Posts filed under ‘Theory of the Firm’
| Nicolai Foss |
Agency theory is a highly important foundational theory in management research. It has been of great assistance with respect to conceptualizing and framing key problems in the design and management of reward systems, and it yields sharp and clear predictions. However, it does not provide a realistic treatment of a key psychological aspects of interpersonal relations. Specifically, agency theory does not adequately account for the principal’s ability to develop, hold and adjust a “theory of the agent’s mind”. The theory in fact contains a very lopsided account of the principal’s ability to read the agent’s desires, intentions, knowledge, and beliefs. Thus, in many models in agency theory, the principal’s knowledge of much of what is “inside the head” of the agent (e.g., the agent’s taste for risk, opportunity costs, and disutility of work) is assumed to be perfect, while he is assumed to be entirely ignorant of other aspects of what the agent intends, knows and believes. Such “asymmetrical” assumptions allow for analytical tractability and clean predictions regarding how incentives and monitoring influences the behavior of agents, such as employees, managers, and suppliers. However, extreme and asymmetrical assumptions can also lead more applied research astray and lead to misapplications of theory in managerial practice. Thus, the assumption that a principal is capable of perfectly grasping, for example, an agent’s motivations seems highly, and increasingly, tenuous: High personnel turnover and the increasing use of fleeting project organization in many industries, as well as the increasing prevalence of cross-national and cross-cultural management teams and networks, make an assumption of a perfect ToM unrealistic.
In a new paper, “Putting a Realistic Theory of Mind Into Agency Theory: Implications for Reward Design and Management in Principal Agent Relations,” my CBS colleague Diego Stea and I take some initial and highly exploratory steps towards working with a more realistic theory of mind in the context of agency relationships within firms (in an as yet unpublished modelling paper, we work these ideas into an adverse selection model). We argue that novel insights into the design and management of rewards follow from explicitly incorporating a realistic theory of mind into agency theory. Thus, a principal with a good theory of mind can better learn the type of the agent, read the signals related to the agent’s effort, signal to the agent, and adjust rewards to the agent. A ToM creates value because it results in lower-variance estimates of the agent’s effort and type, and eases the matching of agents with contracts.
| Peter Klein |
An important announcement from Ning Wang, editor of Man and the Economy:
Man and the Economy
Call for Papers for a Special Issue in Memory of Ronald Coase
“R. H. Coase: The Man and His Ideas”
Man and the Economy will devote a special issue (December 2014) to the life and ideas of Ronald Coase, the 1991 Nobel Laureate in Economics and Founding Editor of this journal. During his long academic life, Coase devoted himself to economics, which, in his view, should investigate how the real world economy works, with all its imperfections. Coase viewed and practiced economics as a social science, a study of man creating wealth in society through various institutional arrangements. To honor the memory of Coase, we welcome original research articles that extend and develop the Coasian economics, including empirical studies of the structure of production and exchange. We also welcome critical and constructive commentaries that clarify and elaborate the Coasian themes, from a law-and-economics/new institutional economics perspective, which include, but not limited to, topics on transaction costs, property rights, theories of the firm and China’s economic transformation. In addition, we also welcome personal reflections and reminiscences of Coase as a colleague, a teacher, an editor, and/or a friend.
Submissions must be made online via the Journal’s website: http://www.degruyter.com/view/j/me
Deadline for submissions is September 30, 2014.
| Nicolai Foss |
In modern standard economics, property rights as an analytical category are mainly associated with the work of Oliver Hart, largely because of his important work, with Sanford Grossman, John Moore and others, on asset ownership in the context of the boundaries of the firm (the pioneering paper is here). Many modern (younger) economists don’t seem to know of the older property rights tradition, associated with Coase, Alchian, Demsetz, Cheung, Barzel, Furubotn, Umbeck, Alston, Libecap, Eggertson et al. Given the prevalent Whig interpretation of the evolution of economic theory, one may be led to the belief that the modern approach superseded or incorporated everything that was sound in the older, verbal approach, while advancing property rights thinking in rigorous game-theoretical terms.
