The organization of economic activity

The information and service economyOctober 3, 2007

Bob Glushko and Anno Saxenian

The classics

1. Adam Smith2. Ronald Coase3. Karl Marx4. Frederick Taylor

Adam Smith

Fundamentals of economic growth Specialization & the division of labor Division of labor is limited by extent of

the market Coordination of specialization

Spontaneous order via competition Alternatives?

Adam Smith, The Wealth of Nations

An Inquiry into the Nature and Causes of the Wealth of Nations The magnum opus of Scottish economist,

Smith. Written in 1776, on the eve of industrial

revolution in Britain. The founding work of “modern” economics

and political economy.

Smith on the division of labor

Of the division of labour: “The greatest improvement in the

productive powers of labour…seem to have been the effects of the division of labour.”

Pin manufacture: 18 distinct operations in pin-making One individual performing all tasks might

make only 20/day Ten individuals can make over 48,000

pins/day

Sources of productivity growth

Division of labor at two scales Specialization within the firm Separation of tasks between firms/industries

in economy (social division of labor) Sources of productivity growth

Increased dexterity, learning Eliminates switching costs Machinery increases individual productivity

. . .the extent of the market “ . . .the division of labor is limited by the

extent of the market” The greater the demand a firm, industry, or

economy faces, the more that firm, industry, or economy can deepen the division of labor.

The more specialized the division of labor, the greater the productive powers of workers

with division of labor . .. “universal opulence extends itself to the lowest ranks of the people”

The “invisible hand”

“It is not from the benevolence of the butcher, the brewer, or the baker that we can expect our dinner, but from their regard to their own interest.” Individuals/households acting solely in their own self-

interest generate collective good/ general interest Market competition, even though it appears chaotic,

maximizes economic benefit overall “…. he intends only his own gain, and he is in

this . . . led by an invisible hand to promote an end which was no part of his intention.”

Ronald Coase “The nature of the firm”

Why is economic activity organized by firms, rather than the market? We observe “islands of conscious power in this

ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk” D. H. Robertson

When do organizations supersede the price mechanism for coordination?

In certain circumstances, organization is more efficient than market competition

Costs of using the price mechanism

1. The cost of discovering the relevant prices (imperfect information)

2. The cost of negotiating and concluding contracts for each exchange

Firm will expand until costs of organizing an extra transaction within the firm equal the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm.

Why isn’t all production in the firm?

“Diminishing returns to management”

1. Decreasing returns to “entrepreneur” (management): rising costs to organizing transactions within firm

2. As transactions organized internally, misallocation of resources raises costs

3. Rising “supply price” of factors of production

Oliver Williamson: Theory of the firm

Markets and Hierarchies: Analysis and Antitrust Implications (1975)

The Economic Institutions of Capitalism (1985)

Develops Coase’s insight that firm boundaries can be explained by efficiency considerations

Focuses on role of firm boundaries in providing incentives, rather than coordination problems.

Transaction-cost economics

Identifies key dimensions of transactions and maps every transaction to a most efficient institutional arrangement: market or firm

Assumptions:1. In the beginning (efficient) markets2. Bounded rationality: human behavior

intentionally rational but only limitedly3. Opportunism: “self-interest seeking with

guile” (economic agents use strategic behavior to gain self-interest)

Opportunism: the “hold-up problem”

One party makes a relation-specific investment to transact with another (value is lower, or zero, to other uses than transaction)

Impossible to draw complete contract to cover all issues that might arise in transaction e.g. Very expensive dies used to shape steel

into specific forms needed for sections of body of a particular car model, paid for and owned by supplier

Result: Supplier is vulnerable to hold-up Efficient solution is vertical integration

Williamson’s conditions

Three crucial transaction characteristics:1. Frequency2. Uncertainty3. Asset specificity (foregone benefits of

discontinuing relationship)

High levels of uncertainty and asset specificity (esp. in combination) result in complex contracting relationship with need for ongoing adjustments. Better resolved within firm than market because easier to resolve disputes.

Markets and hierarchies

Advantage of firm for Williamson:Hierarchical relationships--one party has control over both sides of the transaction, power to resolve disputes.

A Hobbesian solution to opportunism:Market is like Hobbes’s state of nature, and resolution is through internalization of transactions within hierarchy

Hierarchy: originally rule by priesthood; today rule by single ruler with control over organization, authority passed through series of subordinate rulers, through a pyramid.

Beyond transaction costs

What else might a firm consider in deciding what stays inside? Incentives to innovate Incentives to cut costs Flexibility to respond in changing

environment Ability to track external developments Ability to learn from partners

Karl Marx: Das Capital

Karl Marx Capital: A Critique of Political Economy, V. 1: The Process of Capitalist Production 1867

In capitalism, labor power is a commodity that can be bought and sold. Below surface of free exchange, value is

created through “exploitation” of labor. Large numbers of laborers work together to

manufacture commodities in capitalism. Large scale production reveals “collective

power of the masses” and requires concentration of the means of production.

Marx on the division of labor

Manufacture is prevalent characteristic of capitalist production process.

Rise of manufacture from crafts production:1. Loss of general handicraft skills via separation and

application to production of single commodity 2. Specialized division of labor isolates detailed

operations, further reduces breadth of skills The detail laborer converts her body into a

specialized implement; no longer produces (or able to produce) a complete end product.

Anarchy in social DOL v. Despotism in workshop

Marx on capitalism

Goal of capitalist production to extract maximum surplus-value from workers Surplus value: value created by workers beyond

the amount they are paid for individual labor (value created in large scale, social production)

Capital’s role is to direct and control the production process. Class struggle is the result: unavoidable

antagonism between capital and labor. Intellectual work is sole the province of capital.

Marx on science

Separation of intellectual powers of production from manual laborer: loss of the knowledge, judgment, and will of skilled handicraftsmen

Science is pressed into the service of capital, and separated from labor, in modern industry.

Capital converts intellectual powers into control over labor through use of science

Power of the “master” lies in science and the gigantic physical force of machinery combined with the mass of labor that make up factory

Fred Taylor: scientific management

Ordinary management: “initiative & incentive” Scientific management: task management

Science replaces old rules-of-thumb Scientific selection, training, teaching of worker Insure all work done according to scientific

principles Division of labor between management and

workmen

Scientific management

Management: plans based on “laws of science” Define the tasks involved in a job, subdivide labor Establish rules, laws, formulae to replace judgment of

workers Systematically record and index tasks (requires

thousands of pages of scientific data for one shop)

Worker: executes tasks defined by managers “… the man who is suited to handle pig iron cannot

possibly understand it, nor even work in accordance with the laws of this science, without help of those over him”

Taylor and the efficiency movement

Taylorism: “One best way” to perform job can be discovered by scientific analysis of work.

“Time and motion” studies break jobs into component parts and measure each to second.

Taylor’s influence on modern management Professor @ Tuck School of Business, Dartmouth. Harvard 1908 offered first graduate degree in

business management, heavily influenced by scientific management

Influential in early Soviet Union

Coordination of economic activity

Smith: invisible hand Coase: market v. firm

Williamson: market v. hierarchy Marx: class conflict Taylor: scientific management