Last Friday was the first day of my Business Organizations class. We began with two articles that have profoundly influenced my thinking about the world in general and the business world in particular. To inaugurate the new semester, I thought I’d take a moment and pay tribute to the insights in those articles (and solicit first day ideas from other business law profs!).
The first piece is F.A. Hayek’s The Use of Knowledge in Society. The article, written at a time when socialism was all the rage among the intelligentsia, pointed out the fundamental flaw in the socialist system. The problem Hayek highlighted was not the much-discussed motivational problem (i.e., why create wealth when the government is going to take it from you and give it to someone else?) but was instead an informational problem: how can economic planners allocate resources to their highest and best uses, and thereby maximize wealth, when the planners are not privy to the time- and space-specific information that determines what those uses are? In Hayek’s words:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given†resources — if “given†is taken to mean given to a single mind which deliberately solves the problem set by these “data.†It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
The solution to this problem, Hayek argued, is the price mechanism, which he dubbed a “marvel.” Indeed it is. Market prices incorporate gobs of information and quickly process it to produce a single metric that tells consumers and producers precisely what they need to know: whether they should increase their production/consumption or cut back on it.
Suppose, for example, that you own an oil well and can select the level at which you produce oil. You pick up the morning newspaper and read four headlines: (1) “Unrest Worsens in the Middle East”; (2) “Huge Oil Reserve Discovered Off Coast of New Jersey”; (3) “New Senate Leadership Refuses to Budge on ANWR Drilling”; and (4) “GM Announces Plans to Switch Production from SUVs to Hybrids.” What should you do??? Well, headlines (1) and (3) would suggest that oil supplies are going to be tightening, so you should increase production; headlines (2) and (4) suggest just the opposite. What you really need to know is the expected magnitude of each of these effects (and all the others related to oil supply and demand). Fortunately for you, though, you need not spend all day scouring the newswires for oil-related information and estimating the significance of each datum. All you need to do is look at the price of oil, which tells you the best guess of millions of folks about whether or not we need more oil. This is utterly amazing. In Hayek’s words:
The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. … The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction. … I have deliberately used the word “marvel†to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.
The bottom line for Hayek, then, is that resources are most efficiently allocated not by centralized planners but by the “man on the spot” responding to the information inherent in market prices.
Enter Professor Coase. In The Nature of the Firm, he observed that this is absolutely not what we see in business organizations: “Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur/coordinator, who directs production.” Thus, “the distinguishing mark of the firm is the supersession of the price mechanism.” Business organizations are, in short, little islands of socialism in which Hayek’s beloved price mechanism is “superseded.”
So why do these “islands of conscious power” emerge? Because there are costs to using the market to allocate resources — most notably, transactions costs. Suppose, for example, that you want to start a catering business. You could minimize your labor costs by going down to the unemployment office every day and hiring, for the day, the laborers you’d need to fill that day’s orders. By taking that tack, you could pay the lowest wages possible (since your workers’ next best option would be unemployment), and you could ensure that you didn’t have any idle laborers (since you could hire only as many folks as you’d need to fill that day’s orders). But of course you wouldn’t do that because it would be extremely costly to engage in this process day after day. Instead, you’d hire some folks for the long term, accepting the possibility that you’ll probably have some periods of employee idleness. Business organizations emerge, then, as means of economizing on transactions costs. They will grow until the degree to which they reduce transactions costs is exceeded by the efficiency losses they create (e.g., the costs of idle resources, the agency costs that inevitably result when managers command resources they do not own).
This conception of the firm as a construction designed to minimize costs has profound implications for the law of business organizations. It also shows us how transactional lawyers can create wealth (as opposed to merely redistributing it, as lawyers often do). If the nature of the firm is as Coase describes, then the law should treat business organizations as no more than cost-minimizing nexuses of contracts between the suppliers of capital, managerial talent, and labor. This suggests (1) that the law should provide some “off-the-rack” nexuses of contracts that would appear to reflect the needs of large classes of business entities, and (2) that these various off-the-rack collections of contracts should be freely tailorable by business planners. Transactional lawyers can add value, then, by tailoring these off-the-rack contracts to meet their clients’ specific needs.
