The Limits of Firms: Low-Powered Incentives in Markets

A symmetrical treatment of economic organization will examine not merely the strains that result when the high-powered incentives associated with markets are introduced into firms, but will also consider whether the low-powered incentives employed by firms can be introduced without strain into markets. The latter question is the matter of concern here.

Assume, for the purposes of this section, that the innovative tensions discussed in 2.4, above, are slight. Assume further that the amount of physical asset specificity at the supply stage is great. Integration is thus the indicated form of organization.

Suppose, as a consequence of the factors discussed in subsections 2.1 and 2.2, that the integrated firm decides to transfer product between divisions on the cost plus terms. The supply division thus accedes to requests from the procurement division that it adapt the quantity or quality of the product without resistance.60 Lest costs be permitted to escalate or economizing op- portunities go unnoticed or be forgone, however, the supply division is peri- odically reviewed in cost and decision respects. Suppose, arguendo, that the resulting performance is judged to be satisfactory.

If such low-powered incentives coupled with periodic auditing have advantages in firms, why not replicate the same with markets? That is a different way of putting the question that I posed at the outset—only here the question is why can’t the market replicate the firm? It will be useful to address the question by examining the following more operational statement of the problem: What are the consequences of cost plus contracting between autonomous firms?

Interfirm and intrafirm cost plus contracting differ in at least two signifi- cant respects/ Both are related to the fact that an autonomous firm has an added degree of freedom that an integrated division does not: It can take its assets and flee. The first difference: Is that an independent supplier has an incentive to incur costs for strategic purposes that the internal supply division did not. The second is that interfirm auditing cannot be presumed to be as effective as intrafirm auditing.

The strategic difference is this: The independent firm has a stronger incentive to make investments for which reimbursements can plausibly be claimed—in plant and equipment and in human capital—if they give it an added capability to compete for other business. To be sure, both external supplier and the internal supply division can be advised (and may agree) that they are to supply exclusively to the needs of the procurement division. But enforcing such a provision against an independent supplier is apt to be much more difficult. Court ordering is much less effective than administrative fiat in effecting preferences on these matters.61

It is sometimes argued that interfirm and intrafirm- audits are indis- tinguishable. Thus Sanford Grossman and Oliver Hart “assume that integration in itself does not make any new variable observable to both parties. Any audits which an employer can have done of her subsidiary are also feasible when the subsidiary is a separate company” (1984, p. 5). I submit that there are reasons to believe otherwise. Specifically, market and internal organization differ in “informal organization” respects. Chester Barnard put the argument as follows: Since the efficiency of organization is affected by the degree to which individuals assent to orders, denying the authority of an organization communication is a threat to the interests of all individuals who derive a net advantage from their connection with the organization, unless the orders are unacceptable to them also. Accordingly, at any given time there is among most of the contributors an active personal interest in the maintenance of the authority of all orders which to them are within the zone of indifference. The maintenance of this interest is largely a function of informal organization. [1938, p. 169]

Although Armen Alchian does not make reference to informal organization, he nevertheless acknowledges that “anyone vulnerable to [a] threat of loss [if the coalition is impaired] will seek to preserve not only the coalition but also to reduce the possibility of that threat from the other members of the coalition” (1983, p. 9). If a stronger mutual interest in organizational integrity can be presumed among members of an integrated organization than would exist between independent trading units—because their destinies are more closely tied in the former than in the latter case—then internal auditors can expect to receive greater cooperation, including even hints as to where the “dead bodies lie,” than can be presumed when auditing across an autonomous ownership boundary is attempted.62

Indeed, the external auditor can ordinarily anticipate only perfunctory cooperation. Since if “our” costs are disallowed then “our” profits will decline and “our” viability may be jeopardized, the employees of the independent supply stage will engage in cost justification and cover up.

To be sure, divisions also engage in obfuscation and cover-up against internal auditors. Division managements cannot, however, take the physical assets they have accumulated through cost overruns and flee. Termination with and without assets makes a difference. If, therefore, heads must roll in an integrated division where cost excesses have become great, and if guilty and innocent in these circumstances go down together, then it is easy to understand how those who are not implicated in malfeasance will collaborate early and actively with internal auditors.

The upshot is that cost plus contracting in markets cannot be presumed to be identical to cost plus contracting in firms. Transferring a transition out of the firm and into the market therefore will rarely occur on unchanged cost plus terms but will instead be attended by incentive and givernance realignments.

This repeats the argument advanced earlier: Incentives and governance structures that are observed to work well in one organizational milieu do not transfer uncritically to others. To the contrary, organization form, incentive instruments, and governance safeguards must be derived simultaneously.

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

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