MGMT701a
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Book Review 2
Review 2
Book Review of Organization Theory
Iris Jiang
In this review of Williamson’s “organization theory”, I’ll focus on 1), the
difference of several perspectives of the theory of the firm introduced in the book and, 2)
their application and limitations in new economy.
Part I: Summary of perspectives on the theory of the firm
There are several perspectives to study the theory of the firm in economic
literature. The neoclassical approach is based on maximizing behavior, but tells us
nothing about the structure of the firm. The principal-agent theory emphasizes the
optimal incentive schemes, but is silent on the nature and extent of the firm. Then comes
the transaction cost economics starting with Coase’s famous 1937 article. According to
Coase, economic activity is either coordinated via the price mechanism or by fiat. There
are costs to both. Which is chosen for each individual transaction depends which is less
costly. Transactions coordinate by fiat are “within the firm”. Coase posits that the
marginal costs of coordinating by fiat increases in the number of transactions. At some
point, coordination via the price mechanism or within a different firm becomes less
costly. The point at which the marginal cost of organizing an additional transaction
within the firm is more expensive than within the market or another firm determines
firms’ size and scope.
Two points of Coase’s view are often been attacked in the literature: first, Coase
points that firms are characterized by authority relations, but he didn’t make it clear what
ensures that the employee obeys the employer’s instructions. Second, the view that “price
mechanism is suppressed within the firm” is not convincing, and an obvious
counterexample is the transfer pricing within a multidivisional firm. Following Coase,
Alchian and Demsets (1972) developed their theory based on joint production and
monitoring, the latter making possible to assess each agent’s contribution. They applied
the general rule that decision rights should be allocated to the individual with the
strongest incentives toward value-maximizing and argued that the ownership of the
capitalist firm can be effectively defined by the following bundle of rights (i.e., the best
way to provide the monitor with appropriate incentives) : 1, to be a residual claimant. 2,
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Book Review 2
to observe input behavior. 3, to be the central party common to all contracts of inputs. 4,
to alter memberships of team. 4, to sell rights 1 through 4. However, Alchian and
Demsets’s theory also suffer the same problem that they pointed out in Coase’s theory: it
is unclear why the problems of joint production and monitoring cannot be also be solved
through the market (i.e., through contract)?
After Coase originated the idea of transaction costs, the most influencing analysis
on it were carried out by Williamson. Williamson recognized that transaction costs are
likely to particularly important when economic agents make relationship-specific
investment (i.e., the investments to some extent specific to a particular set of individuals
or assets). Once the investments are made, the parties are locked into each other. As a
result, external markets do not provide a guide to the parties’ opportunity costs once the
relationship is underway. The lack of ex-post market signals, combined with “contracts
are unavoidably incomplete”, will lead to two sorts of costs: 1, ex-post costs associated
with negotiation itself, and 2, as bargaining power and resulting share of the ex-post
surplus bear little relation to the ex-ante investment, parties have the wrong investment
incentives at the ex-ante stage. Thus, Williamson points out that bringing a transaction
from the market into the firm (i.e., integration) mitigates the opportunistic behavior and
improves investment incentives. However, Williamson didn’t make it clear how such
opportunism is reduced by bringing a transaction into the firm.
Jensen and Meckling (1976) points out the view of “the firm as a nexus of
contracts”. Under this view, there is no point to distinguish between transactions within a
firm and those between firms, as they are both considered as part of a continuum of types
of contractual relations, with different firms or organizations simply representing
different points on this continuum, i.e., particular standard form contracts. However,
Jenson and Mechling leaves open the questions of why particular standard forms are
chosen, and what limits the set activities covered by a standard form? Given that mergers
and breakups occur all the time, and at considerable transaction cost, the real question is
something like “how integration changes incentives”?
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The perspective which views the firm as a set of property rights (Grossman &
Hart, 1986, for e.g.1) tries to answer such a question. This approach is similar to the
transaction cost approach, but focuses attention on the role of physical, or at least
nonhuman assets in a contractual relationship. Under this view, in a world of transaction
costs and incomplete contracts, ex-post residual rights of control (such control resides
with the owner of the assets) are important because, through their influence on assets
usage, they affect the incentives of agents to invest in that relationship. Hence, when
contracts are incomplete, the boundaries of firm are important. Moreover, control
changes will not only influence the incentives of top management, but will also affect the
incentives of employees2. “the firm as a set of property rights” perspective argues that :1,
highly complementary assets should be owned in common, which may provide a
minimum size for the firm. 2, as the firm grows beyond a certain point, a new firm should
be created, since giving the central manager control of the periphery increases hold-up
problems there without any compensating gains. Moreover, in the absence of significant
lock-in effect, non-integration is always better than integration, as the integration only
increases the number of potential hold-ups without any compensating gains.
