1. 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

2. Motivation Two problems of a theory of economic organization: 1.Whether the conditions that determine if gains from specialization and cooperation are best achieved in the market or an organization (firm) 2.Explaining the structure of the organization Firm is comprised of: –Team use of of inputs/team productive process –Centralized contractual agent 2

3. Research Question “Exactly what is a team process and why does it induce the contractual form, called the firm?” (pg. 778). 3

4. 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

5. 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 5

6. 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 6

7. 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

8. 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) 8

9. Types of firms Firm TypeApplication of Theory Profit-Sharing FirmIncentives 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) Socialist FirmAdditional 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 The CorporationInvolving 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) Mutual and Nonprofit FirmsThe future consequences of improved management are not capitalized into present wealth of stock-holders Greater shirking PartnershipsSelf-monitoring partnerships Small in size to prevent excessive dilution of efforts through shirking Employee UnionsMonitors employer performance for employees 9

10. 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

11. 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

12. 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

13. Thank You! 13