The Foundations of the Economics of Organizations
Why do existing free enterprise systems have the forms of organization that they do? One of the most interesting developments in economics over the past few decades is the articulation of a research program that attempts to answer this and related questions.
Sometimes called the new institutional economics or the economics of organizations, this program seeks to explain why certain organizational forms, policies, and procedures predominate in a free enterprise system. Though some of the most important developments have taken place in recent years (notably, the publication in 1985 of Oliver Williamson’s The Economic Institutions of Capitalism), the roots of this program are to be found in the 1930s and 1950s. This section begins with a discussion of two of the most important early contributions to this program: Ronald Coase’s (1937) seminal contribution to transactions cost analysis and Armen Alchian’s (1950) evolutionary theory of economic organizations. Perhaps more than any others, these two theorists laid the foundations for this research program by asking the right questions and indicating the general form the answers should take.Traditional neoclassical economic theory treats the firm as a production function that transforms inputs into outputs. As such, the firm remains a kind of black box whose internal workings are ignored by the economic theorist. In a famous article, “The Nature of the Firm,” Coase (1937) challenged this view. Coase maintained that one could not adequately understand a market economy without understanding the internal structure—the institutional structure—of the firm. The central question of Coase’s article has an almost philosophical ring to it: Why are there any firms at all? There is a contrast implicit in this question, a contrast between the firm and the market as alternative ways of coordinating economic activity.
Coase is asking why some economic activity is organized within firms as opposed to across markets.The significance of this question can be appreciated by recalling the discussion in chapter 2 of the inefficiencies of central planning as compared to the market. In that discussion, the flexibility and responsiveness of the market was contrasted with the informational and incentive problems facing the hierarchies of a centrally planned economy. In light of that contrast, one might wonder, “If markets are so great, why aren’t all economic relations market relations?” In other words, why do people come together in economic organizations (i.e., firms) instead of being independent contractors who buy inputs and sell outputs on the open market? The obvious answer—that modern production requires large manufacturing and distribution facilities—is inadequate, since the physical requirements of production do not uniquely determine how productive resources are owned. After all, each machine used in a production process could be owned by individuals, as indeed was the case in the putting-out system used in the early part of the Industrial Revolution (Landes 1966, 12).
Coase’s answer to the general question of why there are firms is not particularly surprising. As is often the case, what is most important are the questions, not the answers. The hierarchical relation characteristic of the firm is sometimes more efficient than the market as a way of coordinating productive activity. Instead of having to find, negotiate, and reach agreement with various owners of factors of production at each and every stage of the production process and to do so repeatedly over time, an owner of some factor of production simply hires other factors of production, which are then subject to his direction. This line of thinking leads naturally to the opposite question, Why are there any markets? If it is less costly to bring transactions within the firm (i.e., under one ownership umbrella) why does this not result in an expansion of the scope of the Hrm to the point of extinguishing the market?
What Coase’s article did was raise the question of the nature and determinants of the transaction costs of firms versus markets.
In other words, Coase posed the question of the relative efficiencies and inefficiencies of coordinating productive activity within the firm or across markets. Prior to Coase, to the extent to which the matter had been given any thought, it had been believed that technology determined the firm-market boundary, that is, the extent to which the stages of production and distribution are integrated within a firm. Coase’s argument, on the other hand, implied that transaction costs play an important, if not decisive, role in determining this boundary. An important task for economics became to explain the nature and determinants of this firm-market boundary by appeal to the relative transaction costs of each way of organizing economic activity.This covers such issues as the kinds of contractual arrangements that govern relations between firms and their customers and suppliers, the make-or- buy decision, and the determinants of vertical and horizontal integration. Another area of research suggested by this article, which is most directly relevant to the purposes of this book, had to do with the structure of firms themselves. If the firm is conceived of as a nexus of contracts among its members, transactions cost considerations should be able to explain why firms are organized the way they are. In particular, there might well be transactions cost efficiencies in the classical capitalist firm and the open corporation.
These questions did not receive the immediate attention they warranted. The continued development of neoclassical economics, which treats the firm as a production function, served to divert attention and talent away from the research agenda suggested by Coase’s article. It is only in the past couple of decades, as the neoclassical paradigm has come under increasingly heavy attack, that there has been renewed interest in the institutional perspective implicit in Coase’s outlook.
