An overview of "A brief prehistory of the theory of the firm"

As the manuscript for "a brief prehistory of the theory of the firm" has been delivered to the publisher its worth giving a short over view of what is covered in the book and why.

Firms play a critical role in the modern economy and society. With regard to the size of the contribution made by firms to economic activity McMillan (2002: 168-9) explains that for the US economy more than 70 percent of all transactions take place within firms leaving less than a third taking place via markets. In a mid-20th century report for the Social Science Research Council in the US economist H. R. Bowen identified the firm as one of the most significant institutions in our society, “[t]he business enterprise is one of the most pervasive and influential institutions of our society, and one in which innumerable important decisions and responses are made. These decisions and responses, in small and large enterprises, are links in the chain of factors determining the range of products available to consumers, the level of national income, the degree of economic security, the rate and direction of economic progress, and the distribution of income. These decisions and responses also significantly influence the character of human relations in industry, the quality of the lives of those who work in industry, and even the power structure of our society” (Bowen 1955: 1). More recently, at the beginning of the 21st century, journalists John Micklethwait and Adrian Wooldridge went so far as to argue that “[t]he most important organization in the world is the company: the basis of the prosperity of the West and the best hope for the future of the rest of the world” (Micklethwait and Wooldridge 2003: xv).

Given the significance of firms to today’s economy it would seem plausible to expect that one component of a proper understanding of how an economy functions would be a sophisticated theoretical understanding of the nature, structure and scope of firms. And yet up until very recent times the theory of the firm has largely been neglected as a field of interest in the study of economics. According to Oliver Hart

“[...] the theory of the firm is one of the less developed and agreed upon areas of economics” (Hart 2011: 102).

Birger Wernerfelt argues similarly insofar as he contends that a

“[...] foundational debate, over what exactly a “firm” is, has been raging in economics. Although two Nobel prizes ii have been awarded for answers to this question, the only agreed-upon proposition is that we, as of 2016, do not have a commonly accepted theory of the firm” (Wernerfelt 2016: 3)

This distinct lack of interest in the theory of the firm has in the recent past extended from theoretical economists to historians of economic thought. Fleckner (2016: 5, footnote 2) comments,

“[p]robably the best evidence of the traditional disinterest in the theory of the firm is the fact that the firm has no prominent place, if it is broached at all, in books on the history of economic thought. Two examples: In Sandmo 2011, a new and very readable book, none of the almost 500 pages are devoted to the theory of the firm (the selection of topics is explained on pp.vii, 23, 112); in Heilbroner 1999, one of the best-selling books in economics of all time, firms are mentioned more frequently, especially those whose shares are publicly traded, but there is no discussion of the issues that are typically associated with the theory of the firm (which, given the broad scope of the book, is not meant to be a criticism; neither Heilbroner nor Sandmo would have been well advised to focus on the firm)”.

Backhouse (2002), another well regarded introduction to the history of economic thought, does better in terms of coverage of the theory of the firm than either Sandmo (2011) or Heilbroner (1999) insofar as Backhouse devotes, roughly, one page out of 369 to the history of the post-1970 developments in the theory of the firm.

That the theory of the firm receives little, if any, treatment in recent history of economics texts is one motivation for this book. Here we wish to offer an introductory investigation into the history of the mainstream iv approach to the theory of the firm or production up until the 1970s. This pre-1970 literature is what is referred to here as the ‘prehistory’ of the theory of the firm. It was only starting in the 1970s that the theory of the firm proper came into being with the work of authors such as Armen Alchian, Robert Crawford, Harold Demsetz, Michael Jensen, Benjamin Klein, William Meckling and Oliver Williamson. These authors started the development of the transaction cost based and contract based theories of the firm. Approaches to the firm such as these were inspired, mainly, by the works of Ronald Coase. Before this time what we had was at best a discussion of the theory of micro-level production, and this only developed around 1930. Up until 1930s the most economics had to offer were theories which were predominantly theories of macro-level production. Before the 1970s the development of the theory of the firm was largely a story of neglect and disinterest.

The discussion in the pages that follow concentrates on the mainstream of economic thought and thus ignores the heterodox approaches to the firm. Concentrating on the mainstream in an introductory discussion is reasonable since it is these theories that students are most likely to meet during their initial studies. Also such an emphasis may do little damage to the story of the development of the theory of the firm since there is a close relationship between the advancement of the theory of the firm and the general economic mainstream. Foss and Klein (2006) claim that

“[...] the evolution of the theory of the firm has never taken place far away from the economic mainstream. On the contrary, it has in fact been much driven by advances in the mainstream, and the relatively limited borrowing from other disciplines that has taken place has usually been strongly adapted to conform to central mainstream tenets” (Foss and Klein 2006: 3).