With a frequent co-author, I have penned a paper, “Coasian and Modern Property Rights Economics: A Case of Kuhnian Lost Content,” that argues that such a view is false. In fact, we argue that there has been something akin to a Kuhnian “loss of content” (Kuhn, 1996) in the move from Mark I to Mark II property rights economics. What we call “property rights economics Mark II” is a more narrow approach in terms of the phenomena that are investigated, namely why it matters who owns the asset(s) in a relation that spans at least two stage of production in a value chain. In contrast, “property rights economics Mark I” was taken up with the complex and contingent nature of real ownership arrangements, and pointed to the many margins on which individual can exercise capture of rights, how they seek to protect their rights, the resources consumed in this process, and the role of institutions in facilitating and constraining such processes. This institutional research program is considerably richer than the one implied by Mark II property rights economics.
| Nicolai Foss |
The shifting fortunes in the international automobile industry over the last four decades have, for obvious reasons, been endlessly commented upon. Usually, the two leading protagonists in the various accounts of the dynamics of the industry are General Motors and Toyota, the former because of its conspicuous decline (GM’s share of the US market dropped from about 60 to about 20% over a 30 years period), the latter because it has been steadily growing and is now the world’s largest automaker.
Discussions of the relative performance of these two industrial giants sometimes focus on vacuous categories like “culture” and “capabilities.” More detailed accounts stress the short-termism of General Motor’s investment decisions, its arms-length supplier relations, and its obsession with narrowly defined, easily-measurable jobs. Toyota’s relative success is often explained in terms of the Toyota Management Model with its emphasis on broadly defined jobs, intensive lateral and vertical information flows, and emphasis on problem-solving on the shop floor. However, it is not immediately clear that GM did something very badly that Toyota did very well. The liabilities that led to the decline of GM were apparently were different from the assets that brought Toyota success.
In a new NBER paper, “Management Practices, Relational Contracts, and the Decline of General Motors“, Susan Helper and Rebecca Henderson argue, however, that GM and Toyota are directly comparable in terms of the relational contracts existing inside their corporate hieararchies and across the boundaries of these two companies, and that their differential performance is explainable in terms of the differences between the contracts. Relying on recent contract theory research on relational contracts (rather than the older, but neglected work of Harvey Leibenstein), Helper and Henderson reject a number of conventional explanations (e.g., that GM’s investment policy was oriented towards the short term), and convincingly argue that GM had difficulties understanding the nature and important role of relational contracts behind Toyota’s success and therefores truggled to implement similar relational contracts. They point to a number of reasons why relational contracts may be difficult to build, centering on problems of creating credible commitments and communicating clearly and suggest that these problems were rampant in GM. In all, a very nice read that can be used in a number of different classes (org theory, economics of the firm, strategic management). Highly recommended!
UPDATE: My colleague Henrik Lando draws my attention to Ben-Shahar and White’s 2005 paper on manufacturing contracts in the auto industry which tells a story that is consistent with the Helper and Henderson story. Here.
| Peter Klein |
A friend complains that management and entrepreneurship scholarship is confused about the concept of transaction costs. Authors rarely give explicit definitions. They conflate search costs, bargaining costs, measurement costs, agency costs, enforcement costs, etc. No one distinguishes between Coase’s, Williamson’s, and North’s formulations. “Transaction costs seem to be whatever the author wants them to be to justify the argument.”
It’s a fair point, and it applies to economics (and other social sciences and professional fields) too. I remember being asked by a prominent economist, back when I was a PhD student writing under Williamson, why transaction costs “don’t simply go to zero in the long run.” Indeed, contemporary organizational economics mostly uses terms like “contracting costs,” and since 1991 Williamson has tended to use “maladaptation costs” (while retaining the term “transaction cost economics”).
When I teach transaction costs I typically assign Doug Allen’s excellent 2000 essay from the Encyclopedia of Law and Economics and Lee and Alexandra Benhams’ more recent survey from my Elgar Companion to Transaction Cost Economics (unfortunately gated). Doug, for example, usefully distinguishes between a “neoclassical approach,” in which transaction costs are the costs of exchanging well-defined property rights, and a “property-rights approach,” in which transaction costs are the costs of defining and enforcing property rights.
