The Limits of Firms: Illustrative Examples

Evidence on the incentive limits of firms is not well developed. For one thing, firms are understandably chary of admitting administrative strains that may be interpreted as managerial failures. Additionally, the incentive limits of firms has eluded analytic scrutiny. There is simply no place, within the production function framework in which a profit maximization objective is prescribed, for incentive limits to appear.

The six examples discussed below are merely suggestive. At best they confirm that all the incentive limits discussed so far find real world counterparts. But a much more systematic development of the relevant microanalytic data is needed.

1. Inside Contracting 

The use of high-powered incentives in firms was attempted in New England manufacturing firms at the turn of the century. What has been referred to as the inside contracting system has been described as follows:

Under the system of inside contracting, the management of a firm provided floor space and machinery, supplied raw material and working capital, and arranged for the sale of the final product. The gap between raw material and finished product, however, was filled not by paid employees arranged in [a] descending hierarchy … but by [inside] contractors, to whom the production job was delegated. They hired their own employees, supervised the Work process, and received a [negotiated] piece rate from the company. [Buttrick, 1952, pp. 201-2]

As I have discussed elsewhere, the inside contracting system was beset with a number of contractual difficulties (Williamson, 1975, pp. 96-97):

  1. Equipment was not utilized and maintained with appropriate care.
  2. Process innovations were (a) biased in favor of labor-saving, as against material-saving, innovations and (b) regularly delayed until after contract renewal terms had been reached.
  3. Incentives for product innovation were weak.
  1. Contractor incomes were sometimes thought to be excessive in relation to those of the capitalist, in which event the capitalist sought redress at contract renewal intervals.

Inside contracting can thus be regarded as an effort to implement rules 1 through 4, as described in section 2 above, the main difference being that the inside contractor could be replaced not at will but only at contract renewal intervals. This imaginative effort to preserve high-powered incentives in firms presumably encouraged economizing on variable costs. But those same high- powered incentives also evidently gave rise to asset tnalutilization and were responsible for distortions in the innovation process. Intertemporal income strains between capitalist and contractor also appeared. Those (and perhaps other) disabilities are presumably responsible for the demise of inside con- tracting, although vestiges of that form of organization continue in the con- struction industry, where, however, work is done on a project rather than on a continuing supply basis (Eccles, 1981).

2. Automobile Franchise Dealership 

Recall Alfred p. Sloan’s explanation (see Chapter 5, section 4) for why the automobile manufacturers did not integrate forward into automobile sales and service but used franchises instead. A principal complicating factor was the trade-in. Many hundreds of thousands of such transactions needed to be negotiated at geographically dispersed locations. Considerable judgment was evidently required to assess the highly variable quality of the cars presented for trade-in. A generousused car valuation would help to sell new cars, but a net loss would be recorded upon resale of the traded item. An undervaluation of an automobile proposed in trade would not meet the market and thus would not move new autos.

To be sure, the automobile manufacturer could insist that every transaction be split into two parts: The owner of a used car would strike his own best deal elsewhere and use the proceeds to buy a new car. The sale of the new car would then be more of what Sloan referred to as “an ordinary selling proposition” rather than a’ “trading proposition” (1964, p. 282). But inasmuch as large numbers of customers were evidently attracted to bilateral trade, the relevant question was how to respond. Sloan explains that managers in large firms lack the “knack” for trading, but 1 submit that the fundamental difficulty resides in the incentives of the large, managerially controlled enterprise. Supervisors and salesmen in such an organization lack confidence that they will fully appropriate the gains when highly profitable deals are struck. And those same supervisors and salesmen cannot be held fully accountable if losses are incurred (firing them is an imperfect solution if employees can secure employment elsewhere without bearing a full reputation-effect penalty). A means by which to concentrate incentive effects more effectively is evidently needed. That, rather than the incapacity to support the knack of trading, is what explains the franchised dealership response.

3. Acquisitions, Incentives, and Internal Equity 

Tenneco, Inc., is the nation’s largest conglomerate. Its employees number almost 100,000 and its annual sales exceed $15 billion. Tenneco acquired Houston Oil and Minerals Corporation late in 1980. Houston was a relatively small company with premerger sales of $383 million, 1,200 employees, and an aggressive reputation for oil exploration.

In hopes of retaining Houston’s experienced oil exploration people, Ten- neco offered special salary, bonuses, and benefits that others at Tenneco did not enjoy. Tenneco also “agreed to keep Houston Oil intact and operate it as an independent subsidiary” rather than consolidate the new acquisition (Get- schow, 1982, p. 17).

Despite initial enthusiasm, Houston’s managers and its geologists, geo- physicists, engineers, and landsmen left in droves during the ensuing year. One complaint was the excessive bureaucratic delays in getting the compensation package defined (Getschow, 1982, p. 17). There were also bureaucratic restraints: As Tenneco’s vice president for administration observed, “We have to ensure internal equity and apply the same standard of compensation to everyone” (Getschow, 1982, p. 17), which is to say that the differential treatment could not be sustained. By October 1981 Tenneco “had lost 34% of Houston Oil’s management, 25% of its explorationists, and 19% of its production people, making it impossible to maintain it as a distinct unit” (p. 17). The offers by independent producers, which evidently have fewer or different burdens and restraints, of “stock options, production bonuses and, especially, royalty interests in the oil they discover—[incentives] that the majors have been unwilling or unable to offer to match” (p. 1) were principally responsible for the unraveling. Despite their best efforts, large firms are not always able to replicate small firms in all relevant respects.

