comments?post=130053"}],"version-history":[{"count":0,"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/posts\/130053\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/media?parent=130053"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/categories?post=130053"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.studyproessays.com\/help\/wp-json\/wp\/v2\/tags?post=130053"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}