Sunday, 3 April 2016

The digital revolution, the firm, and economic statistics

As has been noted previously the digital revolution has given rise to a number of problems to do with the measurement of economic statistics. One particular issue has to do with the effects of the digital revolution on firms and the measurement issues this gives rise to. One reason it is problematic to measure the "knowledge economy" at the national level is because it is difficult to measure knowledge at the level of the individual firm. Part of the reason for this is that none of the orthodox theories of the firm offer us a theory of the “knowledge firm” to guide our measurement. I wrote a section on the "The (non)theory of the knowledge firm" in Oxley, Walker, Thorns and Wang (2008).
As has been emphasised by Carter (1996) it is problematic to measure knowledge at the national level in part because it is difficult to measure knowledge at the level of the individual firm. Part of the reason for this is that none of the orthodox theories of the firm offer us a theory of the “knowledge firm” to guide our measurement.

The model of the “firm” found in most microeconomic textbooks does not incorporate knowledge - individual or institutional - or the knowledge worker; it can’t since it isn’t a “theory of the firm” in any meaningful sense. The output side of the standard neoclassical model is a theory of supply rather than a true theory of the firm. In neoclassical theory, the firm is a ‘black box’ there to explain how changes in inputs lead to changes in outputs. The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who place their inputs in the highest value uses, and makes sure that production is separated from consumption. The firm in neoclassical theory is no more or less than a specialized unit of production, but it can be a one-person unit” (Demsetz 1995: 9).

Given there is no serious modelling of the firm in neoclassical theory, there is no way to deal with the knowledge firm within this framework. There are no organisational problems or any internal decision-making process, in fact, there is no organisational structure at all and thus the advent of the knowledge economy cannot alter this nonexistent structure. As there is no role for managers or employees there can be no knowledge workers in the firm. But the growth in knowledge workers is one of the most important aspects in the development of the knowledge society. And their advent will change the way we think about firms.

Knowledge creators\workers\owners have the potential to be highly internationally mobile (unlike the physical capital or land in the old economy) which has the capacity to either reduce the knowledge divide or increase it, but importantly at much higher speeds. Buying the necessary knowledge creators\assimilators is like buying physical capital except the ownership of the ‘means of production’ is now vested more with the capital itself (human) than in the past modes of production. This has a number of important implications including helping understand who wins and who loses from the knowledge economy and this has the potential to affect our understanding\modelling of the traditional ‘theory of the firm’ - in terms of the Grossman/Hart/Moore (GHM) approach - which is vested in the ownership of physical capital alone.

The modern theory of the firm is based on the work of Grossman and Hart, (1986, 1987) and Hart and Moore (1990). Within the GHM approach ownership is defined in terms of residual control over non-human assets, things such as machinery, inventories, buildings, patents, client lists, firm’s reputation etc. Owner-managers employ labour that cannot work without the physical capital these firms own. Dismissal\resignation of the labour requires them to find other physical capital owning organisations (firms) to employ them. On liquidation of the firm, physical capital can be sold and the proceeds disbursed to the owners (shareholders). The standard theory of the firm is based on the role of non-human capital in the firm. The definition of a firm, the determinants of the boundaries of a firm - that is, the determinants of vertical integration of firms, the meaning of ownership of the firm, the nature of authority within the firm are all functions of control rights over the firm’s non-human assets. Making non-human assets the centre of the theory means that questions to do with the ownership and control of the physical information technology can be addressed, but this concentration on non-human assets means that the theory doesn’t deal with firms based on human assets. However it had been noted from the beginning that the theory could beextended to include human capital. As Hart (1988: 151) argues:
“. . . one difference with previous work is the emphasis on how integration changes control over physical assets. This is in contrast to Coase’s 1937 paper which focuses on the way integration changes an ordinary contractual relationship into one where an employee accepts the authority of an employer (within limits). Note that these approaches are not contradictory. Authority and residual rights of control are very close and there is no reason why our analysis of the costs and benefits of allocating residual rights of control could not be extended to cover human, as well as physical, assets.”
Once we move to a situation where firms may own\need little physical capital, then the modern theory of the firm loses much of its main reason for being. Once human capital (labour) becomes the most important\sole creator of wealth\value added then modern economic theory is in need of modification. The theory does not, however, lose all relevance. As Hart (1995: 56-7) explains, at least some, nonhuman assets are essential to a theory of the firm. To see why this may be so consider a situation where ‘firm’ 1 acquires ‘firm’ 2, which consists entirely of human-capital. The question Hart raises is, What is to stop firm 2’s workers from quitting? Without any physical assets, e.g. buildings, firm 2’s workers would not even have to relocate themselves physically.

