Posts filed under ‘Theory of the Firm’
Literature Review Bleg
| Dick Langlois |
One of my graduate students has been working on an idea to formalize Henry Hansmann’s approach to the ownership of enterprise. Hansmann thinks about the ownership margin — which set of “patrons” in the nexus of contracts should own the residual rights of control and of income? The idea of this work would be to think simultaneously about the Coasean margin, the boundaries of the firm, which should be determined endogenously along with ownership. That means that firms would have different levels of vertical integration depending on which patrons own them. One interesting question: what happens to the level of vertical integration of banks if the government comes to own them?
We need to locate this idea in the literature and to find out if anyone else has done anything along these lines. So, if you know of anything remotely related, please send it along.
Oliver Hart: Hon Doc at CBS — and O&M Reader
| Nicolai Foss |
Every year in April the Copenhagen Business School confers honorary doctorates to prominent management theorists, finance scholars, economists, sociologists, etc. Oliver Williamson, James March, and Jay Barney have all received honorary doctorates. This year’s honorary doctors included no less than six scholars, of which one should be familiar to O&M readers, namely Professor Oliver Hart of Harvard University (Hart’s Harvard site is currently down — too many hits? ;-)). Hart is, of course, one of the authors of the seminal 1986 paper, “The Costs and Benefits of Ownership,” and the author of numerous other papers that build on this paper. His property-rights approach to the theory of the firm (really, the theory of the boundaries of the firm) is the dominant approach in economics.
Although I have met Hart on previous occasions, I didn’t expect him to recognize me. However, not only did he recognize me, he also greeted me with “You blog a lot!!” (I confess I didn’t disclose that it is Peter who blogs a lot ;-)). It turned out that Hart was well aware of O&M and apparently also likes it!
The Political Economy of Vertical Integration
| Peter Klein |
An understudied area in the organizations literature is the effect of organizational form on lobbying, rent-seeking, tax-rate arbitrage, and similar kinds of political behavior. The accounting literature on transfer pricing looks at the ability of vertically integrated multinationals to shift income between tax jurisdictions to reduce the overall tax burden, and regulators have expressed concerns about diversified multinationals putting downward pressure on environmental and labor regulations (by threatening to withdraw production from countries with high tax or regulatory burdens). Of course we know that as industries mature, firms are more likely to open lobbying offices in state or national capitols. But, in general, we know little about how firms organize to take advantage of political processes and institutions.
Joseph Fan, Jun Huang, Randall Morck, and Bernard Yeung have a new NBER paper on vertical integreation in China showing that vertical integration in highly interventionist environments may be aimed not at reducing transaction costs, protecting relationship-specific investments, and the like, but at rent-seeking and the pursuit of other forms of political privilege. Abstract:
Where legal systems and market forces enforce contracts inadequately, vertical integration can circumvent these transaction difficulties. But, such environments often also feature highly interventionist government, and even corruption. Vertical integration might then enhance returns to political rent-seeking aimed at securing and extending market power. Thus, where political rent seeking is minimal, vertical integration should add to firm value and economy performance; but where political rent seeking is substantial, firm value might rise as economy performance decays. China offers a suitable background for empirical examination of these issues because her legal and market institutions are generally weak, but nonetheless exhibit substantial province-level variation. Vertical integration is more common where legal institutions are weaker and where regional governments are of lower quality or more interventionist. In such provinces, firms led by insiders with political connections are more likely to be vertically integrated. Vertical integration is negatively associated with firm value if the top corporate insider is politically connected, but weakly positively associated with public share valuations if the politically connected firm is independently audited. Finally, provinces whose vertical integrated firms tend to have politically unconnected CEOs exhibit elevated per capita GDP growth, while provinces whose vertically integrated firms tend to have political insiders as CEOs exhibit depressed per capita GDP growth.
Archived Version of Hitt Presentation on Strategic Management
| Peter Klein |
Here’s an archived version of Mike Hitt’s presentation, “New Theoretical Developments in Strategic Management,” that Mike Sykuta described before. You can also download the slides.
I watched the presentation yesterday and strongly recommend it, particularly the first part, as a good introduction to the resource-based view of the firm and an overview of some of Mike’s recent work on the institutional environment. It was nice of the AEM folks to set this up.
Slides on “Putting Entrepreneurship into Strategy and Organization”
| Peter Klein |
You’ve read the book. You’ve seen the movie. You attended the seminar. Now download the slides. Or something like that. Anyway, Lasse begged me to post the slides from this morning’s talk at NHH — or maybe he begged me not to post them, I forget which — so here they are. Some of the slides may not make much sense without the animation (and accompanying patter), but sadly the event was not captured on video, where it could have won next year’s Oscar in the “Best Obscure Academic Talk” category.
