The organization of
economic activity
The information and service economy
October 3, 2007
Bob Glushko and Anno Saxenian
The classics
1.
2.
3.
4.
Adam Smith
Ronald Coase
Karl Marx
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 selfinterest 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.
2.

The cost of discovering the relevant prices
(imperfect information)
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) markets
2. Bounded rationality: human behavior
intentionally rational but only limitedly
3. 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
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
Three crucial transaction characteristics:
1. Frequency
2. Uncertainty
3. 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
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
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
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
Ordinary management: “initiative & incentive”
Scientific management: task management
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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