The second seminal article for the new economics of organizations was Armen Alchian’s (1950) “Uncertainty, Evolution, and Economic Theory.” Alchian’s article was responsible for two important contributions.
First, he called into question the assumption, standard in neoclassical theory, that firms and individuals are maximizers. He argued that human action takes place in an environment of uncertainty and that in such an environment, there is no well- defined notion of an optimum. Furthermore, even if there is an optimum, it may be inaccessible to human actors. He says, “Uncertainty arises from two sources: imperfect foresight and human inability to solve complex problems containing a host of variables even when an optimum is definable” (p. 212). These observations called into question the applicability of standard neoclassical analysis to the real world, because it assumes that economic actors always maximize. He also suggested that any adequate analysis of economic activity had to hnd a place for this fundamental cognitive deficiency of human actors—a deficiency, it is worth noting, that cannot be modeled by assuming that economic actors know all the relevant probabilities.The second contribution of Alchian’s article is its adumbration of an evolutionary theory of economic organization. This theory starts from the observation that there is a competitive struggle for survival among firms. There are differences among firms in their internal organization, policies, procedures, and so on. Some of these differences are conducive to the firm’s survival, and some are not. Those with the more efficient organizational forms, policies, and procedures will make positive profits (the criterion for success) and survive, while those with maladaptive features will not. The selection process is weak selection, not strong selection; that is, firms do not have to optimize to succeed or survive. Indeed, they need not be very efficient at all in any absolute sense. Consistent with making positive profits, they need only approximate the efficiency of their most efficient rivals.
The parallels with Darwinian evolution are striking. Firms evolve over time to become better adapted to their economic environment.
But what corresponds in this system to heredity and mutation? Alchian’s answer: imitation and innovation. Successful firms keep doing what they have been doing (they “imitate” themselves), and other firms adapt by imitating their more successful rivals. He says, “What would otherwise appear to be merely customary ‘orthodox,’ non-rational rules of behavior turns out to be codified imitations of observed success, e.g., ‘conventional’ markup, price Tollowship,' ‘orthodox’ accounting and operating ratios, ‘proper’ advertising policy, etc.” (1950, 218). In other words, various features of economic organizations (policies, procedures, and even organizational forms themselves) can be explained by an evolutionary process in which the more efficient features persist and the less efficient are weeded out. Those who adopt conventional markup policies in retail pricing of women’s clothing, for example, may do so not from some complicated price projection models but just because that is the way it is done in the business. This policy has persisted because of its survival value, whether those who use it recognize that fact or not.Innovation may be the result of a conscious search strategy for new and better ways of doing things, but it need not be. Innovation can come from imperfect imitation, trial and error, and even sheer chance. If an innovation is conducive to survival, it will tend to persist and become widespread. If not, it will die out.
As this example illustrates, one implication of Alchian’s evolutionary model is that economic actors do not have to understand the efficiency advantages of the organizational forms, policies, and procedures in which they participate. How individual participants view their situation and react to it is immaterial from an evolutionary point of view. They may or may not believe that what they are doing is conducive to the survival of the firm. Indeed, they may have no opinion on the matter; they may have some other end in view.
For example, an executive may follow some standard procedure simply because he is too timid to try anything else. Or he may innovate by misinterpreting what his by-the-book superiors have told him to do or by miscopying a rival who is about to self-destruct. And on some occasions, executives actually reason their way to a better way of doing business. The theory does not require that individuals know the efficiency advantages of what they are doing. All that matters is that those advantages exist; competition does the rest.For the economic theorist, an important attraction of Alchian’s evolutionary approach is that the story of how a type of organization, policy, or procedure came into existence is irrelevant to explaining why it persists. The environment simply selects out those organizational forms, policies, and procedures that produce positive profits; those that do not are extinguished. Absent significant change in the external environment, this results in a measure of uniformity over time, as competitors who adapt by imitating successful rivals survive and competitors who do not go under.8 Thejob of the theorist is to discover and elucidate the efficiency advantages of the object of study.
