Just for fun: theory of the firm 9

One of the most well known approaches to the theory of the firm is often referred to as the "nexus of contracts view." While this approach derives its name from a passage in Michael Jensen and William Meckling's 1976 paper "The Theory of the Firm: Managerial Behavior, Agency costs and Ownership Structure",

The private enterprise or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and which is also characterized by divisible residual claims on the assets and clash flows of the organization which can generally be sold without the permission of the other contracting individuals. (page 311)

the idea that the firm is nothing but a legal fiction can be seen in the 1972 paper by Armen Alchian and Harold Demsetz, "Production, Information Costs, and Economic Organization".

For Alchian and Demsetz, and the others following this approach, it is meaningless to draw a hard line between firms and markets. Although firms are clearly legal entities, and this fact has important economics consequences such as limited liability, the right to tax deductions for input costs, infinite lifetime for the firm and so on, they are still best thought of as a special kind of market contracting. A possible distinction firms and other market contracts is that firms have a continuity of association between input owners that other forms of contracting may not have.

An important result of this line of argument is that the distinction emphasised by Coase’s 1937 paper between authority-based and price-based modes of allocation is a misnomer. In reality, claim Alchian and Demsetz, there is no difference between “firing” one grocer and firing one’s secretary. What looks like a employment relationship is little more than a market relationship.

However the firm is a special form of market contracting and what makes it so has to do with team production. That is production where the individual production functions are inseparable. This means that marginal products are costly to measure. From this comes the fact that free riding is a problem since team-production can be a cover for shirking. With unknown individual productivities it is difficult to know who has done what and thus to detect shirking.

The Alchian and Demsetz answer to this problem is to appoint a monitor who has the right to hire and fire team members based on his observations of the employees’ marginal productivities. The monitor carries out the efficient amount of monitoring since he is given the right to the residual income of the team. The firm in this case is explained in terms of the reduction in post-contractual measurement costs.

There are, however, a number of problems with the Alchian and Demsetz approach to the firm. First, it is not clear why the monitor has to be the employer of the firm where he carries out his monitoring activities. He could be an employee of another firm which specialises in providing monitoring services. Also why can’t the employees monitor each other? Second, is it plausible that specialised monitoring eliminates the problem of inseparable production functions? Third, is it really meaningless consider authority in a situation where the employer/monitor has the right to prevent the employee from accessing the non-human capital – tools, machinery, equipment etc – that the employee needs to be productive? That is, if you fire your secretary, you keep the non-human assets but if you fire your grocer, the grocer keeps the non-human assets. In a world where human and non-human assets can be strongly integrated, this matters. Last, we observe more firms in the real world than can be explained by team production.

Despite these problems Alchian and Demsetz is still to be considered a seminal contribution to the theory of the firm. This is not just because it is still heavily cited but mainly because it gave rise to a still on going series of papers on the theory of the firm: see, for example, Barzel (1997 chapter 4), Fama (1980), Fama and Jensen (1983) and Jensen and Meckling (1976).

References:

• Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
• Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
• Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
• Fama, Eugene F. and Jensen, Michael C. (1983). 'Agency Problems and Residual Claims', Journal of Law and Economics, June, v. 26, iss. 2, pp. 327-49.
• Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.

Financial market reform

Over at Reason.com Jeffrey A. Miron gives his view on Financial Market Reform: Why new regulations must avoid moral hazards. Miron opens by saying,

In the coming weeks and months, Congress will be turning its attention to financial market reform, in hopes of avoiding future financial crises. According to perceived wisdom, the root cause of the 2008 financial crisis was excessive risk-taking, and proper regulation can detect and prevent such excess in the future.

This view is a pipe dream. Most new regulation will do nothing to limit crises because markets will innovate around it. Worse, some regulation being considered by Congress will guarantee bigger and more frequent crises.

He then notes that government-induced moral hazard caused the crisis.

The Financial Crisis of 2008 did not occur because of insufficient or ill-designed regulation. Rather, it resulted from two misguided government policies.