What we hope to offer here is a concise, readable introduction to the ‘prehistory’ of the firm which is aimed at undergraduates and beginning graduate students. The book has been written in a manner which is, hopefully, understandable to students, with the little mathematics used explained in enough detail that undergraduates can follow it. As background, some knowledge of the basics of the contemporary theory of the firm would be useful. See Walker (2015) and Walker (2016: chapters 3 and 4) for introductions to this literature. The book is designed to give readers an understanding of how the mainstream theories they are taught developed and why the theories are the way they are. This is an understanding that most students, and many of their lecturers, do not have since it is not conveyed via the textbook presentations of the standard models of the firm. These models are presented devoid of all context, there are no consideration given to their development or past and current criticisms of or controversies surrounding the models being discussed. The material on the periods before the neoclassical era is almost never presented. The book may also prove to be of interest to economists working in the history of economic thought and given that most economists are not well acquainted with the history of their subject it could, in addition, be of interest to those working in areas such as the theory of the firm, organisational economics and industrial organisation.

An analysis of the past of the theory of the firm helps cultivate an understanding of the historical developments that have resulted in the contemporary theories. This inquiry helps to add depth to our knowledge of the ideas that are commonly employed today but whose origins lie in past debates to do with production and the firm. It also allows us to see how and why changes in thinking about these issues took place. Such a background will help readers understand why the developments after 1970, when they do finally meet them, are so important and why the modern discussion of the theory of the firm is so different from the past.

As just mentioned the mainstream theory of the firm did not exist, in any meaningful way, until around 1970. It was only then that the current theory of the firm literature began to emerge, based largely upon the work of Ronald Coase and to a lesser degree Frank Knight. It was work by Armen Alchian, Robert Crawford, Harold Demsetz, Michael Jensen, Benjamin Klein, William Meckling and Oliver Williamson, among others, that drove the upswing in interest in the firm among mainstream economists Before then there was no great interest shown in the firm as a significant economic institution by any school of economic thought. For more than two thousand years tools (eg the division of labour) were available that could have given rise to a theory of the firm but none appeared. During this time the best that occurred were discussions of micro-level production, and that only after 1930, while before then the deliberations that did transpire, limited though they were, were more focused on macro-level or aggregate production.

To begin our survey of the development of the theory of production and/or the theory of the firm we briefly look at the history of thought on the division of labour. As has been made clear by work beginning in the twentieth century the division of labour can act as a catalyst for a theory of the firm, but it took more than two thousand years - starting with the ancient Greeks and Chinese - for it to act as such. Until Alfred Marshall at the end of the nineteenth century many authors, including Adam Smith, wrote on the division of labour without applying it to the theory of micro-level production or the firm.

Following on from this discussion we will next consider approaches to production and the firm proposed in the pre-classical, classical and neoclassical periods other than those derived from the division of labour. It will be argued that before the later neoclassical economists no group of writers developed a theory of micro-level production and only Alfred Marshall wrote explicitly on the theory of the firm. Before the neoclassicals the best available theory was one of macro or aggregate production.

As has already been explained the theory of production/the theory of the firm was ignored for a long time in economics. Five, interrelated, explanations for this fact have been put forward. First, the (large/integrated) firm was until very recently just not that important to the economy and thus was ignored by early economic writers. Second, many economists did not see economic theory as being relevant to business or saw the internal workings of the firm to be outside the competence of economists. Thirdly, the development of a theory of the firm was limited by the lack of tools to deal with the task. Fourthly, for much of the development of economic analysis there was a normative/macro origination to economics which could result in a lack of interest in the theory of micro level production and the firm. Lastly, the rise of formalism within economics resulted in the firm being deemphasised.

An extensive bibliography is provided to help guide any readers interested in considering topics raised in the discussion in greater depth.

References. Backhouse, Roger E. (2002). The Ordinary Business of Life: A History of Economics from the Ancient World to the Twenty-First Century, Princeton, NJ: Princeton University Press. Bowen, Howard R. (1955). The Business Enterprise as a Subject for Research: Prepared for the Committee on Business Enterprise Research, Social Science Research Council, Pamphlet No. 11, New York: Social Science Research Council. Fleckner, Andreas Martin (2016). ‘Adam Smith on the Joint Stock Company’, Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2016-1, 1 January. Foss, Nicolai J. and Peter G. Klein (2006). ‘The Emergence of the Modern Theory of the Firm’, Center for Strategic Management and Globalization, Copenhagen Business School, SMG Working Paper 1/2006, January. Hart, Oliver D. (2011). ‘Thinking about the Firm: A Review of Daniel Spulber’s The Theory of the Firm’, Journal of Economic Literature, 49(1) March: 101-13. Heilbroner, Robert L. (1999). The Worldly Philosophers–The Lives, Times, and Ideas of the Great Economic Thinkers, 7th edn., New York: Simon & Schuster. McMillan, John (2002). Reinventing the Bazaar: A Natural history of Markets, New York: W.W. Norton and Company. Micklethwait, John and Adrian Wooldridge (2003). The Company: A Short History of a Revolutionary Idea, New York: The Modern Library. Sandmo, Agnar (2011). Economics Evolving–A History of Economic Thought, Princeton: Princeton University Press. Walker, Paul (2015). ‘Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective’, Journal of Economic Surveys, 29(2) April: 317-38. Walker, Paul (2016). The Theory of the Firm: An overview of the economic mainstream, London: Routledge. Wernerfelt, Birger (2016). Adaptation, Specialization, and the Theory of the Firm: Foundations of the Resource-Based View, Cambridge: Cambridge University Press.