What other articles, chapters, and reviews would you suggest to help clarify the definition and best use of the “transaction costs”? Or should we avoid the term entirely in favor of narrower and more precise words and phrases?
| Peter Klein |
A renewed interest in conglomerates has brought forth a HBR blog post from Herman Vantrappen and Daniel Deneffe, “Don’t Write Off the (Western) Focused Firm Yet.” As they rightly point out, the choice between a focus and diversity “depends on the context in which the business operates. Specifically, focused firms fare better in countries where society expects and gets public accountability of both firms and governments, while conglomerates succeed in nations with high public accountability deficits.” I would put it slightly differently: the choice between focused, single-business firms and diversified, multi-business enterprises depends on the relative performance of internal and external capital and labor markets. The institutional environment — the legal system, regulatory practices, accounting rules — plays a huge rule here, but social norms, technology, and the competitive environment also affect the efficient margin between between intra-firm and inter-firm resource allocation.
The point is that all forms of organization have costs and benefits. There is no uniquely “optimal” degree of diversification or hierarchy or vertical integration or any other aspect of firm structure; the choice depends on the circumstances. Instead of favoring one particular organizational form we should be promoting an environment in which entrepreneurs can experiment with different approaches, with competition determining the right choice in each context. Let a thousand flowers bloom!
Update: From Joe Mahoney I learn that not only was Chairman Mao’s actual exhortation “Let a hundred flowers blossom,” but also he may have meant it sarcastically: “It is sometimes suggested that the initiative was a deliberate attempt to flush out dissidents by encouraging them to show themselves as critical of the regime.” My usage was of course sincere. :)
| Dick Langlois |
I recently ran across this interesting paper on vertical integration and subcontracting in the Japanese kimono industry of the late nineteenth and early twentieth centuries. By this period, most of the Japanese silk (and cotton) industries had adopted the factory system. But there remained a few industrial districts that relied on the putting-out system. This paper is most interested in presenting a risk-aversion model that explains why “premier subcontractors” got relational contracts in the putting-out system. I’m not sure I buy it, but in any case what caught my eye was something else — a modularity story:
In the weaving industry of Kiryu, the factory system equipped with hand looms had been chosen to weave the luxury fabrics, while the putting-out system had been used for most other fabrics, until the factory system equipped with power looms became dominant for most kinds of fabrics in the 1910s and later. Instead of being replaced, the putting-out system developed and dispersed within Kiryu, especially from the 1860s to the 1900s, when the main products of Kiryu were yarn-dyed silk fabrics. “Yarn dying” means material yarn is dyed before weaving. For the luxury fabrics that were dyed after weaving, the cleaning and finishing processes undertaken after weaving were important, and those processes were conducted inside the manufacturers’ workshops. In contrast, in the production of the yarn-dyed fabrics, dying, arranging warps, cleaning yarn, throwing, re-reeling, and other preparation processes were essential. Because those processes needed special skills, the craftsmen who specialized in each process were organized as subcontractors by manufacturers. … With the moving weight from production of traditional piece-dyed (dyed-after-weaving) fabrics to production of yarn-dyed (dyed-before-weaving) silk fabrics, the throwing process, the finishing process, and the designing process, as well as the weaving process, came to be put-out. Manufacturers decreased the production inside of their workshops and established subcontracting relations with independent artisans. This case suggests that the technological change induced by the change of products from piece-dyed fabrics to the yarn-dyed fabrics affected production organization.
This has a bit of a Christensen flavor to it. When “performance” needs were high — high-end kimonos — the industry used a non-modular technology (dyed-after-weaving) and an integrated organization. When performance needs were lower — lower-quality kimonos — it used a modular technology (dyed-before-weaving) and a vertically disintegrated structure.
| Peter Klein |
Diversification continues to be a central issue for strategic management, industrial organization, and corporate finance. There are huge research and practitioner literatures on why firms diversify, how diversification affects financial, operating, and innovative performance, what underlies inter-industry relatedness, how diversification ties into other aspects of firm strategy and organization, whether diversification is driven by regulation or other policy choices, and so on. There are many surveys of these literatures (Lasse and I contributed this one).