The first was the attempt to promote homeownership. Numerous policies have pursued this goal for decades, and over time they have focused mainly on homeownership for low-income households. These policies encouraged mortgage lending to borrowers with shaky credit characteristics, such as limited income or assets, and on terms that defied common sense, such as zero down payment.

The pressure to expand risky credit was especially problematic because of the second misguided policy, the long-standing practice of bailing out failures from private risk-taking. This practice meant that financial markets expected the government to cushion any losses from a crash in mortgage debt. Thus, the historical tendency to bail out creditors created an enormous moral hazard.

One crucial component of this moral hazard was the now infamous “Greenspan put,” the Fed’s practice under Chairman Alan Greenspan of lowering interest rates in response to financial disruptions that might otherwise cause a crash in asset prices. In the early to mid-2000s, in particular, the Fed made a conscious decision not to burst the housing bubble and instead to “fix things” if a crash occurred.

It was inevitable, however, that a crash would ensue; the expansion of mortgage credit made sense only so long as housing prices kept increasing, and at some point this had to stop. Once it did, the market had no option but to unwind the positions built on untenable assumptions about housing prices. Thus government pressure to take risk, combined with implicit insurance for this risk, were the crucial causes of the bubble and the crash. Inadequate financial regulation played no significant role.

The obvious conclusion from this is that if government-induced moral hazard caused the crisis, then new regulation should avoid creating or exacerbating this perverse incentive.

The only way to limit financial panics is to eliminate government-induced moral hazard, and that means letting failed institutions fail. Whether resolution is carried out by the FDIC or a bankruptcy court is not the crucial question; rather, it is whether that resolution process forces all the losses on the institution’s stakeholders rather than bailing them out with taxpayer funds.

So what should be done in the future?

To limit future financial crises, policy must first avoid the distortions inherent in the attempt to expand homeownership. This means eliminating the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Freddie Mac, the Community Reinvestment Act, the deductibility of mortgage interest, the homestead exclusion in the personal bankruptcy code, the tax-favored treatment of capital gains on housing, the HOPE for Homeowners Act, the Emergency Economic Stabilization Act (the bailout bill), and the Homeowners Affordability and Stability Plan. None of this is sensible policy.

In addition, policy must end its proclivity to bail out private risk-taking. This second task is difficult, since it requires policymakers to “tie their own hands.” Specific changes in policies and institutions can nevertheless support this goal. The first is avoiding new regulation that makes bailouts more likely. A second is repealing all existing financial regulation, since this would signal markets that they, and only they, can truly protect themselves from risk.

The third and perhaps most important way to reduce moral hazard is to eliminate the Federal Reserve. As long as the Fed exists, it will regard itself as, and be regarded as, the economic insurer of last resort. In a world with perfect information, appropriately humble central bankers, and an absence of political influence on monetary policy, such a protector might enhance the economy’s performance on average.

What's the bet no one listens to Miron's advice?!

Government meddling in bank executive pay is not going to help.

Over at the PBS-NBR website Steven Horwitz points out that Government Meddling in Bank Executive Pay is Not Going to Help. He writes,

The irony is that bank executives weren't the primary cause of the crisis, the very politicians and Federal Reserve who are now on their moral high horse were. Capping executive pay may make them feel good, but the consequences will be that the talent needed to restore confidence in the financial system will not see the lower pay as worth the trouble and will take their skills elsewhere.

More generally such meddling in markets sends broader anti-capitalist signal to the private sector. Other executives and investors, whether or not they were bailed out, will quite reasonably wonder "are we next?" And as they do, we may well begin to see their confidence in the system fall, leading to a broader withdrawal of financial and human capital. Obama and the Fed are playing with fire by flexing their political muscle this way. An understanding of the Great Depression suggests that they will get burned, further scorching an already crispy economy.