Top 3 Boundary Implications
| Lasse Lien |
Top 3 lists are popular, the financial crisis is a hot topic, and this is Organizations and Markets. Combine all three and you get my top 3 list of implications of the financial crisis/recession for firm boundaries:
1. Increased horizontal specialization (de-diversification)
2. Increased vertical specialization
3. Increased concentration (increased size)
Is this roughly right? If not, provide us with your own list.
An Empirical Test of Williamson’s Adaptation Theory
| Peter Klein |
We’ve noted before, following Bob Gibbons, how Williamson’s transaction-cost approach can be called an adaptation theory of the firm. Vertical integration, in this context, is seen as an efficient means of adjusting a production process to unanticipated changes in market conditions, regulation, or technology.
Most of the empirical TCE literature focuses on the equilibrium rent-seeking version of the story, however (perhaps more influenced by Klein, Crawford, and Alchian’s interpretation). Vertical integration is viewed as an efficient means of mitigating holdup in the presence of asset specificity — and, in equilibrium, holdups don’t occur, so there is nothing to mitigate. Hence the typical TCE empirical paper which compares observed organizational forms to observed transactional characteristics (e.g., the degree of asset specificity). Newer studies attempt to test the relationship between efficient alignment, in the sense above, and long-term performance or survival, but few study the process of adaptation itself. (Exceptions include Mayer and Argyres, 2004 and Argyres and Mayer, 2007.)
Arnaud Costinot, Lindsay Oldenski, and James Rauch have written what I think is the first large-N empirical paper on the adaptation theory, “Adaptation and the Boundary of Multinational Firms.”They construct an occupation-level measure of “routineness” — whether a job involves mainly routine tasks or more creative, problem-solving activities — and show that routineness and vertical integration are negatively correlated. An interesting operationalization of the theory. Abstract:
What determines the boundary of multinational firms? According to Williamson (1975), a potential rationale for vertical integration is to facilitate adaptation in a world where uncertainty is resolved over time. This paper offers the first empirical analysis of the impact of adaptation on the boundary of multinational firms. To do so, we first develop a ranking of sectors in terms of their “routineness” by merging two sets of data: (i) ratings of occupations by their intensities in “problem solving” from the U.S. Department of Labor’s Occupational Information Network; and (ii) U.S. employment shares of occupations by sectors from the Bureau of Labor Statistics Occupational Employment Statistics. Using U.S. Census trade data, we then demonstrate that, in line with adaptation theories of the firm, the share of intrafirm trade tends to be higher in less routine sectors. This result is robust to inclusion of other variables known to influence the U.S. intrafirm import share such as capital intensity, R&D intensity, relationship specificity, intermediation and productivity dispersion. Our most conservative estimate suggests that a one standard deviation decrease in average routineness raises the share of intrafirm imports by 0.26 standard deviations, or an additional 7% of import value that is intrafirm.
Extreme Decentralization at Walmart
| Peter Klein |
A fascinating NY Post story on Walmart by a reporter who went undercover and got hired as an entry-level worker. The story reveals a surprising amount of decentralization for a firm sometimes regarded as some kind of Taylorite dinosaur. (Thanks to Rafe Champion for the pointer.) Excerpt:
Having pledged ourselves, we encountered the aspect of Wal-Mart employment that impressed me most: The Telxon, pronounced “Telzon,” a hand-held bar-code scanner with a wireless connection to the store’s computer. When pointed at any product, the Telxon would reveal astonishing amounts of information: the quantity that should be on the shelf, the availability from the nearest warehouse, the retail price, and (most amazing of all) the markup.
All of us were given access to this information, because — in theory, at least — anyone in the store could order a couple extra pallets of anything, and could discount it heavily as a Volume Producing Item (known as a VPI), competing with other departments to rack up the most profitable sales each month. Floor clerks even had portable equipment to print their own price stickers. This was how Wal-Mart detected demand and responded to it: by distributing decision-making power to grass-roots level. It was as simple yet as radical as that.
We received an inspirational talk on this subject, from an employee who reacted after the store test-marketed tents that could protect cars for people who didn’t have enough garage space. They sold out quickly, and several customers came in asking for more. Clearly this was a singular, exceptional case of word-of-mouth, so he ordered literally a truckload of tent-garages, “Which I shouldn’t have done really without asking someone,” he said with a shrug, “because I hadn’t been working at the store for long.” But the item was a huge success. His VPI was the biggest in store history — and that kind of thing doesn’t go unnoticed in Arkansas.
