Some threads of the “ongoing”:https://www.crookedtimber.org/archives/002232.html “discussion”:https://www.crookedtimber.org/archives/002230.html about the Efficient Markets Hypothesis have begun to address the contrast between markets and planning, with the state as the prospective planner. As is often the case in such discussions, the implicit contrast is between a Hayekian information-processing ideal and, say, North Korea. To break down this assumption a bit, it’s worth drawing a link to a related debate in the economics and sociology of organizations about the existence of the firm. A long time ago, “Ronald Coase”:http://www.nobel.se/economics/laureates/1991/coase-autobio.html asked why, if markets are so great, are there so many firms? Below the fold is an “old post of mine”:http://www.kieranhealy.org/blog/archives/000064.html where I examine “Brink Lindsey’s”:http://www.brinklindsey.com/ efforts to defend the virtues of free markets in the light of Coase’s ideas. It might be of interest as a sidelight to the EMH debate.
In this post to his weblog, Brink Lindsey, author of Against the Dead Hand, tries to put the recent corporate scandals in the context of a wider debate about markets and hierarchies. He wants to answer three questions, in descending order of generality.
First, why are markets so great? Lindsey’s starting point is a standard one. Free markets are the best way to produce and allocate goods, and thereby promote growth and maximize welfare. The reason markets are better at this than (say) the state, was best expressed by Hayek. The distributed and decentralized nature of the market mechanism gathers and transmits a vast amount of dispersed information about demand and supply. The flow of information is reflected in changes in prices. Markets quickly and efficiently allow people to make more or less the right decisions about of how to allocate scarce resources with alternative uses.
Market ideologues generally stop there. Lindsey is more sensible, and asks the second question: If markets are so great at doing what Hayek claims, then why are there so many firms? Let alone, we might add, positively enormous corporate organizations? Lindsey gives the standard response from economics, which originates with Ronald Coase. Firms exist
because markets entail transaction costs (finding parties with whom to exchange, ensuring that exchanges will be performed appropriately, etc.), and administrative hierarchies can sometimes outperform markets by reducing those costs.
Well, maybe. We can note right away that Coase’s explanation for the existence of firms is at odds with Hayek’s reasoning about the superiority of markets. Hayekian markets are spontaneous, costless information processors. The lack of cost-based friction is what allows them to work their magic. When exchanges are costly, then what Lindsey calls “clarity of market feedback” will be severely impaired. A good deal of modern economics has focused on the problems that arise once information is no longer assumed to be cost-free.
Of course, this doesn’t mean Lindsey’s position is automatically undermined. Instead, he suggests that we can combine the two views:
Putting Coase and Hayek together, the organizational structure of a modern market economy reflects the interplay between transaction costs on the one hand, and what might be called “hierarchy costs” on the other—the costs of ignoring dispersed information not available to the decision-makers in the organizational hierarchy. Firms grow in size and scope to the extent that reductions in transaction costs outweigh the loss of access to outside information. To look at the matter from the perspective of creating value rather than containing costs, the boundaries between firms and markets are set according to the relative value of applying specific, available information versus openness to unknown information.
I think Lindsey’s argument begins to break down here. At least, it runs into some unacknowledged issues. First, can we measure the “value of applying specific, available information versus openness to unknown information”? Transaction costs are difficult enough to estimate, though their existence is intuitively compelling. But how does a firm begin to figure the opportunity cost of forgoing some “openness to unknown information”?
Second, given the importance of good information to the smooth functioning of markets, what effect should we expect the various information revolutions of the past 200 years to have on the process of market/firm partitioning? One of the main effects of information technologies, according to many free-marketers, is to reduce friction between buyers and sellers. In other words, I.T. is supposed to lower transaction costs. Wouldn’t we expect more markets and fewer firms as information transmission became cheaper and cheaper, rather than bigger and bigger firms? Yet these revolutions — telegraph, telephone, radio, TV and the computer/Internet — seem to have gone hand-in-hand with the growth of the modern corporation. Shouldn’t someone adopting Lindsey’s theory be surprised at this?