History offer some advice here: the economic historian Robert Higgs has argued that investors in the 1930s were hesitant to make investments because they simply did not know what the rules of the game were. Higgs notes that this "Regime Uncertainty" was one of the reasons that the Great Depression lasted so long. The inconsistent policy moves by both the Hoover and Roosevelt Administration as well as FDR's increasingly anti-business rhetoric and policies through the mid-30s led people to not want to take chances on longer-run investments. This lowered the rate of investment just at the time when investment was so badly needed. The recent moves by the Obama Administration and the Federal Reserve to look at what they claim is excessive pay to bank executives is yet another example of contemporary policy makers not learning this simple lesson from the Great Depression. Insofar as these moves increase regime uncertainty they will do nothing to help, and could more likely hurt, the current state of the economy.

Low prices are bad!

This comes from Mark Perry's blog Carpe Diem. Perry writes

From the American Booksellers Association letter to the Antitrust Division of the U.S. Department of Justice:

We ask that the Department of Justice investigate practices by Amazon.com, Wal-Mart, and Target that we believe constitute illegal predatory pricing that is damaging to the book industry and harmful to consumers.

As reported in the consumer and trade press this past week, Amazon.com, WalMart.com, and Target.com have engaged in a price war in the pre-sale of new hardcover bestsellers, including books from John Grisham, Stephen King, Barbara Kingsolver, Sarah Palin, and James Patterson. These books typically retail for between $25 and $35. As of writing of this letter, all three competitors are selling these and other titles for between $8.98 and $9.00.

The retailers are, in fact, taking orders for these books at prices far below cost. (In the case of Mr. King's book, these retailers are losing as much as $8.50 on each unit sold.) We believe that Amazon.com, Wal-Mart, and Target are using these predatory pricing practices to attempt to win control of the market for hardcover bestsellers.

Authors and publishers, and ultimately consumers, stand to lose a great deal if this practice continues and/or grows. If left unchecked, these predatory pricing policies will devastate not only the book industry, but our collective ability to maintain a society where the widest range of ideas are always made available to the public, and will allow the few remaining mega booksellers to raise prices to consumers unchecked.

We urge that the DOJ investigate and request an opportunity to come to Washington to discuss this at your earliest convenience.

Perry responds to all this by saying,

In other words, according to the booksellers, the "sky is falling," and the very foundations of our civilization are about to be destroyed by the rapacious book pricing policies of Amazon, Wal-Mart and Target. Where to start?

1. How exactly are low book prices "harmful to consumers?" Consumers have several remedies at their disposal to combat the "predation" whenever they feel they are being harmed by low prices: a) refuse to buy the book from Amazon or Wal-Mart for $9 and instead pay full price from an independent bookseller, b) refuse to buy the book at all, or c) offer to pay more than the "predatory" price from the "predator." That last option might not work so well at Amazon or Wal-Mart (if the book is priced at $9, it might be hard to actually pay $20 instead - how would the cashier ring it up?), but there might be some cases where a consumer could pay more than the listed price.

2. Keep in mind that about 90% of antitrust investigations involve one firm or group of firms complaining about one of their more efficient, low-cost competitors, like in this case.

3. Assuming that the predation worked and Amazon, Target and Wal-Mart were able to successfully drive all of the independent booksellers out of the market, there would be two problems:

a) They would still have to compete against each other and it could remain an intensely competitive book market even without the independents, to the continued benefit to consumers and

b) if the three oligopolists (Amazon, Target and Wal-Mart) did conspire to raise book prices to "book scalping" or "book gouging" levels, they could then: i) face antitrust charges, this time for high anti-competitive "monopoly" prices, and/or ii) face new competition from firms re-entering the market from the attractive "smell of profits" emanating from the monopoly pricing.

4. Notice in the Amazon listing above (click to enlarge) that Amazon offers "free shipping" on orders over $25, which is obviously below its actual cost. Isn't that then "predatory shipping?" Should that be investigated by the Dept. of Justice?

5. Also notice in the Amazon listing that there are more than 30 new copies of the Grisham book available from small, private booksellers at prices starting at $4.25, or more than 50% below Amazon's price of $9.59. Aren't those small booksellers engaged in predatory pricing AGAINST Amazon?