If these workers were linked by telephones or computers, which they themselves own, they could simply announce one day that they had decided to become a new firm. For the acquisition of firm 2 by firm 1 to make economic sense there has tobe a source of value in firm 2 over and above the human-capital of the workers. It makes little sense to buy a ‘firm’ if that ‘firm’ can just get up and walk away. Hart argues there must be some ‘glue’ holding firm 2’s workers in place.

The value which acts as this glue may consist of as little as a place to meet; the firm’s name, reputation, or distribution network; the firm’s files, containing important information about its operations or its customers; or even a contract that prohibits firm 2’s workers from working for competitors or from taking existing clients with them should they quit. The source of value may even just represent the difficulty firm 2’s workers face in co-ordinating a move to another firm. But, Hart points out, without something binding the firm together, the firm becomes a phantom, and as such we should expect that such firms would be flimsy and unstable entities, constantly subject to the possibility of break-up or dissolution.

Thus even a human-capital based firm will involve some nonhuman-capital, but the human capital will play the dominate role. The important characteristic of human-capital is that it embodies information and knowledge. A theory of the human-capital based firm has to model this co-existence of the human and nonhuman-capital. Brynjolfsson (1994) deals with the issue by extending the property rights approach to the firm to include information whether this information is embodied in humans, in the form of human-capital, or in artifacts. Rabin (1993) also works within the property rights framework, but extends it by assuming that an agent has information about how to make production more productive which they are willing to sell.

If the firm comprises human capital resources (eg., a legal or accounting firm) whose accumulated knowledge is the source of wealth creation, the balance of power stemming from the “ownership of the means of production”, has changed. Likewise predictions about what would happen at the dissolution of a knowledge-firm, is also unclear. Who has the rights to the sell-off of the assets, where these assets are embodied in human beings? How can these assets be sold-off? These issues, although important in the context of the economic theory of the firm may have less importance when trying to measure the size\scale of the knowledge economy. However they are likely to have profound effects on the idea f a Knowledge Society where the balance of (economic) power will change - owners of physical capital losing this to owners of human capital, which without slavery map one-to-one to each individual. An individual’s own economic power would likely vary with their different stocks of human capital as would the price they charge to hire it to others in the form of employment. This in turn affects who wins and who loses from the knowledge society.

While the Brynjolfsson model is distinct from the Rabin model, they are complementary. The relationship between information, ownership and authority is central to both papers. Rabin works within a framework of an adverse selection model and shows that the adverse selection problems can be such that, in some cases, an informed party has to take over the firm to show that their information is indeed useful. The Brynjolfsson model is a moral hazard type framework which deals with the issue of incentives for an informed party to maximise uncontractible effort.

As has been discussed Hart (1995: 17) noted that the neoclassical model tells us nothing about where a firm’s boundaries will lie or about the size or location of a plant or factory within a given firm. This approach is consistent with every existing firm being a plant or division of one huge firm which produces everything. It is also consistent with every plant or division of each existing firm being a separate and independent firm in their own right. Thus it is not clear in what organisational form production will occur. Will it be organised as a single large factory, several smaller factories or a household? The GHM approach does delineate the boundaries of the firm but still does not tell us anything about the location or size of a plant or factory which is part of the firm. Again the form of production organisation is indeterminate. What will be argued below is that the division of knowledge is one important influence on the form of organisation in which production takes place. The most obvious issue has to do with the determination of whether or not work occurs in a centralised factory or in separate households or some combination. This has been an issue since at least the industrial revolution.