The property rights approach has an important implication: the purchase of
physical assets leads to control of human capital, as it is in a worker’s self-interest to put
more weight on his boss’s objectives as this will put him in a stronger bargaining position
with his boss later. This implication can help us to understand integrations where the
control of organizational assets(or organization capital) rather than the physical capital is
the crucial part (Klein, 1988). However, this implication is only reasonable when the nonhuman assets are important or relevant. In the absence of non-human assets, what are the
conclusions? Another draw back of the property rights approach is that it makes no
distinction between ownership and control. Fortunately, recent work (for e.g., Grossman
& Hart 1988, Aghion and Bolton 1988) shed more light on this issue.
Grossman and Hart’s The costs and benefits of ownership: a theory of vertical and lateral integration
(1986) states “…contractual rights can be of two types: specific rights and residual rights. When it is costly
to list all specific sights over assets in the contract, it may be optimal to let one party purchase all residual
rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party,
they are lost by a second party, and this inevitably creates distortions. Firm 1 purchased firm 2 when firm
1’s control increases the productivity of its management more than the loss of control decreases the
productivity of firm 2’s management.”
2
Hart and Moore’s Property rights and the nature of the firm (1990) analyze this issue in detail.
1
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Book Review 2
Part II. Human capital, Internet Economy and The Theory of Firm
The perspectives on the theory of the firm in part I all appeared before the 90’ of
last century, and the terms of the modern debate on corporate governance were set in the
1930s3. In those days, the dominant model was a vertically integrated firm, controlling a
large set of unique assets through a rigid command-and-control system.(for e.g., GM, the
archetypical vertically integrated public firm, is often cited and studied in literature).
Such organizational form was called MBE (modern business enterprise) (Chandler,
1977), and MBEs dominated most sectors of the US economy by the end of the 1920s.
MBE was well defined by the ownership of assets, and the legal and economic
boundaries of the firm can be represented by the ownership of unique assets. As a
consequence, corporate governance mainly focused on the agency problem at the vertex
of the organizational pyramid.
While economists mostly focus on the framework originated by Berle and Means,
one thing has the changed dramatically over the time: the nature of the firm itself.
Perhaps the most significant effect of such change has been to human capital.
In the past, firms’ main assets (plant, machinery, brand names, etc.) were hard to
replicate and were primarily what made the firm unique. The human capital of employees
was in large part tied to these assets and immobile. Thus ownership of unique nonhuman
assets was the primary source of power4 in the corporation. However, recent changes
have made human capital much more important, and also much more mobile, at the
expense of other more tangible assets, and weakens the command and control system that
emanated from the ownership of the non-human assets. Some of these changes include:
1) as competition has increased, physical assets have become less unique and employees
have many more outside options; 2) competition has increased the importance of a firm’s
innovation ability, which comes from human capital. So at the same time as employees
have been unshackled by the competitive market, they have also become more important
“The modern corporation and private property” by Berle and Means came out in 1932. This book focused
on the separation of ownership and control in large corporations where multiple layers of salaried managers
coordinate production and distribution.
4
Power here refers to the control over valuable resources over and above that determined through explicit
contract in a competitive market. Economists say an agent in an organization has more bargaining power if
he can get more of the surplus produced by the organization, net of costs.
3
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Book Review 2
to firms. Then, where does top management get authority over subordinates, especially as
human capital is not ownable? What determines the boundary of the firm?
How does a firm obtain control over a unit that is composed entirely of human
capital when slavery is impossible? What needed are links that cause the person or unit to
be better off voluntarily following the firm’s commands rather than going their own way.
Such links are called “complementarity” by economists, and I learn this from Rajan and
Zingales, 1998. A complementarity is said to exist when the unit and the firm can
together create more value than they can when going their own separate ways, and it
induces a unit to obey orders from the firm for fear that disobedience would jeopardize
the joint value they can create together. So, while ownership legally links non-human
assets to a firm, complementarities link to the firm the human assets that can not be
owned by the firm. Complementarities can be built through technical specialization or
firm-specific specialization5. Competition destroyed technical specialization as a source
for complementarity since employees could do as well by joining competitors. So, for
firms to acquire power over their employs’ human capital, the firm has to get employees
to make firm-specific investments. But will employees have such incentives to make
firm-specific investments, which will make them more dependent on the firm, as
compared to acquiring more marketable technical skills?
The answer is “yes” if the firm gives key employees/units privileged access to the
enterprise or its critical resources, so that they will gain power if they specialize6. For
e.g., a brokerage firm usually gives brokers leads to new clients, and thus effectively
allocate valuable residual rights or power to brokers. Of course, the power from the
privileged access is contingent on the employees’ specializing. If the brokerage provides
enough unique value to clients, the broker is of little value without the firm to back him.
By investing in building client relationships, the broker builds complementarities
between himself and the brokerage, giving the latter some power over him. But the
broker also has power over the brokerage because he “owns” the clients. Thus, the broker
and brokerage achieve an more balance of power than do employee and firms in
Chandler’s vertically integrated MBE.