The point to remember when you see complaints about "predatory pricing," is that predatory pricing is basically a myth for which there is virtually no real-world examples of it ever being successful, harmful to consumers, or leading to anti-competitive behaviour in the long run. Low prices are not bad!

As I have noted before, Louis Phlips suggests that the necessary conditions for predatory pricing are,

To sum up, economic theory suggests that predatory pricing is a real possibility only when the following five conditions are simultaneously met:
1 The aggressor is a multimarket firm (possibly a multiproduct firm).
2 The predator attacks after entry has occurred in one of its markets.
3 The attack takes the form of a price cut in one of the predator's markets, which brings this price below a current non-cooperative Nash equilibrium price at which the entry value is positive for the entrant (possibly below a discriminatory current Nash equilibrium price with the same property).
4 The price cut makes the entry value negative (in present value terms) in the market in which predation occurs.
5 Yet the victim is not sure that the price cut is predatory. The price cut could be interpreted by the entrant as implying that its entry value is negative under normal competition. In other words, the victim entertains the possibility that there is no room for it in the market under competitive conditions.

It seems unlikely that such conditions are ever met in the real world and such conditions also mean that it is unlikely that competition agencies will find a robust and simple rule to use to detect predatory pricing. Most just seem to fall back on the old presumption that firms with market power are always suspect. William Landes tells the story about why Ronald Coase gave up antitrust,

“Ronald [Coase] said he had gotten tired of antitrust because when the prices went up the judges said it was monopoly, when the prices went down they said it was predatory pricing, and when they stayed the same they said it was tacit collusion.”

–William Landes, “The Fire of Truth: A Remembrance of Law and Econ at Chicago”, JLE (1981) p. 193.

It's only in the strange world of competition policy that any price you charge can be considered illegal.

50 Years of Coasean brilliance

Peter Boettke over at the Austrian Economists blog writes on 50 Years of Coasean Brilliance. Boettke is discussing the the 50th anniversary of the publication of Ronald Coase's watershed article on the Federal Communications Commission.

For those who only know Coase via the so-called "Coase Theorem" (which is in fact due to George Stigler) and the implications of a zero transaction cost world, it should be pointed out that Coase never believed in zero transaction costs. His zero transaction cost analysis (most famously in his "Problem of Social Cost" paper) served mainly as an attack on the standard Pigovian analysis and is there to show that under the assumptions of that analysis, in particular zero transaction costs, the Pigovian remedies - Pigovian taxes and subsidies - are not needed. Coase wanted to move economics away from the zero transaction cost assumption to consider the world of positive transaction costs. It is only in a positive transaction cost framework that things like firms make sense.

Learning to love insider trading

Donald J. Boudreaux suggests we should be Learning to Love Insider Trading. Writing in the Wall Street Journal Boudreaux points out that

Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest—in keeping prices from lying to the public about corporate realities.

Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.

And when prices lie, market participants are misled into behaving in ways that harm not only themselves but also the economy writ large.

I have never really understood the problem with insider trading. Letting informed people trade on their information just makes that information available to everyone in the market. Why not set up a situation where companies have to say whether or not they will allow insider trading in their stocks, then the market can price this information into the stock price of that company. If you don't like insider trading don't buy the stocks of firms that allow such trades.

EconTalk this week

Charles Calomiris of Columbia Business School talks with EconTalk host Russ Roberts about the financial crisis. Calomiris argues that it is important to put the crisis in historical perspective in the context of other bank crises. He argues that bank crises differ widely across time and place--some times and some places are placid, others are prone to regular crises. Calomiris argues that frequent episodes of failure are tied to government guarantees such as various forms of deposit insurance or similar incentives for risk-taking. Looking at the current crisis, Calomiris indicts "too big to fail," the government's reliance on ratings agencies as a measure of risk, and poor corporate governance as the key causes.

EconTalk this week

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the limits of prices and markets, especially in the area of health. They talk about vaccines, organ transplants, the ethics of triage and what role price should play in allocating. The discussion concludes with a discussion of how markets respond to price controls, particularly minimum wages.

