Considering the above limitations of autonomous contracting, a shift from market to hierarchy warrants examination. Rather, however, than move immediately to a complex hierarchy, might the unified ownership of plant and equipment between the successive stages suffice? Simple hierarchy would be maintained; only the ownership of physical capital would be changed.
Two variants of the model of simple hierarchy suggest themselves. One entails extending the span of control of a single manager (the owner) over all the workers in the combined facility without an increase in the number of hierarchical levels. The wheel model of Chapter 3 would be maintained, but the number of spokes would greatly increase. However appealing such a suggestion is, it can be dismissed on bounded rationality grounds. Spans of control can be progressively extended only by sacrificing attention to detail. Neither coordination economies nor effective monitoring can be achieved if capacity limits are exceeded.
Consider instead, therefore, what Buttrick has described as the “inside contracting system” (1952, pp. 201-202):
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.
The system developed among New England manufacturing plants at the time of the Civil War and was continued in many of them until World War I.
The inside contracting system had the attractive attributes that it: (1) provided for the aggregation at a single location of a series of primary work groups that were involved in successive manufacturing processes, thereby reducing transportation expense and assuring that a cheek-by-jowl association would develop with corresponding economies of communication; (2) permitted the capitalist with relatively little technical knowledge to employ his capital productively while limiting his involvement to negotiating contracts with the inside department heads, inspecting and coordinating the output of the various departments, and taking responsibility for final sales; and (3) provided the inside contractors (first-level supervisors) with incentives for efficient labor performance in both supervisory and process innovation respects. In addition, although neither is mentioned by Buttrick, (4) the monopoly powers of the various inside contractors were, in relation to supply by an exclusive outside supplier, presumably limited by the capitalist s ownership of plant and equipment, and (5) problems of information impactedness, which might otherwise inhibit new investment, were avoided. The system nevertheless experienced numerous difficulties (Buttrick, 1952, pp. 210-215):
- A bilateral monopoly position, albeit restrained, developed between the parties.
- The periodic renegotiation of rates induced the contractor to hoard information and to delay process innovations.
- The flow of components was difficult to regulate.
- Work-in-process inventories were excessive and, since each stage incurred only its own direct labor costs, later stage processes were wasteful of components on which early stage work was completed.
- Contractor incomes were sometimes excessive in relation to those of the capitalist, endangering the status of company officials.
Moreover the system was beset by defective incentives in that:
- Equipment was not utilized and maintained with appropriate care.
- Process innovations were biased in favor of labor saving, as against materials saving, innovations.
- Incentives for product innovation were insufficient.
Buttrick attributes the supplanting of the inside contractor system by a hierarchical control apparatus in the Winchester Repeating Arms Company to the conjunction of internal personnel chages in the late 1800’s with external “scientific management” developments in the early 1900’s (1952, pp. 213-220). But whatever the immediate explanation for the abandonment of inside contracting at Winchester — or any other firm — might be, it is evident that the inside contractor system possessed serious defects and that, to the extent that a more comprehensive system of hierarchical controls served to mitigate these defects (and did not incur offsetting costs), an eventual change in organization form was to be expected.
Although defects numbered 4 and 7 might have been remedied by making simple changes in the internal pricing system, the other disabilities of inside contracting appear really to be immanent. Given uncertainty, whence the occasion to make coordinated adaptations between successive parts, and bounded rationality, whence the limitations on long-term contracts and the infeasibility of a flat (single stage) hierarchy, the defects listed are manifestations of small-numbers bargaining relations in which opportunism and information impactedness conditions obtain. Thus the disabilities of yet another organizational mode —this time inside contracting—are explained in terms of the markets and hierarchies framework of Chapter 2.
To illustrate, suppose that all of the cost and related data bearing on the exchange were costlessly available to both capitalist and contractor (that is, information impactedness does not obtain). Long-term contracts containing a general clause and sharing rule (of the type described in Section 3) could then be written. Given that a large number of bidders are qualified to compete at the outset, the bilateral monopoly problem (defect number 1) would vanish. Alternatively, if winners of original bids made self-enforcing promises not to exploit first-mover advantages at contract renewal intervals, short-term contracts could be written and the initial large-numbers condition would be sufficient to assure competitive supply relations throughout. Inasmuch, however, as both of these assumptions are a fiction (the necessary information is not costlessly available and promises of the sort described are unreliable), the bilateral monopoly condition emerges.
The information hoarding and strategic delay of process innovations (defect number 2) are manifestations of the gaming behavior which the absence of full information permits. Information relating to costs and technology was asymmetrically distributed to the advantage of the inside contractor. Absent opportunism, this would pose no problem. But the inside contractor was evidently opportunistic; whence defect number 2 resulted.
The disruptions in component flows between the parts (defect number 3) can be attributed in the first instance to contractual incompleteness (bounded rationality). In principle, this could be overcome by relying on the capitalist to coordinate the parts flow in an adaptive, sequential manner. Given, however, that each inside contractor assesses the consequences of intervention by the capitalist in terms of the effect on his individual profit stream (again, promises to be guided by joint profit maximization con- siderations are unenforceable), this proves unacceptable. The defect, there- fore, continues.
The status threat posed by defect number 5 is somewhat special. I conjecture that it arises because the inside contractor was relatively secure against displacement (because of first-mover advantages) and because he was not fully candid in disclosing his true costs to the capitalist. The normal correspondence between hierarchical position and income was sometimes upset as a result, which the capitalist regarded as a status threat. Moreover, adverse efficiency consequences can result if the capitalist attempts to reassert his primacy by converting what could be instrumental contractual relationships into subordination relationships instead. Dysfunctional per- formance easily obtains when such power contests are waged.
The equipment utilization problems referred to in defect number 6 are akin in their origins to the component flow problems discussed above, while the equipment maintenance problems are a reflection of free-riding behavior. The defective incentives for product innovation (defect number 8) are due, probably, to appropriability problems. Although the capitalist has an interest in improving the product, he is able, given the first-mover advantages which inside contractors acquire, to introduce such changes only by securing the consent of these contractors. The prospect of having to bargain and the inability to appropriate the full value of product innovations reduces his incentive to undertake research and development efforts. [See Buttrick’s discussion of the Winchester Company’s experience in this connection (1952, p. 214).]
Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.