Employment, markets, contracts, and the scope of the firm

Birger Wernerfelt has a new working paper out to do with the theory of the firm. Wernerfelt is most well known for his pioneering work on the resource-based view of the firm. In his new  paper Wernerfelt looks at the economic functions of firms, contracts, and markets and characterise the optimal scope of the firm. Governance structures appear as equilibria and are compared in terms of production costs - determined by a tradeoff between standardisation and adaptation, - and adjustment costs – sometimes incurred when new prices have to be agreed upon. Under natural conditions, employment, markets, or sequential contracting weakly dominate all other equilibria. As firms become larger, gains from standardisation come at the cost of increasingly poor adaptation, ultimately bounding their scope.

To get an intuitive sense of Wernerfelt's argument, suppose that a business needs a worker for a specific service. (For example, an apartment building has to have a bannister fixed.) The main emphasis of the paper  is on two aspects of the situation:

1. Which experiences should the ideal worker have, and
2. How should the parties agree on compensation?

As the demands of a job vary with the business and the service, gains from specialisation mean that workers who have experience with either of the two will do better. (Carpenters and superintendents, respectively, are examples of these two types of workers.) The ways in which compensation can be agreed upon depend on the type of worker best used. Service-specialists will work for a new business in every period and have the ability to sell their labour in a larger market. Business-specialists will work for the same business in every period and can thus be on a single long term - or a series of short term contracts. Since bilateral bargaining is costly, the relative attractiveness of these two types of contracts depends on the frequency with which needs change. While adaptation is good, change is costly. Workers are best when they can approach every task in the same way: Consistently going for the same objective such as high speed, low cost, or perfection. So the most efficient workers will perform the same service for the same business in every period: Perfect adaptation to both service and business with no changes from period to period. This creates incentives to grow the business to the point where it can employ such service-specialists (as when very big landlords have their own carpenters). If the opportunities for such growth are limited, some “different but similar” businesses can combine and use a service-specialist whose approach (way of doing things) is imperfectly adapted to the businesses, but still not too far off. (Property companies with a mixed portfolio of real estate.) The scope of the firm is determined by the point at which the resulting mal-adaptation becomes too severe. (It may not be appropriate to use the same approach to carpentry in a barn and a high end office building.)

Wernerfelt's paper is Employment, Markets, Contracts, and the Scope of the Firm and the abstract reads:

We look at the economic functions of firms, contracts, and markets and characterize the optimal scope of the firm. Governance structures appear as equilibria and are compared in terms of production costs - determined by a tradeoff between standardization and adaptation - and adjustment costs – sometimes incurred when prices have to be agreed upon. Under weak conditions, employment, markets, or sequential contracting weakly dominate all other equilibria. As firms become larger, they lose their focus and gains from standardization decrease, ultimately bounding their scope. The model does not rest on non-standard assumptions and is consistent with the managerial literature on the scope of the firm. Its predictions depend on several factors that do not play a role in other contemporary theories of organization.