Just for fun: theory of the firm 8

The obvious missing discussion from the previous seven theory of the firm postings, and one on the theory of the farm, is a discussion of Oliver Williamson's work on the theory of the firm. This omission is all the more glaring now that Williamson has won the Nobel Prize in Economics. This posting is drawn from an interesting attempt at a formalisation of Williamson's work by Robert Gibbons.

In his 2005 essay (see also here) on the major mainstream economic theories of the firm, Robert Gibbons argues that there are two (formal) theories which can be discerned within the informal theoretical arguments offered in Oliver Williamson's work. The first theory is what Gibbons refers to as a "rent seeking " theory and the second an "adaptation" theory. Within Gibbons's discussion, the theory of the firm means the Coasian "make-or-buy " decision, that is, vertical integration or the theory of the boundaries of the firm.

Gibbons argues that the rent seeking theory was first articulated in Williamson (1971, 1979, 1985) and Klein et al (1978). In the rent seeking theory, the advantage of vertical integration is that it can stop socially destructive haggling over "appropriable quasi-rents" (AQR). Williamson (1971: 114-5) argues, for example, that "fiat is frequently a more efficient way to settle minor conflicts ... than is haggling". The important point here is that given the existence of AQRs, non-integration cannot avoid inefficient haggling because, while "jointly (and socially) unproductive, it constitutes a source of private pecuniary gain," so integration, including its dispute-resolution by fiat powers, can be more efficient.

An important source of AQRs is relationship specific investments, that is, investments that have a higher value within a successful, on going, relationship between the contracting parties than they do should the relationship breakdown. This can trap the investing party in the relationship. If the investment is only (or at least, largely) productive within a given relationship, it will have a higher value or higher rents within that relationship than within any other relationship. These additional rents can be haggled over. The basic idea is that the larger are AQRs, the more likely is integration. This is because the larger the AQRs the more likely or costly (or both) is socially destructive haggling.

There is a problem here. One feature of this theory is that its assumptions are not entirely clear. As Gibbons explains

[...] the rent-seeking theory explicitly assumes that integration can stop the haggling induced by AQRs, but this explicit assumption requires an implicit focus on certain kinds of haggling. Specifically, if the haggling were accomplished by manipulation of alienable (say, physical) capital, then integration could remove the relevant control rights from the haggler, but if the haggling were accomplished by manipulation of inalienable (say, human) capital, then integration could not stop rent-seeking. More generally, the most that integration can do is to unify the alienable control rights; any inalienable control rights are staying put, by definition. Thus, the distinctive point in (this telling of) the rent-seeking theory of the firm is that ownership can stop haggling that is undertaken via alienable instruments. (Gibbons 2005: 204-5)

Looking at the world around us, what we see is many hold-ups between firms that do not result in integration. Gibbons continues,

To explain these observations, the rent-seeking theory has two options: (1) assert that these hold-ups utilized inalienable instruments (so that the observed hold-ups are unavoidable), or (2) enrich the theory to include a downside of integration (so that the observed hold-ups are a lesser evil than integration would have been). As I have so far told the rent-seeking theory, it says nothing about what life was like as the Fisher division of General Motors and, hence, gives no insight into whether integration could ever be the greater of two evils. As a result, the prediction I stated above is flawed: so far, we can conclude that larger AQRs make non-integration more costly, but we cannot draw an inference about the likelihood of integration until we say something about the costs of integration. (Gibbons 2005: 205)

Thus the rent seeking theory is, in the main, a theory of the benefits of integration and not the costs of integration.

The second theory, the adaptation theory of the firm, is based on work from Simon (1951); Williamson (1971, 1973, 1975, 1991); Klein and Murphy (1988, 1997); Klein (1996, 2000). The question here is whether or not integration facilitates "adaptive, sequential decision-making" (Williamson 1975: 40) in environments where uncertainty is resolved over time better than non-integration.