[Interestingly, Henry Manne has recently suggested that business planners might want to create Hayekian price mechanisms within the firm in order to enhance the quality of information available to managers. His fascinating short paper Hayek, Virtual Markets, and the Dog that Did Not Bark suggests how planners might choose to authorize insider trading (or internal prediction markets) in order to provide managers with the information-revealing benefit of prices.]
That’s the nutshell version of the first day of my Bus Orgs class. I’d be most interested in hearing what other law profs do to introduce this subject.
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No apologies necessary Mike! Perhaps you will read the copy in your office and tell me why I am wrong? Both the Hayek and Coase essays (among others) are classics we could all benefit from reading repeatedly. I learn something new every time I read these and other classics.
Josh. My apologies. I have my copy of the essay in the office, and I am at home. But, once again, your answers are helpful and illuminating. Thanks.
Michael: that’s not quite fair. I’ve excerpted a lead line from a single paragraph in a long essay which supports this claim with more details if you find the single line too vague (even with some specific transactions costs).
Again, I’m not disagreeing with you that Williamson (and for that matter Klein, Crawford & Alchian) makes the immensely important contribution of giving more meaning to “transactions costs” here by adding asset specificity to the analysis. And the the empirical literature on the relationship between asset specificity and vertical integration IS very consistent — and perhaps strong enough to conclude that asset specificity considerations should be our primary focus in TCE. That Williamson made a very important contribution to further Coase’s analysis, I think, goes without saying. I’m just making the claim here that Coase does more than say “there exist firms … discuss.”
Coase does elaborate on the specifics of these costs (without using the notion of “transaction” costs specifically) considering “the most obvious cost of ‘organizing’ production through the price mechanism [to be] that of discovering what the relevant prices are.” This harks back to Hayek’s argument that socialist planning is (at least) unscalable/intractable/humanly un-thinkable at the level of a whole economy; remarkably, Coase notes that even though the costs of ascertaining this information may decline, e.g., through telephone, or, nowadays, internet, etc., they are never eliminated–there will always be “friction” in the economic environment, and thus a place for lawyers, consultants, etc., to engineer value-added in “combinations” and “integrations,” etc. Coase does claim that “in a competitive system there is an ‘optimum’ amount of planning!” (his bang)–the planning done within firms by what he calls “entrepreneurs,” with diminishing returns though it may be. A pedagogically interesting discussion might be whether the level of complexity is the only/main/defining difference between socialist planning (“macro”) and enterprise planning (“micro”)?
Well then I guess I am not that happy with Coase’s answer either: “there is a cost of using the price mechanism.†Pretty darn vague. I might have preferred if Coase had just called it a mystery, which was my sense of what he intended.
My recollection is that Williamson tries to specify what these costs are, based on various economic characteristics of transactions, e.g. asset specific investments. When I hear references to transaction cost economics I assume people are talking about Williamson’s theories rather than Coase’s more open-ended statement. But aren’t there many plausible explanations as to why “there is a cost of using the price mechanismâ€? Is there any evidence as to the magnitude of the various economic factors that a Williamsonian transaction cost analysis would suggest, which I assume is what Thom and Vic would have us teach, as compared with a variety of other hypotheses about what the costs of the price mechanism might be?
Your use of Hayek is interesting and thought provoking. Coase’s insight, along with Williamson’s transaction cost elaboration, should be carefully explained as a fundamental organizing principle. But equally important for students to appreciate the first day of class is the second basic principle–Agency Cost Theory. (Berle & Means; Alchian & Demsetz;and especially Jensen & Meckling). A simple hypothetical example of the conflict between managers and investor/owners should be used to drive this home. The two other conflicts (majority versus minority owners and manager/owners versus creditors) should also be noted.