Doug Irwin on the history of US trade policy

From David Beckworth’s podcast series, Macro Musings comes this audio of an interview with Doug Irwin on the history of US trade policy.

Douglas Irwin is a professor of economics at Dartmouth College and a leading expert on trade economics. He joins David Beckworth to discuss his new book, Clashing over Commerce: A History of US Trade Policy, which examines the history of American trade policy from the late 1700s to the present. Doug explains how US attitudes toward trade evolved over time and how free trade became the postwar consensus. Specifically, Doug argues that the history of US trade policy has been guided by the “three R’s: revenue, restriction, and reciprocity.” Finally, David and Doug discuss some of Doug’s work on the gold standard and the Great Depression.

What is a Marxist Libertarian?

Yes that is a serious question.

Brendan O’Neill (Editor of Spiked Online) joins Dave to discuss why he defines himself as a ‘Marxist Libertarian,’ his views on the pursuit of happiness, self censorship in the U.S., the issue with Bill of Rights only existing in writing and not in the hearts of Americans, the debate surrounding tearing down monuments, and more.

Tyler Cowen interviews Douglas Irwin

From Conversations with Tyler comes this interview between Tyler Cowen and Douglas Irwin about trade policy. Well worth the hour it takes to lesson to.

Tyler thinks Douglas Irwin has just released the best history of American trade policy ever written. So for this conversation Tyler went easy on Doug, asking softball questions like: Have tariffs ever driven growth? What trade exceptions should there be for national security, or cultural reasons? In an era of low tariffs, what margins matter most for trade liberalization? Do investor arbitration panels override national sovereignty? And, what’s the connection between free trade and world peace?

They also discuss the revolution as America’s Brexit, why NAFTA is an ‘effing great’ trade agreement, Jagdish Bhagwati’s key influence on Doug, the protectionist bent of the Boston Tea Party, the future of the WTO, Trump, China, the Chicago School, and what’s rotten in the state of New Hampshire.

Why do planning economies fail? The economic calculation problem and how markets solve it ....

To appreciate why market prices are essential to human well-being, consider what a fix we would be in without them. Suppose you were the commissar of railroads in the old Soviet Union. Markets and prices have been banished. You and your comrades. Passionate communists all. Now, directly plan how to use available resources.

You want a railroad from city A to city B, but between the cities is a mountain range. Suppose somehow you know that the railroad once built. Will serve the nation equally well. Whether it goes through the mountains or around. If you build through the mountains, you'll use much less steel for the tracks.

Because that route is shorter. But you'll use a great deal of engineering to design the trestles and tunnels needed to cross the rough terrain. That matters because engineering is also needed to design irrigation systems, mines, harbor installations and other structures. And you don't want to tie up engineering on your railroad if it would be more valuable designing those other structures instead.

You can save engineering for other projects. If you build around the mountains on level ground. But that way you'll use much more steel rail to go the longer distance and steel is also needed for other purposes. For vehicles, girders, ships, pots and pans and thousands of other things.

Which route should you choose for the good of the nation? To answer, you would need to determine which bundle of resources is less urgently needed for other purposes. The large amount of engineering and small amount of steel for the route through the mountains, where the small amount of engineering and large amount of steel for the roundabout route.

But how could you find out the urgency of need for engineering and steel in other uses?

Firm-level political risk: measurement and effects

One obvious risk that firms face, especially these days, is political risk, but how does it effect firms and what do they do about it?

These questions are looked at in a new NBER working paper,

Firm-Level Political Risk: Measurement and Effects
Tarek A. Hassan, Stephan Hollander, Laurence van Lent and Ahmed Tahoun
NBER Working Paper No. 24029
Issued in November 2017
The abstract reads:

We adapt simple tools from computational linguistics to construct a new measure of political risk faced by individual US firms: the share of their quarterly earnings conference calls that they devote to political risks. We validate our measure by showing that it correctly identifies calls containing extensive conversations on risks that are political in nature, that it varies intuitively over time and across sectors, and that it correlates with the firm's actions and stock market volatility in a manner that is highly indicative of political risk. Firms exposed to political risk retrench hiring and investment and actively lobby and donate to politicians. Interestingly, we find that the incidence of political risk across firms is far more heterogeneous and volatile than previously thought. The vast majority of the variation in our measure is at the firm-level rather than at the aggregate or sector-level, in the sense that it is neither captured by time fixed effects and the interaction of sector and time fixed effects, nor by heterogeneous exposure of individual firms to aggregate political risk. The dispersion of this firm-level political risk increases significantly at times with high aggregate political risk. Decomposing our measure of political risk by topic, we find that firms that devote more time to discussing risks associated with a given political topic tend to increase lobbying on that topic, but not on other topics, in the following quarter.