The key theoretical challenge in developing such a theory is to define an environment in which neither contracts ex ante nor renegotiation ex post can induce first-best adaptation after uncertainty is resolved, so that the second-best solution may be to concentrate authority in the hands of a “boss” who then makes (potentially self-interested) decisions after uncertainty is resolved. This emphasis on the boss’s authority places the adaptation theory together with the rent-seeking theory in making control the central issue in the theory (whereas the incentive-system theory ignores control in favor of incentives and the property-rights theory blends the two). (Gibbons 2005: 208)

Williamson (1971: 113) hints at the adaptation theory of the firm, arguing that "only when the need to make unprogrammed adaptations is introduced does the market versus internal organization issue become engaging". This idea gets much more development in Williamson (1975). Chapter 4 of the 1975 book used Simon (1951) to explain why many labour transactions are more efficiently conducted in a firm instead of over a market.

In Simon’s model (which is cast as a theory of employment rather than a theory of the firm), two parties choose between (a) negotiating a decision before uncertainty is resolved or (b) allocating authority to one party (the “boss”) who can then make a self-interested decision after uncertainty is resolved. Simon calls the latter an employment contract. Under such a contract, the subordinate faces a tradeoff between flexibility and exploitation: she can sacrifice flexibility by locking in a decision now, or she can risk exploitation by allowing the boss to decide later. Simon provides plausible conditions (roughly, that the parties’ payoffs depend importantly on tailoring the decision to the state, and that the parties’ preferences regarding such tailoring are not too divergent) under which it is optimal for the parties to choose the employment contract. (Gibbons 2005: 2008)

Williamson then carries the argument from Chapter 4 into Chapter 5 where he makes an explicit parallel case for intermediate products: "The argument here really parallels that of Chapter 4 in most essential respects” (Williamson 1975: 99). Thus Willaimson turns Simon’s argument for the labour contract into an argument for the make-or-buy decision and thus a theory of the firm's boundaries.

Gibbons then asks is Williamson been inconsistent or confused or wrong given that he has two theories.

Thus, I do not conclude from this close textual analysis that Williamson has been inconsistent or confused or wrong; rather, I conclude that his collected works suggest two theories of the firm—rent-seeking and adaptation. Much of the literature has focused on rent-seeking, often with AQRs created by specific investments and sometimes without any mention of adaptation. Williamson himself typically emphasizes both asset specificity and adaptation—probably reflecting the view that both will be important if a full-blown theory of the firm is to be realistic, but possibly reflecting the view that both are necessary if an elemental theory of the firm is to be coherent. (Gibbons 2005: 208-9)

References:

• Klein, B. (1996). ‘Why hold-ups occurs: the self-enforcing range of contractual relationships’, Economic Inquiry, 34: 444-63.
• Klein, B. (2000). ‘The role of incomplete contracts in self-enforcing relationships’, Revue D’Economie Industrielle, 92: 67-80.
• Klein, B., R. Crawford and A. Alchian (1978). ‘Vertical integration, appropriable rents and the competitive contracting process',Journal of Law and Economics, 21: 297-326.
• Klein, B. and K. M. Murphy (1988). ‘Vertical restraints as contract enforcement mechanisms’, Journal of Law and Economics, 31: 254-97.
• Klein, B. and K. M. Murphy (1997). ‘Vertical integration as a self-enforcing contractual arrangement', American Economic Review, 87: 415-20.
• Gibbons, Robert (2005). 'Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2) October: 200-45.
• Simon, Herbert (1951). 'A Formal Theory of the Employment Relationship', Econmetrica, 9(3) July: 293-305.
• Williamson, Oliver E. (1971). 'The vertical integration of production: market failure considerations', American Economic Review, 61(2) May: 112-123.
• Williamson, Oliver E. (1973). 'Markets and hierarchies: some elementary considerations', American Economic Review, 63(2) May: 316-25.
• Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications, New York: The Free Press. Press.
• Williamson, Oliver E. (1979). 'Transaction cost economics: the governance of contractual relations',Journal of Law and Economics, 22: 233-61.
• Williamson, Oliver E. (1985).The Economic Institutions of Capitalism, New York: The Free Press. Press.
• Williamson, Oliver E. (1991). 'Comparative economic organization: the analysis of discrete structural alternatives',Administrative Science Quarterly, 36: 269-96.