That’s an honest question, by the way: I haven’t thought hard about what the expected effects should be, and I don’t know if any economists have. Alternative stories are easy to tell. On one view, information technology makes social organization and control possible on an unprecedented scale. (Recent books by Chick Perrow and Bill Roy give accounts consistent with such a view.) Or you could also claim that cheap information technology doesn’t affect the ratio of transaction costs to hierarchy costs. But if it doesn’t, what does? And, more importantly, how do we measure it? The Hayek/Coase rationale for the make-or-buy decision ought to be more than a rationalization.
Lindsey’s third question is this: If markets are so great and firms come into being only for sensible reasons to do with transaction costs, then why is there a horrible wave of corporate scandals right now? He answers that Enron happened because firms are not markets. Instead, they are “pockets of corporate central planning” which , alas, the market is forced to rely on for Coasian reasons. Corporate malfeasance can be traced to agency problems between shareholders and managers. And
Just as we can’t trust politicians and bureaucrats to pursue the public interest rather than their own selfish interests in power and perks, in the same way there is an ever-present risk that corporate managers will feather their own nests at the expense of shareholders.
Lindsey’s position is appealing — it is a tragic market-liberalism rather than a triumphalist one. The tragedy is that, despite being so great for all those Hayekian reasons, markets can’t live without the state to support them on the one hand, or without creating islands of hierarchy inside them on the other. Lindsey takes a much more interesting and sophisticated position than many of his intellectual relatives. Note, though, that his irony-tinged neoliberalism leaves the market mechanism itself off the hook for Enron altogether. This makes me sceptical. For one thing, I think Enron shareholders were quite happy with how their stock was doing, to the point where they weren’t inclined to question their agents about how they could be doing so well. The traditional principal-agent problem is “Can’t Ask, Won’t Tell”. With Enron, it was “Don’t Ask, Don’t Tell.” It happened because of how markets (or particular types of real markets) work, not in spite of it. What Lindsey construes as a failure of bureaucracy inside the firm can just as plausibly be seen as a problem created by market incentives to cheat and lie about profits.
Lindsey sees the institutional machinery that markets need to function, as writers like Adam Smith did and so many contemporary free marketeers do not. He also knows that the market cannot, by itself, be the only check on corporate mismanagement. The difficulty with his position, it seems to me, is that he wants to absolve the market mechanism of any share of blame for Enron et al. So he blames “bureaucracies” instead. Hence his claim that firms are little “pockets of central planning” inside a wider market system. This makes it sound as if WorldCom was managed like North Korea. The distinction is much too sharply drawn. (Read some of the vast literature in organizational sociology on network forms of organization, relational contracting, internal markets or small-firm networks, to see a very different picture of firms.) Further, while Lindsey examines the problems of bureaucratic organization, he lets potential difficulties internal to the Hayekian market mechanism go by without scrutiny. If someone criticized the empirical pathologies of markets in detail and offered an idealized picture of a perfectly rational Weberian bureaucracy as an alternative, Lindsey would rightly cry foul. But he seems unwilling to ask whether an actually-existing market might differ from the idealized Hayekian mechanism, not because of external interference, but for reasons internal to itself.
{ 28 comments }
Nicholas Weininger 07.23.04 at 8:39 pm
One possible answer to the more information/more big firms puzzle is that the modern welfare-regulatory state has also grown enormously in the same timeframe, and the state tends to distort market mechanisms in ways which systematically favor large firms (regulatory capture, monopoly-granting, etc).
sum_product 07.23.04 at 9:25 pm
One of the main effects of information technologies, according to many free-marketers, is to reduce friction between buyers and sellers. In other words, I.T. is supposed to lower transaction costs. Wouldn’t we expect more markets and fewer firms as information transmission became cheaper and cheaper, rather than bigger and bigger firms?
Not to sound too naive here, but… couldn’t the be in the direction of, “as transaction costs drop, we’d expect the ‘total size of all firms’ as a fraction of the size of the market to drop?”
