MGMT701aSeminar in Accounting ResearchBook Review 2
Review 2
Book Review of Organization Theory
Iris Jiang
In this review of Williamson’s “organization theory”, I’ll focus on 1), the difference of several perspectives of the theory of the firm introduced in the book and, 2) their application and limitations in new economy.
Part I: Summary of perspectives on the theory of the firm
There are several perspectives to study the theory of the firm in economic literature. The neoclassical approach is based on maximizing behavior, but tells us nothing about the structure of the firm. The principal-agent theory emphasizes the optimal incentive schemes, but is silent on the nature and extent of the firm. Then comes the transaction cost economics starting with Coase’s famous 1937 article. According to Coase, economic activity is either coordinated via the price mechanism or by fiat. There are costs to both. Which is chosen for each individual transaction depends which is less costly. Transactions coordinate by fiat are “within the firm”. Coase posits that the marginal costs of coordinating by fiat increases in the number of transactions. At some point, coordination via the price mechanism or within a different firm becomes less costly. The point at which the marginal cost of organizing an additional transaction within the firm is more expensive than within the market or another firm determines firms’ size and scope.
Two points of Coase’s view are often been attacked in the literature: first, Coase points that firms are characterized by authority relations, but he didn’t make it clear what ensures that the employee obeys the employer’s instructions. Second, the view that “price mechanism is suppressed within the firm” is not convincing, and an obvious counterexample is the transfer pricing within a multidivisional firm. Following Coase, Alchian and Demsets (1972) developed their theory based on joint production and monitoring, the latter making possible to assess each agent’s contribution. They applied the general rule that decision rights should be allocated to the individual with the strongest incentives toward value-maximizing and argued that the ownership of the capitalist firm can be effectively defined by the following bundle of rights (i.e., the best way to provide the monitor with appropriate incentives) : 1, to be a residual claimant. 2, to observe input behavior. 3, to be the central party common to all contracts of inputs. 4, to alter memberships of team. 4, to sell rights 1 through 4. However, Alchian and Demsets’s theory also suffer the same problem that they pointed out in Coase’s theory: it is unclear why the problems of joint production and monitoring cannot be also be solved through the market (i.e., through contract)?
After Coase originated the idea of transaction costs, the most influencing analysis on it were carried out by Williamson. Williamson recognized that transaction costs are likely to particularly important when economic agents make relationship-specific investment (i.e., the investments to some extent specific to a particular set of individuals or assets). Once the investments are made, the parties are locked into each other. As a result, external markets do not provide a guide to the parties’ opportunity costs once the relationship is underway. The lack of ex-post market signals, combined with “contracts are unavoidably incomplete”, will lead to two sorts of costs: 1, ex-post costs associated with negotiation itself, and 2, as bargaining power and resulting share of the ex-post surplus bear little relation to the ex-ante investment, parties have the wrong investment incentives at the ex-ante stage. Thus, Williamson points out that bringing a transaction from the market into the firm (i.e., integration) mitigates the opportunistic behavior and improves investment incentives. However, Williamson didn’t make it clear how such opportunism is reduced by bringing a transaction into the firm.
Jensen and Meckling (1976) points out the view of “the firm as a nexus of contracts”. Under this view, there is no point to distinguish between transactions within a firm and those between firms, as they are both considered as part of a continuum of types of contractual relations, with different firms or organizations simply representing different points on this continuum, i.e., particular standard form contracts. However, Jenson and Mechling leaves open the questions of why particular standard forms are chosen, and what limits the set activities covered by a standard form? Given that mergers and breakups occur all the time, and at considerable transaction cost, the real question is something like “how integration changes incentives”?
The perspective which views the firm as a set of property rights (Grossman & Hart, 1986, for e.g.[1]) tries to answer such a question. This approach is similar to the transaction cost approach, but focuses attention on the role of physical, or at least nonhuman assets in a contractual relationship. Under this view, in a world of transaction costs and incomplete contracts, ex-post residual rights of control (such control resides with the owner of the assets) are important because, through their influence on assets usage, they affect the incentives of agents to invest in that relationship. Hence, when contracts are incomplete, the boundaries of firm are important. Moreover, control changes will not only influence the incentives of top management, but will also affect the incentives of employees[2]. “the firm as a set of property rights” perspective argues that :1, highly complementary assets should be owned in common, which may provide a minimum size for the firm. 2, as the firm grows beyond a certain point, a new firm should be created, since giving the central manager control of the periphery increases hold-up problems there without any compensating gains. Moreover, in the absence of significant lock-in effect, non-integration is always better than integration, as the integration only increases the number of potential hold-ups without any compensating gains.