Some of the most interesting research deals with the institutional environment. For example, many US corporations were widely diversified in the 1960s and 1970s when the brokerage industry was small and protected by tough legal restrictions on entry, antitrust policy frowned on vertical and horizontal growth (maybe), and a volatile macroeconomic environment encouraged internalization of inter-firm transactions (also maybe). After the brokerage industry was deregulated in 1975, the antitrust environment became more relaxed, and the market for corporate control heated up, many conglomerates were restructured into more efficient, specialized firms. To quote myself:
The investment community in the 1960s has been described as a small, close-knit group wherein competition was minimal and peer influence strong (Bernstein, 1992). As Bhide (1990, p. 76) puts it, “internal capital markets … may well have possessed a signiﬁcant edge because the external markets were not highly developed. In those days, one’s success on Wall Street reportedly depended far more on personal connections than analytical prowess.” When capital markets became more competitive in the 1970s, the relative importance of internal capital markets fell. “This competitive process has resulted in a signiﬁcant increase in the ability of our external capital markets to monitor corporate performance and allocate resources” (Bhide, 1990, p. 77). As the cost of external ﬁnance has fallen, ﬁrms have tended to rely less on internal ﬁnance, and thus the value added from internal-capital-market allocation has fallen. . . .
Similarly, corporate refocusing can be explained as a consequence of the rise of takeover by tender offer rather than proxy contest, the emergence of new ﬁnancial techniques and instruments like leveraged buyouts and high-yield bonds, and the appearance of takeover and breakup specialists like Kohlberg Kravis Roberts, which themselves performed many functions of the conglomerate headquarters (Williamson, 1992). A related literature looks at the relative importance of internal capital markets in developing economies, where external capital markets are limited (Khanna and Palepu 1999, 2000).
The key reference is to Amar Bhide’s 1990 article “Reversing Corporate Diversification,” which deserves to be better known. But note also the pointer to Khanna and Palepu’s important work on diversified business groups in emerging markets, which has also led to a vibrant empirical literature. The idea there is that weak institutions lead to poorly performing capital and labor markets, leading firms to internalize functions that would otherwise be performed between firms. More generally, firm strategy and organization varies systematically with the institutional environment, both over time and across countries and regions.
Surprisingly, diversified business groups were also common in the US, in the early 20th century, which brings me (finally) to the point of this post. A new NBER paper by Eugene Kandel, Konstantin Kosenko, Randall Morck, and Yishay Yafeh studies these groups and reaches some interesting and provocative conclusions. Check it out:
Eugene Kandel, Konstantin Kosenko, Randall Morck, Yishay Yafeh
NBER Working Paper No. 19691, December 2013
The extent to which business groups ever existed in the United States and, if they did exist, the reasons for their disappearance are poorly understood. In this paper we use hitherto unexplored historical sources to construct a comprehensive data set to address this issue. We find that (1) business groups, often organized as pyramids, existed at least as early as the turn of the twentieth century and became a common corporate form in the 1930s and 1940s, mostly in public utilities (e.g., electricity, gas and transportation) but also in manufacturing; (2) In contrast with modern business groups in emerging markets that are typically diversified and tightly controlled, many US groups were focused in a single sector and controlled by apex firms with dispersed ownership; (3) The disappearance of US business groups was largely complete only in 1950, about 15 years after the major anti-group policy measures of the mid-1930s; (4) Chronologically, the demise of business groups preceded the emergence of conglomerates in the United States by about two decades and the sharp increase in stock market valuation by about a decade, so that a causal link between these events is hard to establish, although there may well be a connection between them. We conclude that the prevalence of business groups is not inconsistent with high levels of investor protection; that US corporate ownership as we know it today evolved gradually over several decades; and that policy makers should not expect policies that restrict business groups to have an immediate effect on corporate ownership.
| Peter Klein |
The ISNIE 2014 Call for Papers is now available. The conference is at Duke University, 19-21 June 2014, home of President-Elect and Program Committee Chair John de Figueiredo. Bob Gibbons and Timur Kuran are keynote speakers. ISNIE is one of our favorite conferences, so please consider submitting a proposal! Submissions are due 30 January 2014.
| Peter Klein |
It finds what you’d expect: When agents are assigned multiple tasks, and evaluated using objective performance criteria, they will tend to favor those tasks that produce measurable outputs, at the expense of equally important, but harder-to-measure tasks. This is why, for example, professors at research universities often neglect their teaching duties. Sure it’s important, but quality is hard to demonstrate, so I’ll concentrate on publications, grants, and other research activities.
