Production, Information Costs, and Economic Organization Joshua Downs 9/13/2015 Production, Information Costs, and Economic Organization Armen a. alchian & Harold demsetz American Economic Review, 1972

Main Points Difficult to resolve alternative forms of organization by transaction costs alone, seeks to identify and explain a particular contractual arrangement induced by the cost of information factors Continuous contractual renegotiation No authority Employees with leisure and income considerations on utility curve have incentive to shirk, shirking problem coupled with potential for greater marginal productivity through joint use of inputs (team production) explains the firm with a monitoring central common party to a set of bilateral contracts Presence of monitoring central agent reduces shirking by employees, assignment of residual income to monitor constrains shirking by the monitor Relative costs/benefits of monitoring behavior or output also determines inputs owned by firm

The Metering Problem Productivity doesn’t automatically create reward 2 Key demands on an economic organization Metering input productivity Metering Rewards Competitive markets meter the outputs directly, reveals the marginal product and apportions the rewards to resource owners in accord with that direct measurement of their outputs Those who change outputs control change in market prices System of rewarding stimulates productivity responses 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 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 Individuals adjust rate of work to bring demand prices of leisure and output to equality with their true costs 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 Task of monitoring monitor remains 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

Emergence of the Firm Bundled rights of the residual claimant Defines ownership of the classical firm, arises if it is comparatively better at resolving shirking non-centralized contractual arrangement 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 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 behavior Leads to classical capitalist firms: joint input production, several input owners, & centralized common party to bilateral contracts 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 The Corporation 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) The Corporation 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 straight wages

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 inflicted upon the input in its use Unbreakable hammer with measured marginal product = 0 use cost 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 Human labor impossible to separate into absentee ownership category Information collected and collated by firm through virtue of monitoring Information sold by firm to employees through facilitation of team production

Discussion Would Thor prefer to rent or own his hammer? What concepts presented here require more effort to reconcile logically? Do ordinary markets suffer from defects of communal property rights in organizing and influencing use of valuable resources? Does the discussion effectively counter behavioral theory of the firm’s concept of authority? Team spirit and loyalty