In other words, the fact that you see ‘bigger and bigger’ firms is an observation that results from the growth of the market dominating the drop in transaction costs?
Bob 07.23.04 at 9:54 pm
For the moment, I will accept the explicit and implicit criticism of market systems and the economic rationales for them. However, what I feel uncomfortable about is any implied suggestion that centrally planned systems or governments and their bureaucracies are therefore more efficient and less corrupt, especially when I read news reports like this:
“The [US] Department of Defense, already infamous for spending $640 for a toilet seat, once again finds itself under intense scrutiny, only this time because it couldn’t account for more than a trillion dollars in financial transactions, not to mention dozens of tanks, missiles and planes. . . A GAO report found Defense inventory systems so lax that the U.S. Army lost track of 56 airplanes, 32 tanks, and 36 Javelin missile command launch-units. . . ” – from: http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2003/05/18/MN251738.DTL
“[Britain’s] National Audit Office has vowed to increase its scrutiny of EU spending after Europe’s own financial watchdog failed to approve euro accounts. The NAO stressed that problems in the management of the EU’s funds were a matter of concern, especially in view of worries over enlargement costs. . . The EU’s Court of Auditors failed to approve the EU’s accounts in November for the NINTH year in a row.” – at: http://news.bbc.co.uk/2/hi/uk_news/politics/3688241.stm
“The former Secretary General of Nato, Willy Claes has been given a three-year suspended jail sentence after being found guilty of corruption by Belgium’s highest court. Mr Claes was one of 12 defendants standing trial over allegations that two defence firms paid millions of dollars in bribes during the 1980s to secure Belgian Government contracts.” – from: http://news.bbc.co.uk/1/hi/world/europe/241342.stm
“The former deputy leader of Rotherham Council has been sentenced to three years in prison for plotting to steal £172,000 from a charity. Garvin Reed, a Labour councillor, admitted spending thousands of pounds of a charity’s cash on prostitutes, lavish hotels, meals, and outings.” – from: http://news.bbc.co.uk/1/hi/england/2511047.stm
“Former Prime Minister Alain Juppe resigned from the presidency of France’s ruling party Friday, paving the way for a succession battle at the head of President Jacques Chirac’s powerful political organization. Juppe, one of Chirac’s closest allies, was convicted earlier this year in a corruption case and had agreed to step down from the leadership of the Union for a Popular Movement.” – from: http://www.cnn.com/2004/WORLD/europe/07/16/yuppe.resigns.ap/
“Craxi, Bettino (Benedetto)Italian socialist politician, leader of the Italian Socialist Party (PSI) 1976-93, prime minister 1983-87. In 1993 he was one of many politicians suspected of involvement in Italy’s corruption network; in 1994 he was sentenced in absentia to eight and a half years in prison for accepting bribes, and in 1995 he received a further four-year sentence for corruption. In April 1996, with other former ministers, he was found guilty of further corruption charges, and received a prison sentence of eight years and three months, but avoided imprisonment by living in self-imposed exile in Tunisia.” – from: http://www.tiscali.co.uk/reference/encyclopaedia/hutchinson/m0018909.html
“The European Union was thrown into turmoil on Tuesday [16 March 1999] after the entire 20-member executive commission stepped down in light of a scathing independent report accusing the powerful body of ignoring cronyism and financial irregularities.” – from: http://www.cnn.com/WORLD/europe/9903/16/eu.commission.01/
“EUOBSERVER / BRUSSELS [9 July 2003] The European Commission has come clean and admitted the huge extent of fraud in its statistical office, Eurostat. . . ” – from: http://www.euobserver.com/index.phtml?aid=12040
James Surowiecki 07.23.04 at 9:54 pm
Kieran, empirically speaking, it’s not true that we’re seeing bigger and bigger firms in the last twenty years. At least in the U.S., in terms of employment — which would seem to be the relevant criterion when evaluating the size of organizations — the percentage of the workforce that works for the Fortune 100 — or that works for a large company at all — is significantly smaller today than it was in 1980. In fact, I think the impact I.T. has had in the last decade and a half has been almost exactly what you say it should, in theory, have: the creation of more markets and fewer big firms.