Testing the Theory of Multitasking: Evidence from a Natural Field Experiment in Chinese Factories
Fuhai Hong, Tanjim Hossain, John A. List, and Migiwa Tanaka
NBER Working Paper No. 19660, November 2013
A well-recognized problem in the multitasking literature is that workers might substantially reduce their effort on tasks that produce unobservable outputs as they seek the salient rewards to observable outputs. Since the theory related to multitasking is decades ahead of the empirical evidence, the economic costs of standard incentive schemes under multitasking contexts remain largely unknown. This study provides empirical insights quantifying such effects using a field experiment in Chinese factories. Using more than 2200 data points across 126 workers, we find sharp evidence that workers do trade off the incented output (quantity) at the expense of the non-incented one (quality) as a result of a piece rate bonus scheme. Consistent with our theoretical model, treatment effects are much stronger for workers whose base salary structure is a flat wage compared to those under a piece rate base salary. While the incentives result in a large increase in quantity and a sharp decrease in quality for workers under a flat base salary, they result only in a small increase in quantity without affecting quality for workers under a piece rate base salary.
| Peter Klein |
The University of Dundee’s Scottish Centre for Economic Methodology is hosting a conference 18 November 2013, “Origins of the Theory of the Firm: Ronald Coase at Dundee, 1932-1934.” The program looks really interesting:
- Keith Tribe, “Dundee and Interwar Commercial Education.”
- Billy Kenefick, “‘A great industrial cul-de-sac, a grim monument to “man’s inhumanity to man.” ‘ Dundee by the early 1930s.”
- Carlo Morelli, “Market & Non-Market Co-ordination: Dundee and its Jute Industry – The Case Study for Ronald Coase?”
- David Campbell, “Agency, Authority and Co-operation in the Firm: Coase, Macneil, Marx.”
- Alice Belcher, “Coase and the Concept of Direction: How Valuable are Legal Concepts in the Theory of the Firm?”
- Brian Loasby, “Ronald Coase’s Theory of the Firm and the Scope of Economics.”
- Alistair Dow & Sheila Dow, “Coase and Scottish Political Economy.”
- Eyup Ozveren & Ilhan Can Ozen, “Coase versus Coase: What if the Market Were One Big Firm Instead?”
- Neil Kay, “Coase, The Nature of the Firm, and the Principles of Marginal Analysis.”
| Peter Klein |
Three recent NBER papers on compensation, performance, and productivity:
Ann Bartel, Brianna Cardiff-Hicks, Kathryn Shaw
NBER Working Paper No. 19412, September 2013
Due to the limited availability of firm-level compensation data, there is little empirical evidence on the impact of compensation plans on personal productivity. We study an international law firm that moves from high-powered individual incentives towards incentives for “leadership” activities that contribute to the firm’s long run profitability. The effect of this change on the task allocation of the firm’s team leaders is large and robust; team leaders increase their non-billable hours and shift billable hours to team members. Although the motivation for the change in the compensation plan was the multitasking problem, this change also impacted the way tasks were allocated within each team, resulting in greater teamwork.
William Mullins, Antoinette Schoar
NBER Working Paper No. 19395, September 2013
Using a survey of 800 CEOs in 22 emerging economies we show that CEOs’ management styles and philosophy vary with the control rights and involvement of the owning family and founder: CEOs of firms with greater family involvement have more hierarchical management, and feel more accountable to stakeholders such as employees and banks than they do to shareholders. They also see their role as maintaining the status quo rather than bringing about change. In contrast, professional CEOs of non-family firms display a more textbook approach of shareholder-value-maximization. Finally, we find a continuum of leadership arrangements in how intensively family members are involved in management.
George J. Borjas, Kirk B. Doran
NBER Working Paper No. 19445, September 2013
Knowledge generation is key to economic growth, and scientific prizes are designed to encourage it. But how does winning a prestigious prize affect future output? We compare the productivity of Fields medalists (winners of the top mathematics prize) to that of similarly brilliant contenders. The two groups have similar publication rates until the award year, after which the winners’ productivity declines. The medalists begin to “play the field,” studying unfamiliar topics at the expense of writing papers. It appears that tournaments can have large post-prize effects on the effort allocation of knowledge producers.
