COMPARING FIRMS, CONTRACTS, AND MARKETS Birger Wernerfelt MIT 1

Some simple points about the theory of the firm Firms are “common”, so the theory should be driven by “common” factors It is unlikely that one institution solves two problems (TCE: Ex ante and ex post distortions) It is unlikely that two institutions are driven by the same force (PRT: Asset ownership and employment) It is a plus if the theory resonates with managers It should portray one party as giving “orders” 2

Combination of old premises gives new insights Bargaining costs (Coase, 1937) Gains from specialization (Adam Smith, 1776) Adapting without losing gains from specialization Why Markets, Firms, or Contracts? When? Other implications of the theory Scope of the firm 3

About bargaining costs Many kinds: Incurred before, during, or after Have a bad name Some can be micro-founded: For ex. investment in information/bargaining power (also rent seeking literature) Sub-additive – exhibit economies of scale 4

Experiment on bargaining cost Bilateral, 30 sequential trades, full information Offer a price for the current trade or an average price for rest of them Small cost of pooling the residual trades: Domains overlap and all trades have to be executed under a pooling contract. Results point to positive, sub-additive bargaining cost 5

Gains from many kinds of specialization Performing the same service many times (Plumber) – service specialist Working for the same business many times (Superintendent) – business specialist Doing everything in the same way (Min time or cost, Max durability, appearance, or quality …) - standardization 6

Workhorse model: Fixed firm size Three periods t = 0, 1, 2. Time preference δ Services (S, s) and businesses (B, b) Workers (W, w) and entrepreneurs (E, e) In every period, each business needs a specific service and each worker can perform one For now │B│=│W│=│E│ “Type” of b is ε b ~ F(0, σ B ), type of s is ε s ~ G(0, σ S ) 7

Two frictions Adaptation vs. standardization: -If w performs s for b, the ideal “level” is q w = ε b + ε s -However, standardization requires that the level is constant over time. With standardization, second period base costs are c* instead of c. (Assume: Non-standardization is prohibitively costly) Bargaining costs -Positive for bilateral price determination -Sub-additive, taking values between K and K 8

Bargaining bins Players in a bargaining bin may negotiate a single price in every period. The bin is defined by a set of services to which this price applies. For example, among {0, 1} │S│ x {0, 1} │B│ possibilities, it can be “service s’ for any b ”, “service s’ for b’ ”, “any s for b’ ”, or “no services”. 9

Strategies An entrepreneur selects first and second period bargaining bins as functions of her needs for those periods. A worker selects first and second period bargaining bins as functions of his assignment in the immediately prior periods and, in the first period, a level at which to standardize. 10

Sequence of events: Period 0 -Each entrepreneur is randomly and permanently matched with a business. Workers and entrepreneurs are randomly matched. All ε b, ε s are realized. -Business (entrepreneur) needs for period 0 are realized. Workers learn the ε b of the business with which they are matched and the ε s of the service it needs. 11

Sequence of events: Period 1 -Business needs for period 1 are realized. -Entrepreneurs and workers distribute themselves into bargaining bins and negotiate as indicated. -Entrepreneurs and workers in each bin are randomly matched. -Workers choose the levels q w on which they standardize. -Workers perform the agreed upon services and learn the associated ε b, ε s. 12

Sequence of events: Period 2 - Business needs for period 2 are realized. -Entrepreneurs and workers distribute themselves into bargaining bins and negotiate as indicated. -Entrepreneurs and workers in each bin are randomly matched. -Workers perform the agreed upon services (and learn the associated ε b, ε s ). 13

Equilibria An equilibrium is a Market if all bargaining bins consist of │E│/ │S│ entrepreneurs needing the same service as well as │E│/ │S│ workers who are service-specialists on it, and the members negotiate a price for that service only An equilibrium is Employment if all period 1 bargaining bins consist of one worker and the entrepreneur for whom he worked in period 0, and the members negotiate a single price for all services. An equilibrium is Sequential Contracting if all bargaining bins consist of one worker and the entrepreneur for whom he worked in period 0, and the members negotiate a price for the service needed by the entrepreneur in the current period. 14

Proposition 1 There exists three regions in [σ B 2, σ S 2, K, K, δ] where Markets, Employment, and Sequential Contracting are weakly more efficient that all other sub-game perfect equilibria. σ B 2 – σ S 2 Sequential Contracting Employment Market δ 15

Firms are more likely to be used when frequent adaptation is necessary A car consists of 36 “systems” Changes in one may require changes in others 36x36 matrix of frequency w. w. “coordinated change is needed” Which systems should be co-produced? Data from 8 cars, very different solutions This is an enormously big optimization problem Firms do extremely well: 4 of 8 beat 99,995/100,000 random designs, 1 beats all. 16

Asset ownership An asset is owned by the player whose decisions most influence its depreciation 50 carpenters, 41 tools Employees own 40% of the tools “A hammer is easily lost or stolen” - employee “Some projects are more likely to damage a hammer”- boss Brand specific skills do not matter – no effect 17

Growing a business Some workers can be both business – and service specialists. Very efficient Worthwhile to expand to different but “adjacent” businesses This stops when the portfolio becomes too “unfocused” 18

PROPOSITION 2 If the ε b s are uniformly distributed on [0, 1] and an entrepreneur can meet all needs from n  [0, 1] businesses by hiring n service-specialists as employees, The optimal scope is an interval and profits are maximized at n = Min{2 ½ (2v – c – c* - K) ½, 1} PS: 2v-c-c*-K is average net profit per worker 19

Discussion 1: Summary Firms vs Markets vs Contracts: New forces - Advantages of specialization - Frequency of change - Magnitude of demand - Size of firms Limits to firm size: Resonate with practitioners -Leverage excess capacity of resources -Focus on what you are good at 20

Discussion 2: Turning things upside down Asset ownership -I own the assets because I am the boss Flatter incentives in firms -boss may ask employees to do other things Delegation -it is too costly to agree on everything Incomplete contracts - because they can be renegotiated More communication inside firms -loss of bargaining power matter less 21