James Surowiecki 07.23.04 at 10:03 pm
I’m also thoroughly unconvinced that internal hierarchies are necessary for firms to make decisions. There are a number of internal mechanisms that companies can use to improve their decisions from a Hayekian perspective and to increase their openness to information. (There are obvious limits imposed by the fact that the participants in these mechanisms will all be members of the firm, but they would still represent a significant improvement.) New information technologies can be of use here, in significantly reducing the amount of time required for a group (rather than just an individual) to arrive at a decision.
That doesn’t mean that transaction costs don’t matter –hierarchies probably reduce such costs in executing decisions (rather than making them), but from a Hayekian perspective those hierarchy costs don’t seem especially large.
Sebastian Holsclaw 07.23.04 at 10:17 pm
I’m not able to wade too much into the fine-level details, but one broad idea leaped to mind.
When you say: “…why, if markets are so great, are there so many firms?” perhaps the levels of abstraction are obscuring things. You are comparing ‘market’ to ‘firm’. But there are relatively few types of markets and an enormous number of types of firms. These firms can be tailored to efficiency in whatever their market area is. This is also in contrast with the relatively low number of effective government interventions.
Justin 07.23.04 at 10:32 pm
This is why Brian Leiter thinks you’re all a bunch of morons ;). The answers here are easy.
We have markets because decentralized economies are good ways to enforce power differntials over others (there are benefits, of course, and costs, but thats not why they happen. they happen because this way people with capital can maintain capital and people without capital dont have the power to fight back). Or to make it easier, we have markets because the people who are in political power in market societies find it easier to remain in power and keep their riches than other forms of utility distribution. Or, even more easier: ENTRENCHMENT.
the reason why we have big firms despite having markets that (actually are) getting more and more efficient is because bigger firms mean more power, prestige, and safety for those who run them and those who are in them. bigger firms rae less likely to fold (a nasty side habit of more efficient smaller firms) and theyre more likely to a) be bailed out, and b) exert political power as a unit (think of WorldCom as the Bloods, only with suits).
The economics of it all is just reasoning to make people sleep better at night.
JRoth 07.23.04 at 10:43 pm
Very interesting distinction from Sebastian, although I’m not schooled enough (at all) in the background theories tosay whether his point really gets at the nut of the problem.
Anyway, I’m really writing to respond to James’s suggestion that elaborate internal hierarchies are unnecessary for effective decision-making. I work for a quite small (under 10) firm, and you’d be surprised, I think, at how much hierarchy we’ve had to institute to get a rein on things.
To expand: the firm was started 15+ years ago as a sole proprietor operation, and grew up over 10 people. At that point, it was too many Indians and not enough chiefs (apologies for the un-PC term), and the proprietor brought on a couple of us as project managers to steady things. Over the past 3+ years, we’ve been trying to institute systems and principles to improve decision-making, and we’re still not especially close. And it’s been the initial absence of hierarchy that’s hurt us – it was always one chief and many Indians, and the decision-making aparatus was a shambles.
Now I know that James would approve of our now-collective decision-making (about 5 of us), but even within that there’s a nascent need for more hierarchy. Obviously, this doesn’t speak to much larger orgs, but it hints at the effort it takes to get good decision-making in even a very small org. I’d peg five as the max number in a firm before you start to need hierarchy, and I suspect the increase is non-linear; perhaps not geometric, but….
Kevin Donoghue 07.23.04 at 11:11 pm
Huge questions and I haven’t even read Coase or Hayek, but anyway:
The information which markets provide is very limited; what price signals prompted the development of the Sony walkman, the jumbo jet, mobile phones, Viagra or the Harry Potter movies?
How big do organizations have to be before they become a problem for “market ideologues� Clearly the existence of numerous small firms is not a problem.