The Gig Economy
| Peter Klein |
Tina Brown heralds the rise of the “Gig economy”:
No one I know has a job anymore. They’ve got Gigs.
Gigs: a bunch of free-floating projects, consultancies, and part-time bits and pieces they try and stitch together to make what they refer to wryly as “the Nut” — the sum that allows them to hang on to the apartment, the health-care policy, the baby sitter, and the school fees.
Love the term. She cites poll results on the number of young, educated, skilled workers who bounce from job to job but — as usual with these kinds of breathy pronouncements — doesn’t offer any time-series data. Reliable evidence on “nonstandard labor” (self-employment, part-time work, independent contracting, and the like) is hard to come by, and we don’t really know how much of the Gig economy (like the “new economy”) is actually new. Self-employment rates have generally risen in OECD countries during the 2000s, but I’m not sure about the other data series. Can anyone suggest recent academic studies?
Attacking Incentive Pay is the “Height of Irresponsibility”
| Peter Klein |
Imagine you’re a salesperson at a company. In order to create an incentive for you to bust your tail, the company negotiates with you a leveraged compensation plan under which you receive a relatively small base salary plus fairly generous commissions on the sales you close. Suppose you do a bang up job one year, but the company as a whole suffers a loss because of some poor decisions beyond your control (or because of developments in the macroeconomy, such as the bursting of an asset bubble facilitated by government-sponsored entities). Now imagine that the government perceives your company to be strategically important and therefore decides to subsidize it by, say, buying its preferred stock or extending it a loan. Would it be “the height of irresponsibility” for your employer to honor your legitimate compensation expectations and pay you the wages that you effectively earned under your implicit deal with the firm? And what would happen if your employer didn’t pay you what you legitimately expected? Wouldn’t you and the other successful salespeople at your company immediately bolt, leaving the company with a much less effective sales force?
I have little to add to Thom’s excellent post on Obama’s populist attack on bonuses except to note that the compensation system is just one element of a firm’s organizational architecture (along with the allocation of decision rights, systems of performance evaluation, and so on). The firm, as Holmström and Milgrom put it, is an incentive system, and the elements of this system interact in complex and nuanced ways. The idea that regulators can simply march in and dictate changes to one element or another, based on popular prejudice, without affecting the performance of the system, is typical of the hubris of the intellectual.
The Heath Brothers on Incentives
| Peter Klein |
Dan and Chip Heath worry that incentive plans backfire because of focusing illusion — managers place too much weight on a single variable in the incentive contract, ignoring the likely side effects. I don’t disagree that this is possible but Chip and Dan seem to be knocking down a pretty feeble straw man. The drawbacks of single-variable, quantitative incentive schemes are well known in the organizational design literature, spawning oodles of studies of multi-tasking, the use of multiple performance measures, the benefits and costs of subjective evaluation criteria, and the like. (There’s a nice overview in BSZ chapter 16.)
That Great Klein (1996) Paper
| Peter Klein |
No, not this one. I’m talking about Ben Klein’s 1996 Economic Inquiry paper, “Why Would Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships.” It’s from a special issue honoring Armen Alchian, the entire contents of which are worth reading. Klein’s paper extends the Klein, Crawford, and Alchian (1978) model by explaining why, in equilibrium, holdups can occur, even if parties are farsighted. The basic story — that parties deliberately leave “gaps” in their contracts because the marginal costs of filling in the gaps exceed the marginal benefits — is closer in spirit to neoclassical economics than is Williamson’s Carnegie-style appeal to bounded rationality. Writes Klein:
[In an uncertain world where complete contractual specification is costly, transactors use incomplete contracts that deliberately do not take account of every contingency. As a result, transactors knowingly leave themselves open to the possibility of hold-ups.
The costs associated with contractual specification that lead transactors to use incomplete and imperfect contracts involve much more than the narrow transaction costs of writing down responses to additional contingencies. In addition to these extra “ink costs,” complete contractual specification entails wasteful search and negotiation costs associated with discovering and negotiating prespecified contractual responses to all potential contingencies. Because most future events can be accommodated at lower cost after the relevant information is revealed, much of this activity involves largely redistributive rent dissipation with little or no allocative benefit. Transactors are merely attempting to obtain an informational advantage over their transacting partners, hoping to place themselves in a position where they will be more likely to collect on (and less likely to pay for) hold-ups. Therefore, rather than attempting to determine all of the many events that might occur during the life of a contractual relationship and writing a prespecified response to each, the gains from exchange are increased by the use of incomplete contracts.