Book contract signed

I have just signed a contract with Routledge for them to publish my second book, "A brief prehistory of the theory of the firm". The manuscript is due first thing in December (I have much work to do over the next couple of weeks) and thus with luck the book will appear a few months later.

Keep an eye out and save up so you can be one of the first lucky people to own a copy!


Contents

    Preface and acknowledgements
    A note on the numbering of equations, tables and figures

Background

    Chapter notes
    References

The division of labour and the firm

    Ancient philosophers

    Medieval period

    Pre-classical economics period

    19th century

    20th century

    Chapter notes
    References

Development of a theory of production or the firm

    Pre-classical economists

    The classical economics period

    The neoclassical era

        Behavioural and managerial models

        Contemporary criticisms of the neoclassical model

        Coase versus Demsetz on the neoclassical model

        Profit maximisation

    Malmgren (1961)

    Chapter notes
    References

Possible reasons for the neglect of the firm

    Chapter notes
    References

    Index

Common ownership, competition, and top management incentives

An interesting looking revised version of a working paper from the Cowles Foundation for Research in Economics at Yale University on "Common Ownership, Competition, and Top Management Incentives" (pdf). The paper is by Miguel Antón, Florian Ederer, Mireia Giné, and Martin Schmalz.

The abstract reads:

We show theoretically and empirically that managers have steeper financial incentives to expend effort and reduce costs when an industry’s firms tend to be controlled by shareholders with concentrated stakes in the firm, and relatively few holdings in competitors. A side effect of steep incentives is more aggressive competition. These findings inform a debate about the objective function of the firm.

The basic conclusion of the paper is,

We found that the sensitivity between top managers’ wealth and their firm’s performance is weaker when the firms’ largest shareholders are also large shareholders of competitors. The wealth-performance relation for managers is steeper when firms are owned by shareholders without significant stakes in competitors.

Thus you will get more competition when a firm is owned by shareholders without significant stakes in competitors.

Trade, merchants, and the lost cities of the Bronze Age

An interesting new NBER working paper on Trade, Merchants, and the Lost Cities of the Bronze Age by Gojko Barjamovic, Thomas Chaney, Kerem A. Coşar and Ali Hortaçsu.

NBER Working Paper No. 23992
Issued in November 2017
NBER Program(s): ITI

We analyze a large dataset of commercial records produced by Assyrian merchants in the 19th Century BCE. Using the information collected from these records, we estimate a structural gravity model of long-distance trade in the Bronze Age. We use our structural gravity model to locate lost ancient cities. In many instances, our structural estimates confirm the conjectures of historians who follow different methodologies. In some instances, our estimates confirm one conjecture against others. Confronting our structural estimates for ancient city sizes to modern data on population, income, and regional trade, we document persistent patterns in the distribution of city sizes across four millennia, even after controlling for time-invariant geographic attributes such as agricultural suitability. Finally, we offer evidence in support of the hypothesis that large cities tend to emerge at the intersections of natural transport routes, as dictated by topography.

Alex Tabarrok writes on this paper at Marginal Revolution:

In a stunningly original paper Gojko Barjamovic, Thomas Chaney, Kerem A. Coşar, and Ali Hortaçsu use the gravity model of trade to infer the location of lost cities from Bronze age Assyria! The simplest gravity model makes predictions about trade flows based on the sizes of cities and the distances between them. More complicated models add costs based on geographic barriers. The authors have data from ancient texts on trade flows between all the cities, they know the locations of some of the cities, and they know the geography of the region. Using this data they can invert the gravity model and, triangulating from the known cities, find the lost cities that would best “fit” the model. In other words, by assuming the model is true the authors can predict where the lost cities should be located. To test the idea the authors pretend that some known cities are lost and amazingly the model is able to accurately rediscover those cities.

Dennis Rasmussen on Hume and Smith and "The Infidel and the Professor"

In this audio from EconTalk Russ Roberts interviews Dennis Rasmussen about Rasmussen's new book "The Infidel and the Professor: David Hume, Adam Smith, and the Friendship that Shaped Modern Thought".

How did the friendship between David Hume and Adam Smith influence their ideas? Why do their ideas still matter today? Political Scientist Dennis Rasmussen of Tufts University and author of The Infidel and the Professor talks with EconTalk host Russ Roberts about his book--the intellectual and personal connections between two of the greatest thinkers of all time, David Hume and Adam Smith.