A long bull market always produces lots of scandals; “recessions uncover what the auditors miss.†Corruption is especially likely when business and politics are closely intertwined.
Every generation has to re-learn lessons that have been forgotten. The present stage of the cycle is where we have rediscovered the benefits of markets and forgotten why bank regulators and antitrust laws were invented. Every businessman speaks highly of competition, but the temptations of collusion and jobbery don’t go away.
agm 07.23.04 at 11:17 pm
To look at the matter from the perspective of creating value rather than containing costs, the boundaries between firms and markets are set according to the relative value of applying specific, available information versus openness to unknown information.
Introduction of IT shifts this balance, but for at least one more reason than I’ve seen mentioned so far. As you introduce IT you may be changing unknown info into known and available info. For example, a gym has a record of your interest when you fill out one of those win-a-free-membership cards, whereas before they may not have even known you existed. Add up enough of these little cards and you know where you should spend marketing dollars, where to locate your facilities, where you’re likely to get people buying memberships, what kind of people are likely to give you money… Maybe rich people just buy memberships based in proximity to work while middle classers enter the contest and the poor don’t buy any at all — now you know to market to the middle class cause the other two are already decided. An hypothetical like this could be drawn for lots of markets.
glory 07.23.04 at 11:29 pm
two relevant articles:
here’re a few good discussions i’ve come across on pricing theory/perfect information/economic efficiency:
from the last link:
yet, governments set (short-term) interest rates (in a fiat-money economy) and, as brad delong points out, “the interest rate is the price of capital.”
i would argue that, ever since nixon took the US/world off the gold standard and the macro-lever of monetary policy fell into the lap of the federal reserve, even the mere possibility of “the idealized hayekian mechanism” has been almost irrevocably compromised.
Jonas Cord 07.24.04 at 12:04 am
Note, though, that his irony-tinged neoliberalism leaves the market mechanism itself off the hook for Enron altogether.
If you are of the opinion that the market mechanism is responsible for Enron, this strikes me as comparable to saying that the cash currency mechanism is responsible for bank robberies and muggings.
Unless of course, those who are fond of the Efficient Markets Hypothesis are saying that fraud doesn’t reduce the efficiency of the system, in which case, have at them.
Detached Observer 07.24.04 at 12:06 am
I’m not at an economist or a social scientist and maybe that accounts for my confusion here: can someone explain why good markets implies small number of firms?
James Surowiecki 07.24.04 at 12:17 am
It doesn’t: the more transactions that are done via markets (rather than inside companies), the more firms you’re likely to have, but each firm will be smaller. The word “firm” is a little deceptive here, since it can mean anything from a sole proprietor to Wal-Mart. Regardless, the point is that as markets are used more, the number of separate players in the economy will rise.
Sebastian Holsclaw 07.24.04 at 1:55 am
“The word “firm†is a little deceptive here, since it can mean anything from a sole proprietor to Wal-Mart.”
Which is exactly my point. Isn’t it possible that there is a problem with this abstraction that lumps together sole proprietors and Wal-Mart for the purposes of information gathering and processing? Maybe the difference in need of hierarchy between the two is irrelevant–I’d just be really surprised.
c8to 07.24.04 at 3:51 am
i think we are asking the wrong questions.
of course a firm’s organisational structure can outperform a market. just like a dictator could outperform a democracy.
markets arent a miracle cure for organisation is the answer to why firms exist. but this is the wrong question.
the real problem with the government is not its organisational structure, its whats external to the structure, namely incentive.
governments have no competition (aside from a few elections every now and then) and their customers, the tax-payers, cant decide to not pay tax. that is the problem with governments.
you could have ten different firms, all with different organisational structures (one could make decisions based on tea leaves, it doesnt matter) and if they compete against each other, the bad ones will lose out, and the good ones will flourish (probably the tea leave readers wont do so well)
theres no problem with having an orginisational structure where a bunch of people sit down and tell everyone else what to do, as long as the bad versions of this organisational structure die off, and the good ones suceed.
the problem with government is not the structure, its that it doesnt have enough incentive to suceed.
burritoboy 07.24.04 at 5:35 pm
Kieran,
This post is very good. I personally believe that Perrow and Roy do actually give the most plausible explanations (at least, the most plausible explanations we have right now).