Finally, one can make an argument that a third basic principle which belongs in the first day of lecture is Capital Structure (M&M; Jensen and Meckling). Of course, this principle overlaps a bit with Agency Cost Theory.
Michael, you may be right that there are other interesting theories of the firm, but Thom is right re: Coase drawing the link between transactions cost and the existence of the firm . Here’s Coase (1937):
“The main reason why it is profitable to establish a firm would seem to be that there is a cost
of using the price mechanism.”
Wonderful post. First, as to how I start Business Organizations, I am more of a pragmatist. I display an empty 4 x 3 matrix. The rows are labeled: Formation, Liability to Third Parties, Roles and Duties, and Termination. The columns are labeled: Principal/Agency, Partnership, and Corporations (at some point I assume I’ll add a fourth column for LLC’s). I explain that we are going to deal with the same four issues, those listed in the rows, for each of the three types of entities in the columns. I do this because as a student I really appreciated having a road map for the material that was going to be covered throughout the semester. And then, after some brief introductions to the three types of business entities (borrowed from Bainbridge’s excellent slides), off we go to start talking about how to form a Principal/Agency relationship and why it is so darn easy.
Second, you make a connection between Coase’s article on the firm and transaction costs that has always troubled me. My recollection of the Coase essay is that he presents the question as to why these “islands of conscious power†form as, if I may use the term, a mystery. It is Williamson who claims that the answer is transactions costs, and I, for one, am much more comfortable with Coase’s question than Williamson’s answer. There are a lot of interesting alternative theories as to why types of business organizations form and survive that are not included in the traditional transaction costs stories.
So, to answer Vic’s question, I find the emphasis on transaction costs suggested by Thom’s post as presenting too limited a picture of the kinds of issues a Business Organizations class should address.
To me, the discussion of Coase doesn’t hold much water. Business organisations emerged from the family, and today’s firms owe much more to their familial heritage, than to conscious economic rationale. The first businesses were family businesses.
The paper of Coase misses this historical perspective, which is extremely important in understanding the nature of the company and why it lacks transactions. Nowhere in his paper is the word “family” mentioned.
I’m thankful that Thom brought up this topic, because I believe it’s time to revise many of our fundamental assumptions and theories about our society and our economy. For example, the ubiquitous family model of the company is causing huge frustrations among employees and managers alike, not to mention the losses to our economy.
Central planning (the family model) is not more efficient than transactions and will be gradually replaced by the latter. Why?
– we simply cannot have fair pay with central planning; this leads to huge frustrations in the workplace – people changing jobs, the more capable and individualistic prefer to become self-employed; this distortion has also led to the emergence of unions and other such artificial rifts between “top management” and “employees”
– inefficient allocation of resources, slow feedback systems within the company – all this leads to instabilities within businesses, which then propagate to the rest of the economy and render it more volatile
– transactions within the company are cheaper than those on the open-market; within the company we have a more protective and bounded environment, a place where people know each other a lot better and can establish trusted relations with less effort; we cannot simply assume that internal and external transactions have the same cost, and then use this is an argument for central planning
The family model of the company is going to fall, for exactly the same reason why the Soviet Block collapsed: central planning doesn’t work well economically.
I know that teaching can be difficult a job, especially in situations when you have a fuzzy and controversial topic such as organisations, which you long to present as coherently as possible to students. Good luck, and don’t be afraid to show to the young generation that we, the grownups, still haven’t got the answers to all questions 🙂
Great post. An elegant summary of two of the key foundations.
I’m curious if folks think that anything Thom says in his intro is seriously contestable. I don’t, really. Perhaps a bit at the end, when he firmly embraces a contractarian view of the corporation. When I introduce that concept in Deals I tell the students that some smart folks out there take a different view of the corporation, e.g. as a concession of the state, as a moral entity, as a vehicle for achieving other social goals, or as a vehicle for redistributing wealth. But I then ask them to set aside those views for the purposes of the Deals class.