A direct link to the audio is available here.

Its a book that's well worth reading.

Claudia Goldin on the gender earnings gap

Claudia Goldin (Professor of Economics at Harvard University) writes, in the New York Times, on How to Win the Battle of the Sexes Over Pay (Hint: It Isn’t Simple.)

The executive summary

In sum, the gap is mainly the upshot of two separate but related forces: workplaces that pay more per hour to those who work longer and more uncertain hours, and households in which women have assumed disproportionately large responsibilities.

And now a bit more detail.

Yet it is also true that the time demands of many jobs can explain much of the pay difference, a finding that has sobering implications. Eliminating the gender earnings gap will require changes in millions of households and thousands of individual workplaces.

and

The gap is larger among more educated people, for example, and varies according to occupation, often in big ways. Among college graduates, it is far larger in business, finance and legal careers than in science and technology jobs. In health care, it is larger when self-employment is high (think dentists) and much lower when professionals are mainly employees (think pharmacists).

What’s more, the gap is a statistic that changes during the life of a worker. Typically, it’s small when formal education ends and employment begins, and it increases with age. More to the point, it increases when women marry and when they begin bearing children.

and

Similar patterns appear using data for women and men who have earned master’s degrees in business administration. Immediately after graduation, women earn 92 cents for each male dollar. A decade later they earn only 57 cents.

Correcting for time off and hours of work reduces the difference in the earnings between men and women but doesn’t eliminate it.

On the face of it, that looks like proof of disparate treatment. It may seem understandable that when a man works more hours than a woman, he earns more. But why should his compensation per hour be greater, given the same qualifications? But once again, the problem isn’t simple.

and

The data shows that women disproportionately seek jobs — including full-time jobs — that are more likely to mesh with family responsibilities, which, for the most part, are still greater for women than for men. So, the research shows, women tend to prefer jobs that offer flexibility: the ability to shift hours of work and rearrange shifts to accommodate emergencies at home.

Such jobs tend to be more predictable, with fewer on-call hours and less exposure to weekend and evening obligations. These advantages have a negative consequence: lower earnings per hour, even when the number of hours worked is the same.

Is that unfair? Maybe. But it isn’t always an open-and-shut case. Companies point out that flexibility is often expensive — more so in some jobs than others.

Certain job characteristics have a big impact on the gender earnings gap. I have looked closely at these issues, including the extent to which workers are:

• Subject to strict deadlines and time pressure
• Expected to be in direct contact with other workers or clients
• Instructed to develop cooperative working relationships
• Assigned to work on highly specific projects
• Unable to independently determine their tasks and goals

Occupations with a lower level of these characteristics (like jobs in science and technology) show smaller gaps, corrected for hours of work. Occupations with a higher level (like those in finance and law) have greater gaps. Men’s earnings tend to surge when there are fewer substitutes for a given worker, when the job must be done in teams and when clients demand specific lawyers, accountants, consultants and financial advisers. Such differences can account for about half the gender earnings gap.

Ask yourself, do you really care who your pharmacist is versus do you care who your doctor or lawyer is? A particular pharmacist not having to be there to deal with customers mean greater flexibility in hours worked but this comes with lower pay while the fact that people want a particular doctor or lawyer to deal with them means long hours with little flexibility but with higher pay to compensate.

These findings provide more nuance in explaining why the gap widens with age and why it is greater for women with children. Whatever changes have already taken place in American society, the duty of caring for children — and for other family members — still weighs more heavily on women. And if you thought that moving to a more family-friendly nation would eliminate the gap, think again. In several nations, including Sweden and Denmark, a “motherhood penalty” in earnings exists, even though these nations have generous family policies, including paid family leave and subsidized child care.

Such considerations bring us to a very sensitive area: domestic arrangements at home, especially among couples with children. These are personal questions. In theory, gender earnings equality is possible when both parents take off the same amount of time and enjoy the same flexibility at work.

So domestic arrangement with a more equal distribution of childcare may reduce the wage gap but it may also make the family poorer.

From a classic economic standpoint, if one spouse or partner can earn more by working less flexible hours, as a family, the couple would earn more money by having that parent in that job, while the other partner accepts the more flexible one. A man can certainly be the more flexible member of this household — though he typically is not. Such decisions need to be made couple by couple.

So the answer to the pay gap may be in the choices made within the home. And that makes it difficult for public policy to deal with.

Zingales, McCloskey, Karlson and Kuran on populism and the free society

What does populism mean? Why do people buy it? Is the critique against the established elites valid? What are the main causes of the populist threats to the free society? How can public discourse and liberal democracy be restored?