The development of ICTs has meant that the costs of moving people as opposed to moving information have risen sharply. The costs involved in sending and receiving information have fallen thanks to technologies such as email and the Internet along with falls in the costs of long distance phone calls and the expanding use of cellular networks. The costs of people moving have not fallen however. Commuting to work via congested city and suburban streets, for example, is at least as difficult as it was two decades ago. The increasing interest in congestion pricing in many cities around the world suggests that traffic problems are not lessening. The ever increasing relative cost of moving people would suggest that the size of the “unit of production” should be moving away from the large factory, so dominant for the last two centuries, towards more home based production, as in the period before the industrial revolution.

The previous sections have briefly outlined the effects of the increasing importance of knowledge for the mainstream theory of the firm. It was argued that the neo-classical production function approach is not a true theory of the firm, but rather the firm is portrayed as a uninvestigated perfectly efficient ‘black box’ which simply turns inputs into outputs without organisation structure. The extensions of the GHM framework offered by Brynjolfsson (1994) and Rabin (1993) inherits the implicit owner\manager restriction of the original GHM framework and thus are of limited value when modelling the knowledge firm. When we turn to the location of production the models suggest that we should, in general terms, see a movement back towards home production but we are not given a specific relationship between knowledge and plant size or production location.

We are left with an unsatisfactory model of the (knowledge) firm and thus we are unable to give guidance on either empirical or policy questions that flow, via changes to the firm, from the development of the knowledge economy. Firm’s organisational structures are changing in response to the increased prominence of information and knowledge in the production process. In the new economy, not only will we see changes in the location of production, but even if production still takes place within a traditional firm, a factory or office, that firm may have a very different structure and organisation from that which we see today. Rajan and Zingales (2003: 87) argue that we are in fact seeing a new “kinder, gentler firm”. This is in response to the increase in the importance of human capital, along with increased competition and access to finance, all of which have increased the worker’s importance and improved the outside options for workers, thereby changing the balance of power within firms. In Rajan and Zingales’s view “[t]he single biggest challenge for the owners or top management today is to manage in an atmosphere of diminished authority. Authority has to be gained by persuading lower managers and workers that the workplace is an attractive one and one that they would hate to lose. To do this, top management has to ensure that work is enriching, that responsibilities are handed down, and rich bonds develop among workers and between themselves and workers” (Rajan and Zingales 2003: 87).

Cowen and Parker (1997) make a similar point about changing organisational structures. For them, “[i]nformation as a factor of production is making old functional structures and methods of organisation and planning redundant in many areas of business. The successful use of knowledge involves not only its generation, but also its mobilisation and integration, requiring a change in the way it is handled and processed.” (Cowen and Parker 1997: 12). Organisational change, as far as Cowen and Parker are concerned, is the consequence of the increasing need to make use of market principles within the firm and the growing importance of human capital. They note that as far as a firm’s labour force is concerned, “[t]he emphasis now is upon encouraging knowledge acquisition, skills and adaptability in the workforce as critical factors in competitive advantage.” (Cowen and Parker 1997: 32). Firms are obliged to rely more on market based mechanisms as the most efficient way of processing and transmitting information and giving the firm the flexibility and yet also focus it requires. Companies are decentralising their management systems as a way of coping with the uncertainty and pace of change in their markets. The aim is to ensure that those with the required knowledge and right incentives are the ones making the decisions and taking responsibility for the outcomes. Cowen and Parker (1997: 25-8) emphasise how advances in ICTs underlie the ability to be able to combine the advantages of this organisational flexibility with mass production.

But little of these types of changes are captured or explained by the mainstream theory of the firm. Expanding the orthodox view of the firm to include the new reality of the knowledge economy should be an urgent issue on the economic research agenda. It should be noted that such changes to the firm help determine who are the “winners and losers” from economic change in general. As in all previous “economic revolutions”, this is the ultimate issue to do with the knowledge economy.
All the references in the above can be found in Oxley, Walker, Thorns and Wang (2008).
  • Oxley, Les, Walker, Paul, Thorns, David, Wang, Hong (2008). 'The knowledge economy/society: the latest example of “Measurement without theory”?', The Journal of Philosophical Economics, II:1 , 20-54.
A more detailed discussion of these issues can be found in Walker (2010).
  • Walker, P. (2010). "The (non)theory of the knowledge firm". Scottish Journal of Political Economy, v57 no1, February 2010: 1-32.

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