4. Hybrid Modes 

One way of joining large and small firms in the innovation process is this: Concentrate the initial development and market testing to be performed by independent inventors and small firms (perhaps new entrants) in an industry, the successful developments then to be acquired, possibly through licensing or merger, for subsequent development by a large multidivisional firm. But that is not the only systems solution permitting high-powered incentives to be concentrated at the early innovative stages of the R&D process. A recent Business Week report on how to “tap innovations created at small companies” begins as follows:

In 1982, Ramtek Corp. wanted to add an advanced graphics machine to its line of computer peripherals. Despite its hefty research and development budget—nearly 11% of sales, well above its industry’s average—the Santa Clara (Calif.) company decided against developing the system on its own. Instead, it funneled $2 million into Digital Productions Inc., of Los Angeles, which had a big lead in the technology. But this was no acquisition. Rather, Ramtek invested in the tiny company specifically so Digital would develop the software for a powerful new imaging system that Ramtek now expects will be a big success.

Ramtek’s experience represents an Important shift in the way established companies are tapping the technology of smaller, entrepreneurial ones. In the past, big companies typically bought up little ones when they wanted their expertise. But in many cases, the acquiring corporations mismanaged their new property and lost the very people and creative environment that attracted them in the first place. [Business Week, June 25, 1984, p. 40]

The report subsequently goes on to observe that such arrangements are increasing rapidly, from 30 in 1980 to 140 in 1983—“established firms, although strong in both long-term research and marketing clout, are finding out they are better off relying on entrepreneurial companies for nearer-term innovations” (p. 41). As General Motors explained of its purchase of 11 percent of Teknowledge in 1984, “If we purchased such a company mitriphi we would kill the goose that laid the golden egg” (p. 41).

To be sure, such partial ownership positions are not without hazards. It is nevertheless instructive that, at least for many projects that do not require an enormous research commitment, large companies are becoming increasingly aware that the bureaucratic apparatus they use to manage mature products is less well-suited to supporting early stage entrepreneurial activity. Hybrid forms of organization result.

5. Auditing Limits of Interfirm Organization 

The experience of the railroads in the late nineteenth century is germane. As reported by Alfred Chandler, Jr. (1977), efforts by the railroads to effect interfirm coordination regularly broke down. Informal alliances gave way to federations, which in turn were supplanted by merger. Among the many problems with which the federations had to contend were “false billing re- garding weight or amounts shipped or distances sent and improper classifies- tion of freight moved” (Chandler, 1977, p. 141). Auditing checks were attempted, but the unenforceability of cartel agreements encouraged continued defection (pp. 141-44).

Cartel experience in the telegraph industry ran a similar course. Limited cooperative arrangements in the 1850s proved ineffective. Market division was then attempted by creating six operating regions, with one company assigned to each. Business was pooled where the lines overlapped, but implementation problems arose. The six firms were reduced first to three and then, in 1866, to a single company, Western Union (Chandler, 1977, fa. 197).

Manufacturers in the 1870s and 1880s used trade associations to devise “increasingly complex techniques to maintain industrywide price schedules and production quotas” (Chandler, 1977, p. 317). When those failed, the manufacturers resorted to the purchase of stock in each others’ companies, which “permitted them to look at the books of their associates and thus better enforce their cartel agreement.” But they could not be certain that the company accounts to which they were given access were accurate. As with rail and telegraph, effective control required the next step, merger (Chandler, 1977, pp. 317-19). Auditing limits were evidently a contributing factor.

6. Socialist Enterprise

Internal organization in socialist firms likewise experiences strain when asked to deliver on promises of high-powered incentives. Branko Horvat reports the following incident:

. . . there was a Computer Center that could not cover its costs. We decided to introduce an incentive scheme whereby the members of the center would share in all positive and negative differences in business results compared with those of previous years. Improvement did not appear very likely and, in any case, the incentive differences were very modest. The new manager of the center turned out to be an exceptionally capable man, however, and at the time of the annual business debate, the center could boast of phenomenal improvements. Instead of giving full recognition to what had been achieved, the council decided to ignore its own decision of a year earlier, proclaimed the incentive scheme inapplicable, and distributed the surplus in an arbitrary fashion        We did not know they could do so well, was the [explanation], and it cannot be tolerated that they should earn more than others. The center lapsed into losses again. [ 1982, p. 256]

The incident is noteworthy in two respects. For one thing, bfyth socialist and capitalist managers are evidently responsive to pecuniary Incentives.

Exhortation can be helpful in both (indeed, may be wholly adequate in some circumstances), but the realization of potential cost savings is sometimes promoted by the introduction of high-powered incentives. Second, both socialist and capitalist firms are known to renege if the savings rcalization/profit participation from high-powered incentives is “excessive.” Put differently, both socialist and capitalist “promises” need to be backed by credible commitments of the kinds discussed in Chapters 7 and 8.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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