Deirdre McCloskey, Luigi Zingales and Timur Kuran are some of the sharpets minds in academia today. They have all written extensively on the foundations of liberal societies. In conjunction with a special meeting with the Mont Pelerin Society on the populist threats to the free society and the reconstruction of the liberal project hosted by the Ratio Institute in Stockholm Sweden, they got together for a dialogue on some of the most pressing issues of our time. Professor Nils Karlson, CEO of the Ratio Institute and author of the book Statecraft and Liberal Reform in Advanced Democracies (Palgrave Macmillan), was the chair of the discussion.

Latest Blogwatch column

My Blogwatch column from the latest issue (Issue 59, August 2017) of the NZAE magazine Asymmetric Information

Immigration with Art Carden

An interview from the Libertarian Christian Institute with economist Art Carden about immigration.


THE LIBERTARIAN CHRISTIAN PODCASTEp 16: Immigration with Art Carden

The division of labour and the firm: Rauh (forthcoming)

An interesting new paper which develops a theory, incorporating the division of labour and specialisation and a stochastic ('O-ring') production function, to explain the incentive structure and size of the firm is The O-ring theory of the firm by Micheal T. Rauh, which is set to appear in the Journal of Economics & Management Strategy.

A note on the name 'O-ring'. The O-ring production function was introduced by Kremer (1993). The name comes from the fact that it was an O-ring failure that caused the space shuttle Challenger disaster. The basic idea is that the failure of a small component can have large adverse consequences. Here one part of the production process failing causes the whole process to fail.

Rauh assumes a production process that can be divided into a number of distinct tasks. This makes it possible for the tasks to be allocated across workers (the division of labour) and for workers to make investments in task-specific human capital (specialisation). This is the kind of situation just discussed in the Becker and Murphy paper. We saw that an increase in employment gave rise to a greater division of labour, that is, fewer tasks assigned to each worker, and greater specialisation and thus higher productivity. Importantly Rauh postulates an additional feature of the production process: a breakdown at any point in production, which could be due to shirking, poor decision-making or a negative shock, will have serious adverse consequences for the successful manufacturing of the product--this is the 'O-ring' type production function.

This second condition has important implications for the moral hazard problems that arise within a firm. In the first best case, the principal can directly monitor individual worker effort and thus will be able to identify and respond to any shirking by workers with probability one. In the second best case, individual output can be monitored and again shirking can be punished with probability one. Note that in this case a worker who experiences a negative shock will also be punished. In the third best case all workers will be punished, with probability one, if any single worker shirks. In each of the three cases there will be no free rider issues since shirkers cannot hide behind the efforts of their co-workers.

Rauh considers a production process where the set of tasks is the unit interval. The principal chooses the number of workers, and the set of tasks to be performed is divided equally across all workers. Each of the workers is able to choose their production effort and their level of investment in task-specific human capital for each task they are assigned. To produce one unit of output requires one unit of output of each task. This means that you get zero output if any of the workers shirks or suffers an adverse shock in any of their assigned tasks. In line with Becker and Murphy (1992) greater levels of employment implies fewer tasks being assigned to each worker, which in turn means the workers can increase their investments in human capital for each of their reduced set of assigned tasks. This results in greater productivity and thus increasing returns to employment.

The stochastic (O-ring) nature of the production function is thought about in the following way.

"In addition to production effort and investments in human capital, each agent monitors his assigned tasks and makes decisions about whether or not a problem has arisen, whether or not to halt production to fix it, whether he can fix it himself, and which potential solution is appropriate. When there is only one agent, there is a high probability that at least some of these decisions will be faulty because he has limited cognitive resources and performs all the tasks himself. When there are two agents, the probability that either one will make a mistake should be lower because each performs only half the set of tasks and can therefore devote more care and attention to each of them. On the other hand, we now have two probabilities instead of one, so the effect of an increase in employment is ambiguous" (Rauh forthcoming: 2).

More formally, the probability that a worker suffers a negative shock to at least one of the tasks they have been allocated is an increasing function of the proportion of tasks being performed by that worker. Under an assumption of independence, the probability of a product defect is the product of the individual probabilities. If the number of workers is increased this results in two effects. First, it will decrease the probability that each worker will suffer a negative shock. Secondly, it will increase the number of points in the production process at which a negative shock can occur. Rauh then defines a production process as satisfying the O-ring property if the probability of a defect occurring is increasing in the number of workers and converges to one as the number of workers goes to infinity.

Given this background, the main question for the paper is then considered: What limits the size of a firm? For Rauh the answer has to do with the effects (or lack of effects) of moral hazard. Since there is a one-to-one relationship between the division of labour and the level of employment in the paper, the question can be rephrased as, What limits the division of labour? As has been noted above Becker and Murphy (1992) see this limit as be determined not by the extent of the market, as Adam Smith argued, but rather by coordination costs, including agency costs.

When determining the relationship between moral hazard and the size of the firm, "[ ... ] the optimal employment level balances the following considerations: (i) the increasing returns to employment due to specialization and division of labor, (ii) the O-ring property of the production technology, where the probability of team failure increases with the size of the team, and (iii) the marginal cost of employment (the cost of hiring another agent)" (Rauh forthcoming: 2).

