“Coase and Simon Got It Right, Alchian and Demsetz Got It Wrong”

8 September 2006 at 8:07 am 2 comments

| Peter Klein |

A reader asks: “In a response to a prominent economist who asked ‘what have we learned about . . . organizations,’ you provided a list that began with ‘Organizations can have market-like features, but are inherently different from markets. I.e., authority is real — Coase and Simon got it right, Alchian and Demsetz got it wrong.’ What are the major papers that led to this conclusion?”

I have in mind the Alchian-Demsetz notion that the firm is a legal fiction, a convenient label for a nexus of contracts. (Recall the famous passage in their 1972 paper about “firing the grocer.”) Classic formulations of the opposite view — that the firm does, in fact, have some power of fiat — come from the two Olivers, Williamson and Hart.

Williamson invokes the notion of “forbearance,” the idea that the law treats the firm itself as the arbiter of intra-firm disputes, while the courts are more likely to intervene in disputes between firms. (See the discussion in his 1991 article “Comparative Economic Organization: The Analysis of Discrete Structural Alternatives,” especially pp. 98-100 of the version that appears in The Mechanisms of Governance). Hart’s views are expressed in his 1986 JPE paper with Sanford Grossman and his 1995 book Firms, Contracts, and Financial Structure. If contracts are incomplete, Hart argues, than ownership of alienable assets conveys residual rights of control, which conveys a form of authority.

Nicolai I and I have some papers that are relevant, including this and this. See also my comments on “market-based management.”

Entry filed under: - Klein -, Management Theory, Theory of the Firm. Tags: .

Sometimes I Wish I Were a Professor of “Critical Studies” Wikis Are Great, But. . . .

2 Comments Add your own

  • 1. Joe Mahoney  |  8 September 2006 at 1:26 pm

    The question of who got it right is the wrong question.

    In a world in which there are perfect markets and complete markets for all factors of production, the sole residual claimant, by definition, is the shareholder and all the action takes place in the EX ANTE contactual agreement. In this Alchian and Demsetz (1972) agency view, which is then modeled mathematically by Holmstrom (1979) and Shavell (1979) there is by the LOGIC OF THE RECONSTRUCTED MODEL OF THE FIRM — no room for authority.

    In the world of transaction costs (Williamson, 1975, 1985, 1996), and in the world of Grossman and Hart (1986) and Hart and Moore (1990) — sometimes referred to as the GHM Model there are incomplete contracts, and thus there are, BY THIS RECONSTRUCTED MODEL OF THE FIRM, “residual rights of control” to use Hart’s terminology or “zone of acceptance” to use Simon (1947) and WIlliamson’s (1975) terminology. Such residual rights of control is a widely held DEFINITION of authority.

    Who got it right? If you are asking about the world of experience, the answer is that we do not live in a world of complete contracting and the incomplete contracting approach is far superior for connecting to real-world experience.

    If you are asking in terms of THE RECONSTRUCTED MODEL OF THE FIRM, then concerning whether authority exists, they both got it right: in a world of complete contracting authority does not exist and in a world in incomplete contracting, authority does exist.

    Of course, that is what you already said. I just thought your headline did not contribute to the clarity which then followed in your discussion of the topic

    More pedagogical headings please !!

    P.S.: In terms of the concept of authority I think Barnard (1938) and John R. Commons (1924) are the real fountainheads — with honorable mentions to Coase (1937) and Simon (1947).

  • 2. Peter Klein  |  8 September 2006 at 1:34 pm

    Joe is correct, of course. What I meant to convey with the headline (i.e., the bullet point from the original post on “what we know” about organizations) is that the complete-contracting model of the firm is less realistic, less useful, and so on. My sense is that economists tend to sympathize with the nexus-of-contracts view and are less familiar with the incomplete-contracting alternative.

    Thanks for the clarification!

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