Thank goodness I haven’t won the Clark Medal, Nobel Prize, or a MacArthur Award. I want to keep my productivity high!
| Nicolai Foss |
Fritz Machlup famously argued that economists should not care about the specificities (e.g., internal organization) of individual firms, as this was unlikely to bring substantial additional insight in the market outcomes that were the real objects of interests for economists (here). Thus, for the purposes of price theory, firms within an industry could essentially be taken to be homogenous. Machlup’s view has been reflected in much of the micro-economics of the firm, not just in the standard Marshallian approach, but also in later contract theoretic and transaction cost approaches. While contract theory and transaction cost insights are surely capable of contributing to the understanding of firm heterogeneity, explaining such heterogeneity per se has never been a central explanatory task of these approaches. However, while the Machlup view was still holding sway among economists (well into the 1990s), dissenting economists and management scholars highlighted that heterogeneity among firms could be understood in terms of differential capability—an idea that helped them to explain firm boundaries (see much of the work of O&M blogger Richard Langlois), competitive heterogeneity in a population of firms (evolutionary economics), and competitive advantage (the resource-based view in strategy.
However, while management research has done much to advance the notion of intra-industry heterogeneity, it may have been less forthcoming with respect to theorizing the antecedents of such heterogeneity. Most work on such antecedents has highlighted cognitive a variables, such as managerial cognition and absorptive capacity, and variables related to skill levels and the efficiency of routines. Surprisingly, virtually no work in management research has linked differential capability to organizational design (e.g., the structures of communication, delegation, and incentives) or even to the human capital characteristics of firms’ workforces. (more…)
| Peter Klein |
Ronald Coase passed away today at the age of 102. One of the most influential economists of the 20th century, perhaps of all time. His “Problem of Social Cost” (1960) has 21,692 Google Scholar cites, and “The Nature of the Firm” has 24,501. Adam Smith’s Wealth of Nations, summed across editions, has about 30,000. Coase changed the way economists think about the business firm and the way they think about property rights and liability. He largely introduced the concepts of transaction costs, comparative institutional analysis, and government failure. Not all economist have agreed with his arguments and conceptual frameworks, but they radically changed the terms of debate in the economics of law, welfare, industry, and more. He is the key figure in the “new institutional economics” (and co-founder, and first president, of the International Society for New Institutional Economics).
Coase did all these things despite — or because of? — not holding a PhD in economics, not doing any math or statistics, and not, for much of his career, working in an economics department.
We’ve written so much on Coase already, on these pages and in our published work, that it’s hard to know what else to say in a blog post. Perhaps we should just invite you to browse old O&M posts mentioning Coase (including this one, posted last week).
The blogosphere will be filled in the coming days with analyses, reminiscences, and tributes. You can find your favorites easily enough (try searching Twitter, for example). I’ll just share two of my favorite memories. The first comes from the inaugural meeting of the International Society for New Institutional Economics in 1997. After a discussion about the best empirical strategy for that emerging discipline. Harold Demsetz stood up and said “Please, no more papers about Fisher Body and GM!” Coase, who was then at the podium, surprised the crowd by replying, “I’m sorry, Harold, that is exactly the subject of my next paper!” (That turned out to be his 2005 JEMS paper, described here.) A few years later, I helped entertain Coase during his visit to the University of Missouri for the CORI Distinguished Lecture. At lunch we talked about his disagreement with Ben Klein on asset specificity. After the lunch he got up, shook my hand, and announced, with evident satisfaction: “I see all Kleins are not alike.”
| Peter Klein |
O&Mers attending the AoM conference may find these Professional Development Workshops, sponsored by the Academy of Management Perspectives and based on recent AMP symposia, of particular interest:
The first PDW is on “Private Equity” and features presentations on the managerial, strategic, and public policy implications of private equity transactions. Presenters include Robert Hoskisson (Rice University), Nick Bacon (City University London), Mike Wright (Imperial College London), and Peter Klein (University of Missouri). The private equity session takes place Saturday, Aug 10, 2013 from 11:30AM – 12:30PM at WDW Dolphin Resort in Oceanic 5.