The property rights approach has an important implication: the purchase of physical assets leads to control of human capital, as it is in a worker’s self-interest to put more weight on his boss’s objectives as this will put him in a stronger bargaining position with his boss later. This implication can help us to understand integrations where the control of organizational assets(or organization capital) rather than the physical capital is the crucial part (Klein, 1988). However, this implication is only reasonable when the non-human assets are important or relevant. In the absence of non-human assets, what are the conclusions? Another draw back of the property rights approach is that it makes no distinction between ownership and control. Fortunately, recent work (for e.g., Grossman & Hart 1988, Aghion and Bolton 1988) shed more light on this issue.
Part II. Human capital, Internet Economy and The Theory of Firm
The perspectives on the theory of the firm in part I all appeared before the 90’ of last century, and the terms of the modern debate on corporate governance were set in the 1930s[3]. In those days, the dominant model was a vertically integrated firm, controlling a large set of unique assets through a rigid command-and-control system.(for e.g., GM, the archetypical vertically integrated public firm, is often cited and studied in literature). Such organizational form was called MBE (modern business enterprise) (Chandler, 1977), and MBEs dominated most sectors of the US economy by the end of the 1920s. MBE was well defined by the ownership of assets, and the legal and economic boundaries of the firm can be represented by the ownership of unique assets. As a consequence, corporate governance mainly focused on the agency problem at the vertex of the organizational pyramid.
While economists mostly focus on the framework originated by Berle and Means, one thing has the changed dramatically over the time: the nature of the firm itself. Perhaps the most significant effect of such change has been to human capital.
In the past, firms’ main assets (plant, machinery, brand names, etc.) were hard to replicate and were primarily what made the firm unique. The human capital of employees was in large part tied to these assets and immobile. Thus ownership of unique nonhuman assets was the primary source of power[4] in the corporation. However, recent changes have made human capital much more important, and also much more mobile, at the expense of other more tangible assets, and weakens the command and control system that emanated from the ownership of the non-human assets. Some of these changes include: 1) as competition has increased, physical assets have become less unique and employees have many more outside options; 2) competition has increased the importance of a firm’s innovation ability, which comes from human capital. So at the same time as employees have been unshackled by the competitive market, they have also become more important to firms. Then, where does top management get authority over subordinates, especially as human capital is not ownable? What determines the boundary of the firm?
How does a firm obtain control over a unit that is composed entirely of human capital when slaveryis impossible? What needed are links that cause the person or unit to be better off voluntarily following the firm’s commands rather than going their own way. Such links are called “complementarity” by economists, and I learn this from Rajan and Zingales, 1998. A complementarity is said to exist when the unit and the firm can together create more value than they can when going their own separate ways, and it induces a unit to obey orders from the firm for fear that disobedience would jeopardize the joint value they can create together. So, while ownership legally links non-human assets to a firm, complementarities link to the firm the human assets that can not be owned by the firm. Complementarities can be built through technical specialization or firm-specific specialization[5]. Competition destroyed technical specialization as a source for complementarity since employees could do as well by joining competitors. So, for firms to acquire power over their employs’ human capital, the firm has to get employees to make firm-specific investments. But will employees have such incentives to make firm-specific investments, which will make them more dependent on the firm, as compared to acquiring more marketable technical skills?
The answer is “yes” if the firm gives key employees/units privileged access to the enterprise or its critical resources, so that they will gain power if they specialize[6]. For e.g., a brokerage firm usually gives brokers leads to new clients, and thus effectively allocate valuable residual rights or power to brokers. Of course, the power from the privileged access is contingent on the employees’ specializing. If the brokerage provides enough unique value to clients, the broker is of little value without the firm to back him. By investing in building client relationships, the broker builds complementarities between himself and the brokerage, giving the latter some power over him. But the broker also has power over the brokerage because he “owns” the clients. Thus, the broker and brokerage achieve an more balance of power than do employee and firms in Chandler’s vertically integrated MBE.