Also directly challenging transaction-cost economics are two articles by Ghoshal and Moran in the Academy of Management Review in 1996 that argue TCE theory as internally incoherent. Williamson tried to defend his version of TCE in a response, but Ghoshal and Moran effectively rebut his piece.
Someone else was also recommending to me another article that tried to test the actual costs of transactions with the actual costs of having (large) firms. I can’t recall actually reading the article (the other person believed it was by Ghoshal, but I thought it wasn’t) or much else about it, but my informant claimed that the article showed transaction costs were generating nowhere near the expense level of managing a large firm.
Both the Hayekian and Coasian theories are pretty dubious, in my view. Neither would explain why many markets have gone from being competitive to oligopolies in relatively short timeframes. Did transaction costs increase so rapidly between 1975 and 1995 that the book retail sector went from very competitive to two/three-player oligopoly? Did transaction costs increase so rapidly between 1975 and 1995 that the hardware retail sector went from very competitive to few-player oligopoly? It’s very hard to fit either model unto these events.
Sebastian Holsclaw 07.24.04 at 5:49 pm
RE book retailers at least, the margin of profit for small booksellers has been declining for decades as fewer people regularly read. My GUESS would be that the breaking point was finally reached where being a small bookseller couldn’t pay in many markets.
I don’t know anything about the hardware market. But as a general concept I would bet that shipping costs have a lot to do with hardware profits. As a general rule shipping is less expensive (per unit) in bulk.
burritoboy 07.24.04 at 9:31 pm
Sebastian,
No, that wouldn’t explain book retailing’s transformation into an oligopoly. In fact, it would indicate the exact opposite: if margins declined (without any compensatory factor working for the large retail chain), there would be less money for corporate overhead, thus making the individual retailer more competitive than Borders/Barnes. Both those chains have very substantial headquarters that cost a great deal of money – costs that the individual store doesn’t have (few individual bookstore owners would demand the million-dollar salaries paid to Borders or Barnes executives, for instance).
On your hardware argument, it’s essentially a returns to scale argument, which at least is a plausible argument theoretically. The problem is, however, that transportation costs have been going down, not up – while the industry concentration has been increasing rapidly. It was much more expensive to ship things in 1965 or 1975 (oil was more expensive, trucking was heavily regulated, etc.) than now. But the industry concentration occurred as shipping costs fell – in fact, the period of the most big-box store expansion was in the 1990s, when oil prices were exceedingly low.
Kieran Healy 07.24.04 at 9:38 pm
“The word “firm†is a little deceptive here, since it can mean anything from a sole proprietor to Wal-Mart.†… Isn’t it possible that there is a problem with this abstraction that lumps together sole proprietors and Wal-Mart …?
You might say the same about an abstraction that lumps together my local street bazaar and the global forex or derivatives exchange.
Sebastian Holsclaw 07.25.04 at 6:15 am
Kieran, ok.
And does that change any of the analysis, or is it just a flip comeback?
I’m trying to point out that these abstractions may obscure more than they reveal. If you think it applies equally to the term ‘market’ you are merely strengthening my point. I suspect the criticism does not apply equally to the term ‘market’, especially those markets that reduce information to ‘prices’. I can’t think of such an easily measurable commonality between ‘firms’, but then again I’m not an economist. It seems to me that while the idea of ‘market’ obscures some differences in different types of markets, it might not obscure nearly as many important differences as ‘firm’. And considering the increasing number of relatively small ‘firms’ in the U.S., I think it might be a set of distinctions worth looking at.