Transactors also use incomplete contracts because writing something down to be enforced by the court creates rigidity. Since contract terms are necessarily imperfect, once something is written down transactors can engage in a hold-up by rigidly enforcing these imperfect contract terms, even if the literal terms are contrary to the intent of the contracting parties (p. 447). (more…)
Hart and Holmström on Firm Scope
| Peter Klein |
One drawback of the Grossman-Hart-Moore “property rights approach” to the firm is that it isn’t really a theory of the firm per se, but a theory of which individuals should own which assets. Key organizational issues such as firm scope, delegation, monitoring, information sharing, and other coordination problems do not figure prominently in this approach (though there are plenty of formal theory papers dealing with internal organization by people like Radner, Tirole, Gibbons, Garicano, and Hart himself).
A new paper by Hart and Bengt Holmström extends the GHM model by incorporating intra-firm coordination. In this approach the value of the firm depends not only on the allocation of residual rights of control, but also on operating decisions of the firm’s subunits, decisions that may or may not be in synch. The central office of an integrated firm can internalize these externalities, but at the cost of reducing division managers’ private benefits. Here’s the abstract:
The existing literature on firms, based on incomplete contracts and property rights, emphasizes that the ownership of assets — and thereby firm boundaries — is determined in such a way as to encourage relationship-specific investments by the appropriate parties. It is generally accepted that this approach applies to owner-managed firms better than to large companies. In this paper, we attempt to broaden the scope of the property rights approach by developing a simple model with three key ingredients: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm’s profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. We show that firm boundaries matter. Nonintegrated firms fail to account for the external effects that their decisions have on other firms. An integrated firm can internalize such externalities, but it does not put enough weight on the private benefits of managers and workers. We explore this tradeoff in a model that focuses on the difficulties companies face in cooperating through the market if the benefits from cooperation are unevenly divided; therefore, they may sometimes end up merging. We show that the assumption that contracts are reference points introduces a friction that permits an analysis of delegation.
You can comment here or at the Harvard Corporate Governance Blog.
Interview with Richard Rumelt
| Peter Klein |
This interview with UCLA strategy giant Dick Rumelt appeared in the McKinsey Quarterly in November 2007 (free registration required). My old classmate Dan Lovallo is one of the interviewers. I’m sure Steve Postrel, David Hoopes, and others from the UCLA crowd can provide some Rumelt stories.
Sentences to Ponder
| Peter Klein |
[A] firm’s internal organization is not fully reducible to routines, norms, and firm-specific customs. The element of command — emphasized rightly by Coase and Williamson — is of great importance as well. A firm is neither reducible to custom and norms, nor to hierarchy and command. All elements interact strongly, and monetary incentives play a role as well.
That’s from Ekkehart Schlicht’s “Consistency in Organization,” in the December 2008 issue of JITE (not yet online; SSRN version here). Schlicht argues that the exercise of authority in organizations establishes precedent — commands to do this or that become routines or customs that are embedded into the organization’s culture — and that authority must be used consistently within the organization, suggesting limits to firm size and scope. Interesting read. Some similarities to Nickerson and Zenger’s envy theory.
A Hostage Situation in Pittsburgh?
| David Gerard |
I would like to thank Peter for inviting me to guest blog, as I have been a fan of Organizations & Markets for some time. I spent the better part of the past year developing courses that emphasized organizations, entrepreneurship, and innovation. O&M has been an invaluable resource, whether to “borrow” slides from Richard Langlois, or to get ideas for classroom topics.
I am writing from the “Steel City” of Pittsburgh, though the steel industry has largely fled the region. For evidence of that we need to look no further than our skyline (which we can now see because there is less smog), where the University of Pittsburgh Medical Center’s UPMC logo is now emblazoned atop the US Steel Tower. Health care accounts for about 15% of the region’s workforce.
Aside from being a case-study in post-industrialization, UPMC is also an interesting point of departure for exploration of some fundamental organizational questions. One that leaps to mind: Are non-profits where the real money is? Last year, UPMC generated $6 billion in revenue and cleared more than $600 million in “non-profit.”
