Production, Information
Costs, and Economic
Organization
Authors: Armen A. Alchian & Harold Demsetz
The American Economic Review Vol. 62 (No. 5) 1972
pg. 777-795
1
Motivation
• Two problems of a theory of economic organization:
1.
2.
Whether the conditions that determine if gains from
specialization and cooperation are best achieved in the
market or an organization (firm)
Explaining the structure of the organization
• Firm is comprised of:
–
–
Team use of of inputs/team productive process
Centralized contractual agent
2
Research Question
• “Exactly what is a team process and
why does it induce the contractual form,
called the firm?” (pg. 778).
3
The Metering Problem
• Meter = to measure/to apportion
• Economic theory assumes an economic organization (market or
firm) has to measure input productivity and allocate rewards to
resource owners
• Economic theory has not addressed the costs associated with
metering productivity and rewards
– Implicit assumption that metering is zero cost
– Implicit assumption that productivity automatically creates
reward
• The authors suggest rewarding determines productivity
– If the economic org meters well, productivity will be greater
4
Team Production
• Makes metering difficult and costly
• Team production is production in which:
1. Several types of resources are used
2. The product is not a sum of separable outputs of each team
member
3. All of the resources do not belong to one person
• Team production is used if it yields an output larger
than the sum of individual production and the costs of
organizing and disciplining team members
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Rewarding team members and
getting them to work efficiently
• Observing behavior of individual inputs
– But there is a cost (tax on work rewards)
– Each member will have more incentive to shirk
when working as part of a team
• How can team production be organized to
reduce shirking and the costs of detecting
performance?  A monitor
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The Monitor
Owner/Employer of the firm
• A specialist to meter the marginal productivity of individual
inputs to the team’s output
• Constrained by entitlement to net earnings of the team (residual
claimant status)
– Received as long as shirking is reduced
• Central party common to all contracts with inputs
• Has power to revise contract terms and incentives of individual
members
• Can sell his/her rights
7
Necessary Conditions for Existence
of the Classical Firm
• Productivity can be increased through team-oriented
production
– Costly to directly measure the marginal outputs of each
individual’s inputs
– More difficult to restrict shirking through simple market
exchange
• It is economical to estimate marginal productivity by
observing or specifying input behavior
• Firms exist due to costs of managing
– Extension of Coase (1937)
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Types of firms
Firm Type
Application of Theory
Profit-Sharing Firm
•
•
•
Socialist Firm
•
•
•
The Corporation
•
•
Mutual and Nonprofit Firms
•
•
Incentives to shirk are positively related to the optimal size of the
team
Profit-sharing to encourage self-policing is more appropriate for
small teams
The cost of managing team inputs increases if the productivity of
a team member is difficult to correlate with his/her behavior (e.g.,
artistic or professional work)
Additional management techniques will be developed to help
reduce degree of shirking
Sharing in the residual results in losses from enhanced shirking
by the monitor that exceed the gains from reduced shirking
The workers’ committee may be given the right to recommend
the termination of the manager’s contract
Involving every stock owner in each decision would increase
bureaucracy and lead to more shirking by stock owners
More effective to transfer decision authority to smaller group
(e.g., board of directors)
The future consequences of improved management are not
capitalized into present wealth of stock-holders
Greater shirking
Partnerships
•
•
Self-monitoring partnerships
Small in size to prevent excessive dilution of efforts through
shirking
Employee Unions
•
Monitors employer performance for employees
9
Inputs owned by the firm
hired vs. owned
• Machines, land, buildings, raw materials
– Sufficient to cover negative residuals
– Employers will invest in inputs with higher
resale values and longer expected use
• Renting may be more costly than owner
use
10
Firms as specialized market
institution
• The firm is a highly specialized surrogate market
• Employer acquires superior information about inputs’
productive talents
– Aids employer’s directive (market hiring) efficiency
– Allows for opportunities for profitable team production to be
ascertained more economically and accurately (within the
firm)
11
Recap/Summary
• The essence of the classical firm:
–
–
–
–
Joint input production
Several input owners
One party who is common to all contracts of the joint inputs
The monitor has the right to renegotiate any input’s contract
independently of contracts with other input owners
– The monitor holds the residual claim
– The monitor has the right to sell central contractual residual
status
• The monitor = firm’s owner/employer
12
Thank You!
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