In the first best case of no moral hazard Rauh shows that the standard zero incentive, full insurance contract is employed. Effectively the firm is behaving as if it were a perfectly competitive wage-taker despite it being a monopolist. Since, in this case, each worker's payment is fixed, the firm's labour costs (the number of workers times the expected payment to each worker) are linear in workers and the marginal cost of a worker is constant. Importantly, however, given increasing returns to employment, which arises from specialisation and the division of labour, but only linearly increasing costs to employment, these costs cannot limit the extent of employment. Thus, in this case, the extent of the market for labour or the O-ring property must be limiting employment and thus the size of the firm. If it wasn't for these constraints the first best firm would be of infinite size since there are increasing returns to employment.

Next Rauh considers the second best contract. Here effort cannot be observed but individual output can. Rauh shows that the optimal (second best) contract involves awarding a bonus to a worker when their individual output is high, i.e., when the worker's effort is first best and there is a positive shock, and replacing the worker otherwise. Rauh shows that the worker’s bonus is decreasing in employment. This follows from the fact that as employment increases the proportion of tasks carried out by each worker falls which increases the likelihood of a positive shock. This increases the expected value of the worker’s payment if the worker selects the first best effect level. This means the principal can reduce the bonus paid to the worker. It is also shown that this reduction in the bonus reduces the expected payment to the worker and this implies that the payment is decreasing in employment as well. If this type of effect is large enough then the marginal cost of an extra worker can decline with employment and could even be negative. In this situation the second best cost of employment could be less than the first best (constant) marginal cost of employment. This would mean the second best firm could be larger than the first best firm. Thus, the second best firm would have weak incentives (low bonus), low expected pay (small worker payment) and an excessive division of labour (and an excessive amount of specialisation). Motivation is provided by the fact that shirking workers will be identified and fired, rather than through the use of incentive schemes. As before, as the level of employment increases fewer tasks are carried out by each worker and the probability of a positive shock converges to one. This means that the second best expected payment to a worker converges to the first best payment. In turn, this means that the second best cost function tends towards the (linear) first best cost function. Thus as with the first best case the increasing returns resulting to employment resulting from the division of labour and specialisation cannot be contained by an asymptotically linear cost of employment. Rauh concludes from this that when the principal can monitor individual output, even if not effort, the size of the firm under moral hazard is again limited by either the total number of workers available or the O-ring property .

Lastly, Rauh looks at the third best situation where the where the principal can observe only team output. Here the results are the opposite of the second best case. This is because the third best incentive relies on the probability that all workers experience a positive shock rather than depending on the probabilities that individual workers experience a positive shock. Given the O-ring property, an increase in workers increases the probability that an individual worker experiences a positive shock but reduces the probability that all workers experience a positive shock. In this case increasing the number of workers decreases the team probability of success and this decreases the expected payments made to workers when they put in the first best level of effort. This means that the principal will increase the third best bonus, which increases the third best expected payment to workers and the marginal cost of employment. From this it is clear that all of the third best bonus, expected payments and the marginal cost of a worker are increasing in the number of workers. This is the opposite of the second best case above.

As the number of workers employed continues to increase, the third best bonus, expected payments and the marginal cost of employment all explode. This is contrary to the second best case where all these variables tended to their first best levels. The third best marginal cost of employment is shown to always exceeds the first and second best marginal costs of employment. This means the third best firm is usually smaller than either the first or second best firms.

Thus for Rauh's model moral hazard concerns only limit the division of labour, and the size of the firm, when the principal can monitor just the output of the whole team. When either worker's effort or individual output can be observed either the extent of the labour market or the O-ring property limit the extent of the division of labour or the size of the firm.

Rauh's paper is interesting in part because it combines, in some ways, the older division of labour approach to the firm with the more modern principal agent approach to the firm. The more modern mainstream approaches to the firm don't emphasise the division of labour with their emphasis being more on incomplete contracts and agency problems. The division of labour approach has largely fallen out of favour.

Well worth a read if you are into the theory of the firm.

Refs.:

• Becker, Gary S. and Kevin M. Murphy (1992). 'The Division of Labor, Coordination Costs, and Knowledge', Quarterly Journal of Economics, 107 (4) November: 1137-60.
• Kremer, M. (1993). 'The O-ring theory of economic development', Quarterly Journal of Economics, 108(3) August: 551-75.
• Rauh, Michael T. (forthcoming). 'The O-ring theory of the firm', Journal of Economics & Management Strategy.

Speaking truth to "power"

Bob McManus writes at the City Journal:

Stephen Colbert, with arguably the sharpest tongue among America’s late-night TV ankle-biters, made his bones at the 2006 White House Correspondents Dinner, laying a vile spiel on President George W. Bush and finding himself the man of the moment. How brave, to speak such truth to power, gushed the usual suspects, and Colbert has been riding that wave ever since.