Williamson and the theory of firm

As is well known Oliver Williamson won this years Nobel Prize in economics along with Elinor Ostrom. Williamson is one the the top theory of the firm economists around today. His work starting in the early 70's bought the theory of the firm back to life. After Coase's path breaking 1937 paper and before Williamson's contributions, very little happened in the theory of the firm. Among economists the small amount of work that did take place in this period was , by and large, ignored. Then came Williamson.

As Peter Klien writes,

In economics textbooks, the firm is a production function or production possibilities set, a "black box" that transforms inputs into outputs. Given the existing state of technology, the prices of inputs, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. The firm is modeled as a single actor, facing a series of uncomplicated decisions: what level of output to produce, how much of each factor to hire, and the like. These "decisions," of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In short: the firm is a set of cost curves, and the "theory of the firm" is a calculus problem.

Williamson attacks this conception of the firm, which he calls the "firm-as-production-function" view. Building on Coase's (1937) transaction-cost or "contractual" approach, Williamson argues that the firm is best regarded as a "governance structure," a means of organizing a set of contractual relations among individual agents. The firm, then, consists of an entrepreneur-owner, the tangible assets he owns, and a set of employment relationships — a realistic and thoroughly Austrian view.

The economics Nobel committee summarises Williamson's theoretical framework is four steps,

Williamson’s theoretical argument is fourfold. First, the market is likely to work well unless there are obstacles to writing or enforcing detailed contracts. For example, at the beginning of a buyer-seller relationship, there is usually competition on at least one side of the market. With competition, there is little room for agents on the long side of the market to behave strategically, so nothing prevents agreement on an efficient contract. Second, once an agent on the long side of the market has undertaken relationship-specific investments in physical or human capital, what started out as a transaction in a “thick” market, is transformed into a “thin” market relationship in which the parties are mutually dependent. Absent a complete long-term contract, there are then substantial surpluses (quasi-rents) to bargain over ex post. Third, the losses associated with ex-post bargaining are positively related to the quasi-rents. Fourth, by integrating transactions within the boundaries of a firm, losses can be reduced.

The first two points are relatively uncontroversial, but the third may require an explanation. Why do bargaining costs tend to be higher when it is harder to switch trading partners? Williamson offers two inter-related arguments. First, parties have stronger incentives to haggle, i.e., to spend resources in order to improve their bargaining position and thereby increase their share of the available quasi-rents (gross surplus from trade). Second, when it is difficult to switch trading partners, a larger surplus is lost whenever negotiations fail or only partially succeed due to intense haggling.

The final point says that these costs of haggling and maladaptation can be reduced by incorporating all complementary assets within the same firm. Due to the firm’s legal status, including right-to-manage laws, many conflicts can be avoided through the decision-making authority of the chief executive.

Williamson’s initial contributions emphasized the benefits of vertical integration, but a complete theory of the boundaries of firms also has to specify the costs. Such an argument, based on the notion that authority can be abused, is set forth in a second major monograph from 1985, The Economic Institutions of Capitalism (especially Chapter 6). The very incompleteness of contracting, that invites vertical integration in the first place, is also the reason why vertical integration is not a uniformly satisfactory solution. Executives may pursue redistribution even when it is inefficient.

Williamson work has lend to a renewed interest in the firm. Many empirical, policy and theoretical applications are based on Williamson's work. One of the interesting policy applications of Williamson's work is to anti-trust, or competition policy. The Nobel committee explains,

Williamson’s theory of vertical integration clarifies why firms are essentially different from markets. As a consequence, it challenges the position held by many economists and legal scholars in the 1960s that vertical integration is best understood as a means of acquiring market power. Williamson’s analysis provides a coherent rationale for, and has probably contributed to, the reduction of antitrust concerns associated with vertical mergers in the 1970s and 80s. By 1984, merger guidelines in the United States explicitly accepted that most mergers occur for reasons of improved efficiency, and that such efficiencies are particularly likely in the context of vertical mergers.