The second is on “Microfoundations of Management,” and features presentations from Nicolai Foss (Copenhagen Business School), Henrich Greve (INSEAD), Sidney Winter (Wharton), Jay Barney (Utah), Teppo Felin (Oxford), Andrew Van de Ven (Minnesota), and Arik Lifschitz (Minnesota). The microfoundations session takes place Monday, Aug 12, 2013 from 9:00AM
– 10:30AM at WDW Dolphin Resort in Oceanic 5
| Dick Langlois |
The title of this paper, by Laura Alfaro, Paola Conconi, Harald Fadinger, and Andrew F. Newman, caught my eye. Then the abstract really caught my attention.
What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper shows that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. If true, it follows from firms’ maximizing behavior that higher prices cause firms to choose more integration. The reason is that at low prices, increases in revenue resulting from enhanced productivity are too small to justify the cost, whereas at higher prices, the revenue benefit exceeds the cost. Trade policy provides a source of exogenous price variation to assess the validity of this prediction: higher tariffs should lead to higher prices and therefore to more integration. We construct firm-level indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tariffs to examine their impact on firm boundaries. Our empirical results provide strong support for the view that output prices are a key determinant of vertical integration.
The surprising part is not the empirical result, which is interesting. The surprising part is that the underlying theory of vertical integration in the paper is no more sophisticated than what’s in the abstract: vertical integration is always more efficient than using the market, because a lot of people like Williamson and Hart and Moore have said so. Since integration implies fixed costs, firms (in perfect competition) won’t engage in this wonderful and indisputably efficient practice unless prices are high enough to cover the fixed costs. Readers of this blog will not need me to tell them what’s wrong with this. But I like the empirical result, which is consistent with my own suspicion that tariffs provide cover for firms to engage in inefficient vertical integration. The right spin on this result may well be the Michael Jensen story: lack of competitive pressure from the product market enables managers to retain earnings, which they spend on buying divisions or integrating into things they could buy more cheaply on the market.
| Nicolai Foss |
When I was a graduate student 20-25 years ago I remember transaction cost economics being routinely mocked by all and sundry for “being static,” “neglecting learning,” and “not saying anything about innovation and entrepreneurs,” in addition, of course, to the usual charges of working with an impoverished and overly cynical view of human nature.
While TCE still highlights opportunism as a key assumption, it is fair to say that over the last decade important work has brought dynamics, learning and innovation within the orbit of TCE. This has mainly been brought about by a coterie — some of which are former students of Oliver Williamson — such as Nicholas Argyres, Kyle Mayer, Todd Zenger, Steve Michael, O&M’s Peter Klein, and last, but certainly not least, Jackson Nickerson.
Jackson is the author of a large number of truly innovative papers in management research and economics, many of which have a TCE bent. Thus, with Todd Zenger he has done important work on envy (and other aspects of social comparison processes) as an antecedent of internal transaction costs, on why firms seem to switch between extremes in their organizational forms, and, again with Zenger, he has pioneered a “problem-solving approach” to economic organization.
My department will feature this extremely original thinker as a speaker in our seminar series on Friday (here). Jackson will present a novel take on the dominant design stream of thinking about industry evolution, building on the US auto industry data base that (his co-authors) Lyda Bigelow and Nick Argyres have successfully exploited in earlier publications. Will be exciting!!
| Dick Langlois |
The title of this paper caught my attention.
“Cognition & Capabilities: A Multi-Level Perspective”
J. P. Eggers and Sarah Kaplan
Academy of Management Annals 7(1): 293-338
Research on managerial cognition and on organizational capabilities has essentially developed in two parallel tracks. We know much from the resource-based view about the relationship between capabilities and organizational performance. Separately, managerial cognition scholars have shown how interpretations of the environment shape organizational responses. Only recently have scholars begun to link the two sets of insights. These new links suggest that routines and capabilities are based in particular understandings about how things should be done, that the value of these capabilities is subject to interpretation, and that even the presence of capabilities may be useless without managerial interpretations of their match to the environment. This review organizes these emerging insights in a multi-level cognitive model of capability development and deployment. The model focuses on the recursive processes of constructing routines (capability building blocks), assembling routines into capabilities, and matching capabilities to perceived opportunities. To date, scholars have focused most attention on the organizational-level process of matching. Emerging research on the microfoundations of routines contributes to the micro-level of analysis. The lack of research on capability assembly leaves the field without a bridge connecting the macro and micro levels. The model offers suggestions for research directions to address these challenges.