But he had done no such thing. In the absence of personal risk, haranguing the powerful can be soul-satisfying, and sometimes it forges careers, but it isn’t brave by a long shot. Thomas More spoke truth to Henry VIII, and it cost him his head. Dietrich Bonheoffer spoke truth to Adolf Hitler and was hanged in a concentration camp. Aleksandr Solzhenitsyn spoke truth to the Soviet Union and suffered grievously for it. Stephen Colbert piddled on the president’s rug, and he’s been cashing big-bucks checks ever since. See the difference?

Statements have to be costly to be credible. Cheap talk is .... well .... cheap talk. Signals need to be costly if people are to believe them. And there is nothing costly or brave about just sounding off against "power" when that "power" will not respond.

Palgrave studies in ancient economies

An interesting looking new book series from Palgrave.

Call for Proposals - Palgrave Studies in Ancient Economies

Announcing a new series

This series provides a unique dedicated forum for ancient economic historians to publish studies that make use of current theories, models, concepts, and approaches drawn from the social sciences and the discipline of economics, as well as studies that use an explicitly comparative methodology. Such theoretical and comparative approaches to the ancient economy promotes the incorporation of the ancient world into studies of economic history more broadly, ending the tradition of viewing antiquity as something separate or ‘other’.

The series not only focuses on the ancient Mediterranean world, but also includes studies of ancient China, India, and the Americas pre-1500. This encourages scholars working in different regions and cultures to explore connections and comparisons between economic systems and processes, opening up dialogue and encouraging new approaches to ancient economies.

Series Editors:
Paul Erdkamp, Vrije Universiteit Brussel, Belgium
Ken Hirth, Penn State University, USA
Claire Holleran, University of Exeter, UK
Chunyan Huang, Yunnan University, China
Michael Jursa, University of Vienna, Austria
J. G. Manning, Yale University, USA

Contact for Proposals
Submissions are ideally between 60,000 and 110,000 words, although shorter submissions (25,000-50,000 words) will be considered for our Palgrave Pivot publication format.

Authors interested in submitting a proposal should contact the series editors directly or Laura Pacey (laura.pacey@palgrave.com)

Civil asset forfeiture, crime, and police incentives

Yes the police, like criminals, respond to incentives.

A new NBER working paper makes this point.

Civil Asset Forfeiture, Crime, and Police Incentives: Evidence from the Comprehensive Crime Control Act of 1984

Shawn Kantor, Carl Kitchens, Steven Pawlowski

The 1984 federal Comprehensive Crime Control Act (CCCA) included a provision that permitted local law enforcement agencies to share up to 80 percent of the proceeds derived from civil asset forfeitures obtained in joint operations with federal authorities. This procedure became known as “equitable sharing.” In this paper we investigate how this rule governing forfeited assets influenced crime and police incentives by taking advantage of pre-existing differences in state level civil asset forfeiture law and the timing of the CCCA. We find that after the CCCA was enacted crime fell about 17 percent in places where the federal law allowed police to retain more of their seized assets than state law previously allowed. Equitable sharing also led police agencies to reallocate their effort toward the policing of drug crimes. We estimate that drug arrests increased by about 37 percent in the years after the enactment of the CCCA, indicating that it was profitable for police agencies to reallocate their efforts. Such a reallocation of effort, however, brought an unintended cost in the form of increased roadway fatalities, seemingly from reduced enforcement of traffic laws.

Enforcement goes where the money is, not where the need is.

Intellectual property rights: yay or nay?

From the IEA comes this podcast in which Kate Andrews and Steve Davies talk about the good and bad aspects of intellectual property rights.

The Institute of Economic Affairs's Dr Steve Davies joins Kate Andrews to discuss the arguments for and against intellectual property rights - a topic that which particularly divides the libertarian movement.

In the podcast, Steve explains the philosophical arguments both for and against, ultimately arguing that copyright law forms illogical conclusions when taken to the extreme.

However, Steve thinks certain forms of intellectual property are justifiable and helpful, like trademarks, often because they spring up organically, and recognised by courts rather than determined by state policy.

He also points out, that as it becomes increasingly more difficult to monitor copyright infringement, changes to law may be needed for the 21st century.

The Latest bad idea in town: economic nationalism

From the IEA comes this podcast in which Kate Andrews and Steve Davies talk about the rise of economic nationalism.

From the left-ward shift of the Conservative Party in Britain, to the rise of Donald Trump in America, there seems to be a growing appetite for protectionism and central planning in contemporary politics. Steve and Kate examine some of the reasons behind this trend - and whether advocates of free trade are losing the "Battle of Ideas" in the 21st century.

They also look at what protectionist governments hope to achieve from adopting these policies - and how likely they will be to succeed in "bringing back jobs" for declining domestic industries.