Williamson's work remains informal. In an attempt to formalise his work Robert Gibbons suggests that there are two theories within Willamson's frame work - rent-seeking and adaptation:

Thus, I do not conclude from this close textual analysis that Williamson has been inconsistent or confused or wrong; rather, I conclude that his collected works suggest two theories of the firm—rent-seeking and adaptation. Much of the literature has focused on rent-seeking, often with AQRs created by specific investments and sometimes without any mention of adaptation. Williamson himself typically emphasizes both asset specificity and adaptation—probably reflecting the view that both will be important if a full-blown theory of the firm is to be realistic, but possibly reflecting the view that both are necessary if an elemental theory of the firm is to be coherent.

Personally I think Williamson's Nobel is one of best prizes that have been given in recent times. Its also worth noting that all the big three of New Instiutional Economics, Coase, North and Williamson, have now received the Nobel.

2009 Econ Nobel

As you will already know by now The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2009 has gone to Elinor Ostrom and Oliver Williamson for their analysis of economic governance. Eric discusses the prize here and here, while Brad Taylor comments here and here. They mainly discuss Ostrom's work since no one would have picked her. In fact most economists couldn't tell you much about her work at all. I will post on Williamsons' work when I have a spare few minutes since I know more about that.

Christchurch bloggers' bash

Eric, good lad that he is, is organising a Christchurch bloggers' bash: 9 PM Friday at The Thirsty Weta.

Be there!

EconTalk this week

Daniel Willingham of the University of Virginia and author of the book Why Don't Students Like School? talks with EconTalk host Russ Roberts about how the brain works and the implications for teaching, learning, and educational policy. Topics discussed include why we remember some things but not others (and what we can do about it), the central role of memory in problem solving and abstract reasoning, the current state of math education in America, and what makes a good teacher.

Nobel predictions

Brad Taylor makes his picks here, Tom M makes his picks here and Eric makes his picks here. But note one thing, they are all wrong!

I’ll go with the theory of the firm and bet on Williamson/Hart/Holmstrom.

Caplan and Boettke debate Austrian economics

In 2002 Peter Boettke and Bryan Caplan debated the topic of whether or not someone should pursue a career as an Austrian economist. Bryan argued no, Peter argued yes. The debate is now available on YouTube in 13 videos. Boettke has written of the debate

I haven't gone back over to watch the debate, but I remember two impressions from the time: (1) I am not very good at debate, and (2) Bryan and I talked past each other. I remain unpersuaded by Bryan's critique of Kirzner, and I do believe the world is full of genuine surprise. I also think there is a point about the contextual nature of our knowledge which is loss in Bryan's rendering. However, I do agree with Bryan that ultimately there is only good economics and bad economics. And I agree with Bryan that clarity in thought and argument is much better than buzz words that pretend to substitute for analysis.

The protectionist juggernaut threatening world trade

From VoxEU.org comes this audio in which Simon Evenett of the University of St Gallen talks to Romesh Vaitilingam about ‘Broken Promises’, the latest report from Global Trade Alert, which collates information on state measures taken since last November that discriminate against foreign commercial interests, and reveals how the G20 countries have broken their 'no protectionism' pledge.

Is anyone in the world actually surprised that the G20 countries have broken their 'no protectionism' pledge?

EconTalk this week

Gary Stern, former President of the Minneapolis Federal Reserve Bank, talks with EconTalk host Russ Roberts about Stern's book, Too Big To Fail (co-authored with Ron Feldman), a prescient warning of the moral hazard created when government rescues creditors of financial institutions from the consequences of bankruptcy. Stern traces the origins of "too big to fail" to the rescue of Continental Illinois in 1984 and then follows more recent rescues including those of the current crisis. The conversation explores the incentive effects of such rescues on the decision-making by executives in large financial institutions. The discussion concludes with Stern's ideas for alternative ways to deal with large, troubled financial institutions.

Well done Brad!

Over at Offsetting Behaviour Eric points out that Brad Taylor, of Brad Taylor's Blog fame, won this year's Templeton Foundation essay contest.

Well done!