When the ownership of non-human assets is no longer the primary source of power, mutual dependence and specialization between various units of enterprise generate the power to govern transactions. Since ownership is relatively unimportant, and human capital is not tied to non-human assets, the boundaries of the firm become less distinctive. Something is more a part of the enterprise when it has greater complementarities with the rest of the enterprise. Besides, as the firm gets power over its employees because it commits to share surplus generated by complementarities with the employees, the surplus is shared much more evenly in the firm instead of concentrated at the top, and corporate governance expands beyond watching top managers. As employees have a larger stake, and share price corresponds more closely to factors in their control (because of the common ownership with the firm), the role of ownership in providing motivation have increased. For e.g., the generalized award of stock options to employees in high tech companies.
By so far, we see when human capital replaces non-human capital as the main source of value, the origination of authority, and consequently, the monitoring and motivation schemes of the firm greatly change from what we learn in part I.
In the remaining of Par II, I’ll take a slightly different perspective: how those old ideas about the firm, particularly those after Coase’s transaction cost theory, can be used to help answering questions like “What’s the boundary of the firm?” in the Internet economy[7].
Coase theorized that the transaction cost frequently determine whether or not a company will seek an outside supplier or service provider. At the time he wrote his famous article, the transaction costs were prohibitively high. As information flowed at a glacial speed, and supplies moved only slightly faster, companies strove to manage the entire chain of production within the walls of their own corporation[8]. However, with Internet, the transaction costs have plunged. In the so-called new economy, information itself is typically the product and it comes within a few clicks and moves at the speed of a T1 line. So, companies can easily get complete information about potential suppliers and business partners, and set up contracts with its suppliers and alliance companies with only a fraction of what it would have cost years ago. This might help to explain the increasing number of alliance announcements of dot-coms in the past two years[9]. Coase’s theory thus applied here: with diminishing transaction costs, more alliances are inevitable.
Here are some quotes. David Ernst of Mckinsey & Co. put it “with lower transaction costs, companies are able to focus on narrow product slivers or business activities, and have other parties do the rest… if you have a network of partners you can attract incremental business, and plug the revenues back into your core business,..” David Jefferds of CyberElves said “…we could probably target that by partnering with firms, getting expertise, and then making the buy-versus-build decision.” Of course, an alliance does not come as a free lunch. Jefferds explained “you’re taking a risk with a client that you’re really not compensated for” and Earnst pointed out managing alliance was particularly critical. For some dot-coms, their alliance even include their competitors, and this phenomenon is totally beyond the old idea of “buy or merge”.
The points made earlier about human capital are particularly relevant with dot-coms. The employees are the principal source of the firms’ costs, and they’re all shareholders, and there exists a real advantage of having people see the value of their work on daily basis. As a consequence, there is advantage to having a smaller operation. What’s more, as these employees (themselves being valuable assets) do not require enormous investments, there is no deed to have a large number of investors. Thus, ownership and operational control are much more closely associate, and the traditional principle-agent analysis weakens here. In the Internet economy, “alliance and partnership” makes more sense than“buy and merge”.
This might also help to explain why in recent years, we’ve seen some of the large vertically firms breaking apart. However, we also see increase in merger activity in recent years. Is it evident against the argument in Part II? No. Rajan and Zingales (1998) explained this with the example of mergers in the media industry. According to them, in now days, a sizeable fraction of mergers are horizontal mergers(as compared with the vertical mergers in the past), a way of re-gaining market power. For current vertical mergers in some industries, Rajan and Zingales propose that such mergers helpbuilding a value line toget substantial investment to make advantage of some special assets (e.g., brandname).Examples and detailed explanation can be found in their paper.
In conclusion, while I was reading through “ Organization theory”, theories of the firm (as in Part I) captured my interest, and also arose questions: how those theories can be validated or adopted in new economy? These questions pushed me to sources outside the book itself, and lead to Part II in this review.
[1] Grossman and Hart’s The costs and benefits of ownership: a theory of vertical and lateral integration (1986) states “…contractual rights can be of two types: specific rights and residual rights. When it is costly to list all specific sights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchased firm 2 when firm 1’s control increases the productivity of its management more than the loss of control decreases the productivity of firm 2’s management.”