Production, Information Costs, and Economic Organization Armen a. alchian & Harold demsetz American Economic Review, 1972 Weihao Li (Originally created by Joshua Downs)

Main Points The motivation to organize firms Team production: 1+1>2 Metering performance of team Reducing shirking and metering costs The essence of the classical firm Joint input; several input owners; a monitoring central common party to a set of bilateral contracts; rights to renegotiate contract independently; residual claimant; right to sell central contractual residual status. Different types of firms are organized due to different needs of metering Owners of the firm will be investors of resalable capital equipment The firm can be considered as a privately owned market Continuous contractual renegotiation No authority

The Metering Problem 2 Key demands on an economic organization Metering input productivity Metering Rewards Problem: productivity doesn’t automatically create reward System of rewarding stimulates productivity responses Poor metering leads to loose correlation between rewards and productivity Productivity thus rises and falls depending on ability to meter http://blogs.theprovince.com/2012/01/26/dan-murphy-vancouver-mulls-new-high-tech-parking-meters/ Dan Murphy: Vancouver mulls new high-tech parking meters

Team Production Team Production Team Production vs Individual Inputs Several types of resources are used The product is not a sum of separable outputs of each cooperating resources Not all resources belong to one person Team Production vs Individual Inputs Central common party to a set of bilateral contracts vs numerous multilateral contracts among all inputs Joint use of inputs vs Sum of products of separately used inputs Higher vs lower costs of monitoring due to nonseparability of marginal input productivities Lower vs higher leisure costs = Higher vs Lower Shirking Problem Choose team production instead of individual inputs When net increase in productivity available from team production over metering costs, team production will be used Similar to Coase’s comparative analysis

Reducing Shirking: The Monitor 1 team member specializes as a monitor Measuring output performance Apportioning rewards Disciplining Shirking Observing the input behavior of inputs as means of detecting or estimating their marginal productivity Giving assignments or instructions in what to do and how to do it Earns his residual trough the reduction in shirking that he brings. Monitoring the monitor Market mechanism constrains shirking, but limited Assignment of net earnings of the team, residual product above prescribed amounts Must be agreed to by owners of cooperating inputs

The Classical Firm The following bundle of rights defines the ownership of the classical firm To be a residual claimant To observe input behavior To be the central party common to all contracts with inputs To alter the membership of the team To sell these rights 2 necessary Conditions for the emergence of the firm It is possible to increase productivity through team-oriented production It is economical to estimate marginal productivity by observing or specifying input behave Classical capitalist firms: joint input; several input owners; a monitoring central common party to a set of bilateral contracts; rights to renegotiate contract independently; residual claimant; right to sell central contractual residual status Other Theories of The Firm: Coase and Knight Coase: Difficult to resolve alternative organizational forms with transaction costs alone Knight: Risk aversion not sufficient of incentive to explain classical firm

Types of Firms Profit-sharing firms Socialist firms As percentage of monitor’s residual claims decreases, cost of team production increases from monitor shirking Incentives to shirk are positively related to the optimal size of the team under an equal profit-sharing scheme Best in smaller firms where cost of specialized management is large relative to increased productivity of team production Monitoring becomes reciprocal, dedicated specialization in monitoring not required Socialist firms All employees are residual sharers Increased costs from monitor shirking requires management technique innovation (Employee committees recommending managers termination)

Types of Firms The Corporation Mutual and Non-Profits Partnerships Financial capital inputs acquired through promise of future returns Shirking of multiplicity of small relative to cumulative firm investors dealt with through limited liability Control achieved by transferring decision authority to smaller group of input managers constrained by unrestricted salability of shareholders (Principal and Agents) Agent shirking reduced through probability of shareholder action (Proxy battles) Mutual and Non-Profits No present day value of future improvements means shirking should be more prevalent Partnerships Reduced monitoring costs should be less relative to employee employer contract writing Employee Unions Serve as monitors of employers on behalf of employees for more ambiguous and contingent types of compensation than

Inputs Owned by the Firm Residual claimants will be investors of resalable capital equipment Monitoring not only gross product performance of inputs but the abuse or depreciation inflicted upon the input in its use Breakable equipment with vulnerability varying according to degree of carelessness in use Use or monitoring by owner will have lower price than rental absent owner The degree to which it is easier to detect cost by monitoring usage behavior over inspection post use increases likelihood of ownership Absentee ownership is impossible in human capitial Labor service cannot be performed in the absence of its owner

The firms as a private market The firm is a device for enhancing competition among sets of input resources a device for more efficiently rewarding market The firm and the ordinary market as competing types of markets Competition between private proprietary markets and public or communal markets

Discussion Does the claim that authority is not attributed to the conception of the firms or its efficiency contradict behavioral theory or the hierarchy in TCE? Do you agree that metering team performance is an essential problem in achieving efficiency? How should we understand the firm is a specialized private market? Team spirit and loyalty