“technical specialization” is specialization to the technology necessary for production in and industry, and
“firm-specific specialization” is specialization to the idiosyncratic needs of the firm.
6
See Rajan and Zingales (1998a) for more on “control over access”.
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Book Review 2
When the ownership of non-human assets is no longer the primary source of
power, mutual dependence and specialization between various units of enterprise
generate the power to govern transactions. Since ownership is relatively unimportant, and
human capital is not tied to non-human assets, the boundaries of the firm become less
distinctive. Something is more a part of the enterprise when it has greater
complementarities with the rest of the enterprise. Besides, as the firm gets power over its
employees because it commits to share surplus generated by complementarities with the
employees, the surplus is shared much more evenly in the firm instead of concentrated at
the top, and corporate governance expands beyond watching top managers. As employees
have a larger stake, and share price corresponds more closely to factors in their control
(because of the common ownership with the firm), the role of ownership in providing
motivation have increased. For e.g., the generalized award of stock options to employees
in high tech companies.
By so far, we see when human capital replaces non-human capital as the main
source of value, the origination of authority, and consequently, the monitoring and
motivation schemes of the firm greatly change from what we learn in part I.
In the remaining of Par II, I’ll take a slightly different perspective: how those old
ideas about the firm, particularly those after Coase’s transaction cost theory, can be used
to help answering questions like “What’s the boundary of the firm?” in the Internet
economy7.
Coase theorized that the transaction cost frequently determine whether or not a
company will seek an outside supplier or service provider. At the time he wrote his
famous article, the transaction costs were prohibitively high. As information flowed at a
glacial speed, and supplies moved only slightly faster, companies strove to manage the
7
For e.g., an article in New York Times (Nov. 2, 2000) wrote “ Mr. Coase, … has recently witnessed a
revival of his ideas, particularly among dot-com executives and leaders of established companies as the
forge internet initiatives. And though his theories do not provide a road map for e-commerce success, they
do provide a compass for executives whose strategic vision has been blurred by a sandstorm of alliance
offers, shifting business models and new competition…”
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Book Review 2
entire chain of production within the walls of their own corporation8. However, with
Internet, the transaction costs have plunged. In the so-called new economy, information
itself is typically the product and it comes within a few clicks and moves at the speed of a
T1 line. So, companies can easily get complete information about potential suppliers and
business partners, and set up contracts with its suppliers and alliance companies with only
a fraction of what it would have cost years ago. This might help to explain the increasing
number of alliance announcements of dot-coms in the past two years9. Coase’s theory
thus applied here: with diminishing transaction costs, more alliances are inevitable.
Here are some quotes. David Ernst of Mckinsey & Co. put it “with lower
transaction costs, companies are able to focus on narrow product slivers or business
activities, and have other parties do the rest… if you have a network of partners you can
attract incremental business, and plug the revenues back into your core business,..” David
Jefferds of CyberElves said “…we could probably target that by partnering with firms,
getting expertise, and then making the buy-versus-build decision.” Of course, an alliance
does not come as a free lunch. Jefferds explained “you’re taking a risk with a client that
you’re really not compensated for” and Earnst pointed out managing alliance was
particularly critical. For some dot-coms, their alliance even include their competitors, and
this phenomenon is totally beyond the old idea of “buy or merge”.
The points made earlier about human capital are particularly relevant with dotcoms. The employees are the principal source of the firms’ costs, and they’re all
shareholders, and there exists a real advantage of having people see the value of their
work on daily basis. As a consequence, there is advantage to having a smaller operation.
What’s more, as these employees (themselves being valuable assets) do not require
enormous investments, there is no deed to have a large number of investors. Thus,
ownership and operational control are much more closely associate, and the traditional
principle-agent analysis weakens here. In the Internet economy, “alliance and
partnership” makes more sense than “buy and merge”.
For e.g., the Ford Motor Company, a paragon of the “vertically integrated” corporation of the early
1990’s, bought Fisher (a rubber plantation) rather than cede control of that part of tire manufacturing. We
discussed this example extensively during the class.
9
Other reason for Internet alliance partners might be using it as a way of building pre- IPO buzz.
8
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This might also help to explain why in recent years, we’ve seen some of the large
vertically firms breaking apart. However, we also see increase in merger activity in recent
years. Is it evident against the argument in Part II? No. Rajan and Zingales (1998)
explained this with the example of mergers in the media industry. According to them, in
now days, a sizeable fraction of mergers are horizontal mergers (as compared with the
vertical mergers in the past), a way of re-gaining market power. For current vertical
mergers in some industries, Rajan and Zingales propose that such mergers help building a
value line to get substantial investment to make advantage of some special assets (e.g.,
brand name). Examples and detailed explanation can be found in their paper.
In conclusion, while I was reading through “ Organization theory”, theories of the
firm (as in Part I) captured my interest, and also arose questions: how those theories can
be validated or adopted in new economy? These questions pushed me to sources outside
the book itself, and lead to Part II in this review.