The reason it caught my eye is that some 16 years ago I published a paper with exactly the same title (albeit with a different subtitle). Of course, I didn’t approach the issue in exactly the way these authors do, which is obviously close to Nicolai’s work on microfoundations. But I did arguably try to “link the two sets of insights,” and I did not do so “only recently.”
| Peter Klein |
Transaction cost economics, the property-rights approach to the firm, and the judgment-based view all assume that contracting parties cannot sign complete, contingent contracts, in which case firm boundaries would be arbitrary and unimportant. TCE tends to attribute incompleteness to bounded rationality, while the judgment-based view appeals to Knightian uncertainty and subjectivism to describe markets for judgment are incomplete. The property-rights approach of Grossman, Hart, and Moore did not have an explicit theory of incompleteness, which critics such as Maskin and Tirole saw as a major weakness.
Oliver Hart has written a series of recent papers on “reference points” as a new explanation for incompleteness. The newest, released today as an NBER working paper (with Maija Halonen-Akatwijuka), is the most explicit. It argues that parties deliberately leave gaps in contracts because explicit clauses can make it more difficult for parties to parties to renegotiate after the fact. Check it out and see what you think.
More is Less: Why Parties May Deliberately Write Incomplete Contracts
Maija Halonen-Akatwijuka, Oliver D. Hart
NBER Working Paper No. 19001, April 2013
Why are contracts incomplete? Transaction costs and bounded rationality cannot be a total explanation since states of the world are often describable, foreseeable, and yet are not mentioned in a contract. Asymmetric information theories also have limitations. We offer an explanation based on “contracts as reference points”. Including a contingency of the form, “The buyer will require a good in event E”, has a benefit and a cost. The benefit is that if E occurs there is less to argue about; the cost is that the additional reference point provided by the outcome in E can hinder (re)negotiation in states outside E. We show that if parties agree about a reasonable division of surplus, an incomplete contract can be strictly superior to a contingent contract.
| Peter Klein |
My old classmate, fellow Oliver Williamson student, and coauthor Howard Shelanski has been nominated to head the Office of Information and Regulatory Affairs (the post typically described as Regulation Czar). Howard was in the joint PhD-JD program at Berkeley, went on to clerk for Antonin Scalia, joined the faculty at Berkeley’s School of Law, and served in a number of regulatory posts before moving to Georgetown. He currently heads the FTC’s Bureau of Economics.
Howard’s a super-smart guy, whom I’d describe as an antitrust moderate (unlike me, an anti-antitrust extremist). He’s sympathetic to “post Chicago” antitrust theory and policy, but more of a nuts-and-bolts, case-by-case guy. I’m not a fan Cass Sunstein, current head of the OIRA, and I expect to like Howard’s performance much better. Howard doesn’t share Sunstein’s enthusiasm for behavioral analysis, for example, as seen in an interview last December, where he said this about the role of behavioral economics in antitrust:
I think there is a role, but one needs to be very modest and cautious. There has been a lot written and a lot said about how behavioral economics fundamentally undermines the models on which we do antitrust analysis. And I think most people involved with antitrust enforcement, most people who think about competition issues, would disagree that there is some fundamental new paradigm shift in the works. But behavioral economics does supply insights into how consumers might respond to certain kinds of information, contracting practices, or pricing schemes. This can be very useful to understanding certain kinds of market performance and has led to greater modesty about imputing perfect foresight or rationality to consumers.
But one needs to understand that that is not the sign of a broader behavioral economics revolution in antitrust.
My general feelings about regulatory czars are well summarized by this passage from Fiddler on the Roof, quoted today by Danny Sokol in the same context:
Young Jewish Man: Rabbi, may I ask you a question?
Rabbi: Certainly, my son.
Young Jewish Man: Is there a proper blessing for the Tsar?
Rabbi: A blessing for the Tsar? Of course! May God bless and keep the Tsar . . . far away from us!