Burritoboy, shipping costs as a whole are down. The difference in shipping costs between a single item and a large number of items has increased with shipping efficiency. That still favors large shipments to large locations–and it favors it more so now. For analysis effect say the 1970s shipping cost for one item by itself was $20 while the per item shipping cost of 100 items together was $10. If the 2004 costs in constant dollars is now $10 for the single item and $4.50 per item for 100 items, the cost of shipping has gone down, but that has favored the large shipments.
RE booksellers, I’m not sure it is obvious that the need for a corporate headquarters and CEO salary outweighs the advantages of being a big bookstore.
The big bookstore has a lot of advantages. It has larger floorspace, which typically means cheaper rent per square foot. It often has fewer empolyees per book. It has lower shipping costs. It can often pay lower wages because it has many new-to-marketplace trainee workers who don’t intend to stick around in the job. It can sell a good selection of music to try to offset the reduction in book sales, something that your small bookstore can’t add in any meaningful quantity with limited space. I’m not sure that these and other scale advantages are outweighed by the corporate offices.
Also small booksellers aren’t necessarily dead, they just have to fill a niche that the general booksellers do not. There is a great store in San Diego called “Mysterious Galaxy”. It sells only certain genres of fiction–mystery, fantasy, sci-fi and horror. It has a number of book clubs and is very agressive about getting author signings. I have seen it go from a little store to a medium store to a fairly big store in the past 12 years. It does quite well, though it has a level of dedication from the owners that probably isn’t easy to reproduce.
travc 07.25.04 at 10:05 am
A quick observation about the current “mega-corporation” trend…
As I see it, huge firms generally don’t realize a significant benefit by internalizing transactions and minimizing their costs. Instead, the benefit of a huge size comes mostly from being able to coerce suppliers, regulators, customers, and everyone else a firm has to deal with. Wal-Mart is prime example #1 of this effect.
A potentially significant, and less pathological from a free market perspective, effet is the standard gambling problem. Larger firms are more likely to survive a streak of bad luck (or bad decisions) since they have more financial resources. Selection (as in natural selection) plays a big role in what sorts of firms exist, since there is a very large “death” rate. Firms that are harder to kill, are more likely to be around.
Back to transaction costs… internal transactions in large corporations are very frequently less efficent than transactions between firms. They lack the obvious pressures that increase transaction efficiency in a traditional market. Sure, it is in the best interest of the firm to minimize the costs, and it theorectially has the power to do so… but the immediate feedback of a buy-sell relationship is missing. Indirect costs within a firm are notoriously under weighted when it comes to cost containment for the simple reason that people are not rational and see ovbious costs first and foremost.
Now, one does have to ask, is a more centrally planned system better? I think not. It is even more prone to pathologies.
Just my perspective from a perspective more along the lines of dynamic systems than traditional economics. Hope it isn’t too trite or uneducated.
Phill 07.25.04 at 3:41 pm
The Efficient Markets stuff looks to me like it is begging the question.
Looks to me like these people want to conclude that government intervention is unnecessary so they code an axiom that essentially says that the market is all that is necessary.
Sure there is some truth to the notion that over extended periods of time markets tend to converge on reasonable valuations but since the market is being used as the definition of true value this is hardly a profound insight.
The problem with economics is that it is the only academic field where eminence is effectively judged by politicians. So for the past thirty or so years constructing useful models of the economy based on sound logic has been a less successful career promotion strategy than developing sophisticated arguments that support the policies that serve the interests of politicians favorite constituencies.
Sure markets can be reasonably effective. They can also be utterly wrong.
For the protection of the rest of society there should be a rule that requires all economics papers to carry a government wealth warning, “WARNING: This Paper Contains UNREALISTIC ASSUMPTIONS. Prolonged implementation of policy conclusions may lead to economic ill health”
chris borthwick 07.26.04 at 4:19 am
Economics, political science and management theory seem to be slighting Ev biol.
Let us imagine you are in a position of power. A proposal comes to your desk. One of the options is obviously sensible, is supported by the data, and comes with the recommendation of your experts. One is less satisfactory. One is plainly an almost total wipeout. What do you do?