An example illustrates. Gilson and Mnookin (1988) argue that the up-or- out system for associates in law firms, which is similar to tenure in universities, has efficiency advantages over alternative employment practices. The policy says that after a probationary period, the firm must promote an associate attorney to partner or fire her. If the probationary period were of indeterminate length, firms would be strongly tempted, regardless of what they might have informally promised, to keep a good attorney on at the associate level indefinitely. The reason for this is that after five or six years, a good associate has built up a great deal of firm-specific knowledge (of operating procedures, of clients, etc.) and thereby has greatly increased her productivity; yet she is costing the firm relatively little. Because much of her value to the firm is due to this firm-specific knowledge, she is not in a good position to move on to another job at her current salary, which is nevertheless significantly less than the value of her contribution. This is why it is in the firm’s interest to keep her on at the associate level indefinitely. However, by publicly committing itself to the up-or-out system, the firm is effectively precommitting itself to making the partnership judgment strictly on the merits of the case. The efficiency advantage of this arrangement is that in the absence of such a system, it would have to pay all associates a premium in compensation for the risk of being strung along. (And, because this example is about lawyers, the premium would undoubtedly have to be substantial.) Other, more costly alternatives might have been tried in the past, but if so, none has survived. All major firms now use the up-or-out system.
Within the evolutionary framework provided by Alchian, identifying or explaining these advantages would count as an explanation for why most firms use this employment practice. However, this does not mean that individual firms have instituted this policy because they saw that this was the most efficient way to do it; they might have simply been imitating more prestigious firms. Interviewers for the law firm tell prospective associates, ‘Just like at Cravath and Swain, we here at Dewey, Cheatham, and Howe use the up-or- out system for associates.” Partners and associates need not be aware of these efficiency advantages. From their point of view, this is simply the way it has always been done. Moreover, Alchian would say that this system might have come into being for any number of reasons, including sheer chance. However, it survives and persists because of its superior efficiency properties.
Perhaps the most important implication of Alchian’s evolutionary perspective is that there is a (rebuttable) presumption of efficiency in the common or widespread organizational forms, policies and procedures found in existing free enterprise systems. In other words, if an organizational form, policy, or procedure is common and has persisted for some extended period of time in a free enterprise system, then there is probably some efficiency advantage to it. This invites the researcher to discover and elucidate that efficiency. However, it is vital that this rebuttable presumption of efficiency not turn into the false Panglossian assumption that if something exists, then it must be efficient. There are a number of reasons why the Panglossian assumption is false. One is that economic systems do not exist in a vacuum. Other social institutions, such as the political system and the family, have pervasive and systematic effects on economic life; there is no guarantee, (despite Gary Becker and others) that economic principles can explain these other institutions and their effects on the economic system. In addition, noninsti- tutional cultural forces may have a profound influence on the economic environment in ways that the science of economics cannot fathom. Finally, some habitats in the economic environment may be so volatile and unstable that the forces of natural selection are unable to perform their winnowing function. So there is no guarantee that if something exists, it is efficient.
However—and on the other hand—these confounding influences are less likely to be a factor when the phenomenon to be explained is widespread and pervasive. For example, if the classical capitalist firm is an enduring fixture of free enterprise systems across a broad historical and geographical sweep, it is likely that it has substantial efficiency advantages over alternative organizational forms. Transactions cost analysis ought to be able to explain that by appeal to the efficiencies of that organizational form; as the next section shows, it can. However, since it is not the only type of economic organization, the transactions cost analyst has to identify the circumstances and conditions under which this organizational form will thrive and explain why alternative forms cannot prosper under those conditions.
Although for both Coase and Alchian, efficiency considerations are crucial to their explanations for a wide range of phenomena, those considerations enter into their explanations in fundamentally different ways. For Coase, there is the presumption that individuals are acting on the belief that the firm (or the hierarchical relations that characterize it) is more efficient than the market (or vice versa) as a way to handle some type or range of transactions and that this is why this way of organizing transactions is used.
By contrast, for Alchian, efficiency considerations functionally explain, via a natural selection argument, why organizations have the attributes they do, whether participants are acting on a recognition of those efficiency advantages or not. The environment has simply selected out those features which are conducive to survival. Such explanations are not genetic (i.e., they do not explain how that type of phenomenon came into existence in the first place), but they do explain why, once on the scene, that type of phenomenon persists. The next section provides just such an explanation of the classical capitalist firm.