Organizations and Markets

Is Selective Intervention Really “Impossible”?

18 September 2006 at 9:41 am Nicolai Foss 3 comments

| Nicolai Foss |

One of the most difficult notions in the theory of the firm is surely that of “selective intervention,” and particularly the associated notion of the “impossibility of selective intervention.” These terms were coined by Oliver Williamson to describe attenuation of incentives that accompanies integration (see this book, chapter 6). What Williamson calls “the fiction of selective intervention” refers to the thought experiment of one big firm replicating small firms for all activities “save those for which the expected net gains from intervention could be projected.” If this were possible, all economic activity, Williamson argues, would be organized in a single firm.

What then are the reasons why “selective intervention” thus defined is a “fiction”? Williamson concentrates on two main manifestations of the incentive distortions he associates with selective intervention. The first cause, “asset malutilization,” appeals to costs of measuring the wear and tear on equipment. Given such costs, owner-managers who become managers in the merged firm will utilize equipment with less care and invest less in maintenance. The second one is “accounting contrivance,” that is, the integrating firm will pay a low price for the assets of the integrated firm in exchange for a promise of a favorable net receipt stream, but will then squeeze the net receipts of the integrated firms by means of accounting manipulation after integration. Both problems arise because incentives in the merged firm are high-powered. Recourse to low-powered incentives is to be expected. The attendant organizational failures help explain the optimum size (the efficient boundaries) of the firm.

Note that in spite of Williamson’s wording none of these explanations directly say that selective intervention — that is, the conscious managerial (or owner) attempt to intervene to produce net gains — is costly. Rather, they imply that integration is costly because “[e]fforts to ‘hold incentives constant,’ thereby to effect incentive neutrality . . . turn out to be delusional” (Williamson 1985: 161). For example, it is costly for divison managers to commit to promises to utilize assets with due care, and it is costly to enforce such promises.  

However, Williamson (1985: 161) also notes, albeit only briefly, that upon merger “none of the following is costlessly enforceable: . . . promises by owners to reset transfer prices and exercise accounting ‘discretion’ responsibly; promises to reward innovation in ‘full measure’; promises to preserve promotion prospects ‘without change’” (ibid.). These commitment and enforcement problems speak more directly to the issue of the cost of selective intervention, properly defined. Specifically, selective intervention may break commitments, and be harmful for this reason.

Thus, the “impossibility of selective intervention” seems mainly to be a convoluted way of expressing the organizational failures that should be weighed against the commitment problems implied by hold-up in the market place, these two commitment problems jointly determining the boundaries of the firm.

However, Williamson (and Williamsonian scholars, see this paper and this paper) often writes as if firms, because of the built-in lack of third-party enforcement mechanisms, generally score worse with respect to honoring commitments than markets do. The property rights structures are inherently different, i.e., property rights in firms are always loaned, not owned so management can always renege on promises, whereas reneging in the market place is limited to opportunistic hold-up. 

However, this argument seems to presuppose that third-party enforcement is generally efficient in the marketplace, save for those rare instances of opportunistic hold-up. This is not generally correct. Perhaps in countries without a stable rule of law, etc., firms may actually perform better than markets with respect to the honoring of promises. In such countries, we should observe a lot of vertical integration.

Entry filed under: - Foss -, Institutions, Theory of the Firm.