If you do the sensible thing, you are doing what anyone could do. You don’t need power for that. If you want to demonstrate to others that you have power, you have to take a decision that nobody in their right mind would take and push it through against unanimous opposition.
This is in some ways in line with the present trend in evolutionary biology, which explains survival handicaps such as the peacock’s tail by hypothesizing that it is a way of demonstrating to potential mates or rivals that you have such potency that you can cope successfully with enormous self-imposed handicaps.
At some point this comes up against the imperatives of simple survival, but if you are Stalin or a top manager in a large corporation you have a very wide range of action before you reach this boundary.
If accepted, this theory explains quite a lot — perhaps too much, in fact; as in evolutionary biology, it means that any decision, good or bad, can be accounted for under one arm of the theory, making it virtually irrefutable and in Popperian terms trivial. But any good theory has to be able to explain Hitler as well as Bill Gates.
burritoboy 07.26.04 at 6:08 pm
Response to sebastian:
In your response to the booksellers argument, I noted that your first argument failed if we held all else equal. You responded by arguing a number of factors which wouldn’t hold all else equal. The largest problem I see with your argument is that all of your proposed factors would have been true 35, 50 or even 100 years ago. Essentially, you reverted to a returns to scale argument with the addition of a replacing labor with capital argument. The only part I find plausibly increasing over the past century is the capital versus labor factor, since computers probably did replace some of the labor previously needed to organize a large bookstore. I don’t know if that’s a substantial enough reed to hang your entire argument off of. I don’t believe that the cheaper labor factor in the large bookstore chain is really that substantial, if it even exists at all. Remember that while the front-line labor might be marginally cheaper at a large bookstore chain, the managerial labor is vastly more expensive at the large chain than it is with a single store. The equation may work out positively but also may not. Without real data to support either side, that initially doesn’t seem to be a massively compelling competitive advantage.
As to the shipping costs issue, it’s possible that what you’ve proposed is true. If you had any figures to prove it, I would admit that to be an actual factor. However, I would rebut by pointing out that shipping is not really that much of a expense. Plus, there’s no reason why it all has to be done through Home Depot as a vertically integrated firm, since a distributor could be handling the national shipping level, with the small retailer handling the actual retail activities. Distributors could be (and in fact are) very large indeed. That is the way the supply chain worked before the big-box expansion. The scale of shipping doesn’t seem to be a massively compelling advantage either.
khr 07.27.04 at 10:04 am
Re: Fraud
If the market is, in theory, a perfect information system, shouldn’t any type of fraud be, in theory, impossible ?
If all the information is available to everybody, false information could easily be recognised and rejected.
kevin quinn 07.27.04 at 12:20 pm
Just a few comments on a very interesting thread. It has always seemed to me that the most important idea to come out of the transactions cost lit. is the idea that non-market institutions – firms, governments, eg -have advantages over markets when it comes to creating environments that encourage “specific” investments. A world organized only by markets would be a much poorer world than the one we see because the level of investment in highly productive but specific assets would be abysmally low. On the other hand, I don’t share the confidence of the tc people that there is some meta-market that insures that the trade-off between markets and hierarchy is efficiently made. I have been thinking lately that there is a potential link here with the more narrow EMH discussion. The idea is Keynes’, that pathologies occur in the pricing of infinitely-lived assets due to the illusion of liquidity fostered by the secondary market.
Nicholas Gruen 07.28.04 at 1:58 pm
It surprises me that after over sixty years of Hayek saying it and over 30 years of the Arrows and the Akerlofs of the world saying it, the idea of policy seeking to systematically improve information flows in markets has not really entered mainstream economics as a normative program. True we all hear that securing integrity of information flows in markets is a function of governments, and a rationale for regulation in the markets for consumer and investor information for instance. But is this all the state can do to improve information flows in markets and thus (providing the interventions are not too costly) improve economic efficiency? I would suggest there are lots of things it could do to do so. They are relatively light handed things also. I have had a go at sketching some ideas in this article.
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