Sunday, 15 November 2015

Cheung on Alchian and Demsetz

An argument made by Alchian and Demsetz (1972) in their discussion of the reasons for the formation of a firm is that in situations where the effort levels of individual members of a team are difficult to observe, moral hazard can become a problem. And a firm can arise to deal with such issues.

If total output is all that can be observed, due to high monitoring costs, and the proceeds of the team effort must be divided among the whole team then this can will give rise to a moral hazard problem. Any gains from higher individual effort will be shared with the entire team and, conversely, the losses from poor effort will be felt only partially by the shirker. No team member has an incentive to monitor any other member because of the costs involved and the low reward from doing so. Alchian and Demsetz's answer to this problem is to use a residual claimant to observe effort, hire and fire members of the team, direct activities and act as the single contractual agent. This central agent can deal with the moral hazard problem by careful monitoring of the team members and has an incentive to do so efficiently since he is the residual claimant.

But there are problems with this answer. Why, for example, can the central agent not be hired by the team members rather than the other way round. McManus (1975) gives a nice story to illustrate this idea:
Anecdote told by Steve Cheung: On the Yangtze River in China, there is a section of fast water over which boats are pulled upstream by a team of coolies prodded by an overseer using a whip. On one such passage an American lady, horrified at the sight of the overseer whipping the men as they strained at their harness, demanded that something be done about the brutality. She was quickly informed by the Captain that nothing could be done: 'Those men own the right to draw boats over this stretch of water and they have hired the overseer and given him his duties' (McManus 1975: footnote 3, page 341).
  • Alchian, A.A. and H. Demsetz (1972). 'Production, Information Costs, and Economic Organization', American Economic Review 62(5) December: 777-95.
  • McManus, John C. (1975). 'The Costs of Alternative Economic Organizations', The Canadian Journal of Economics 8(3) August: 334-50

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