A more traditional organizations question is the question of organization boundaries, and the tortured negotiations between UPMC and Highmark illustrate concepts such as transaction costs (hint for the exam: if it takes 3+ years to strike a deal, transaction costs may be high), vertical integration versus arm’s-length contracting, market power, bilateral dependency, credible commitment, and the hostage model. Indeed, the linchpin of the deal was Highmark kicking in for the construction of the new Children’s Hospital:
Highmark and UPMC have had a good working relationship since 2002, when the two companies signed a landmark 10-year deal. UPMC won a contract with its best customer, and hundreds of millions in loans and grants from Highmark so UPMC could build a new Children’s Hospital in Lawrenceville. Highmark, meanwhile, was guaranteed access to the wide UPMC network for a decade.
Having students explain why Highmark built a hospital rather than simply writing a check turned out to be a pretty good exam question.
The Pittsburgh Post Gazette ran a nice five-part series on the growth of UPMC growth and its phenomenal role in medical innovation. Despite the is long-term agreement, UPMC and Highmark are at odds over a proposed merger between Highmark and Independence Blue Cross. The federal authorities granted antitrust clearance, but Pennsylvania regulators won’t rule on the matter until next month. The state’s hesitation to give the green light gave Senator Specter and federal regulators time to reexamine the matter, and this might be a case to follow to see how the new Administration exercises its antitrust authority.
Guilds and Innovation
| Peter Klein |
Most economic and management historians see the guild system as partly responsible for the stagnation of the medieval European economy. A new book, Guilds, Innovation and the European Economy, 1400-1800 (S. R. Epstein and Maarten Prak, eds., Cambridge, 2008) offers a revisionist view, challenging the stereotype of guilds as “moribund rent-seekers whose habitual reaction to technical innovation was resistance and rejection.” The reality is more complex, says reviewer Christine MacLeod:
What emerges from this exceptionally coherent volume is not only the complexity of this institution, whose history spans more than half a millennium and a myriad of particular trades and local circumstances, but also the persistent tensions to which it was subjected, both internally from individualistic and capitalist challenges to its collective ethos and externally from the exigencies of nation states. Moreover, it adds another spur to the demanding search for innovation in the workshop and on the construction site, rather than in the too easily accessed and counted records of the patent office.
Indigenous Entrepreneurship in Rural China
| Peter Klein |
A very interesting article in the McKinsey Quarterly by MIT’s Yasheng Huang: “Private Ownership: The Real Source of China’s Economic Miracle.” The key to China’s recent economic is not state-led capitalism (call it “Bush-Bernanke-Paulson capitalism”) but private property and financial-market liberalization, leading to a burst of indigenous rural entrepreneurship. Writes Huang:
Big cities like Beijing, Shanghai, and Shenzhen are routinely extolled in the Western press as vibrant growth centers. China’s rural areas, if mentioned at all, typically figure as impoverished backwaters. But a close analysis of the economic data reveals that these breathless descriptions of China’s modern city skylines have it exactly backward: in fact, the economy was most dynamic in rural China, while heavy-handed government intervention has stifled entrepreneurialism and ownership in the urban centers.
Particularly interesting is Huang’s account of why so many Western economists fail to understand this. (more…)
Spulber’s Separation Theory of the Firm
| Peter Klein |
Dan Spulber’s new paper, “Discovering the Role of the Firm: The Separation Criterion and Corporate Law,” defines the firm “as a transaction institution [in which] the consumption objectives of the institution’s owners can be separated from the objectives of the institution itself.”
The separation criterion provides a bright line distinction between firms and other types of transaction institutions. Firms under this criterion include profit-maximizing sole proprietorships, corporations, and limited-liability partnerships. Institutions that are not classified as firms include contracts, clubs, workers’ cooperatives, buyers’ cooperatives, merchants associations, basic partnerships, government enterprises, and government sponsored enterprises. The separation theory of the firm yields insights into corporate law that extend and complement the standard contractarian approach. The separation theory of the firm places emphasis on shareholder property rights and corporate governance.
The separation approach, Spulber argues, suggests that the corporate governance literature may pay too much attention to agency costs while downplaying the benefits of delegation. The paper builds on Spulber’s earlier work on intermediation and develops themes in his forthcoming book on the firm. Worth a look.
Outsourcing of Legal Services
| Peter Klein |
Interesting footnote to this recent discussion between me and Gordon Smith on the organizational structure of law firms. Last week the WSJ ran an item, “With Times Tight, Even Lawyers Get Outsourced,” profiling a subsidiary of India’s Pangea3 LLC that performs routine legal services for foreign (mainly US) clients. According to Forrester, quoted in the story, 35,000 US legal jobs will be moved offshore by 2010 and 79,000 by 2015.
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