Economics 267
Industry and Government
Summer 2003
Tu-Th 9:00-12:15 Castleman 201
R. N. Langlois
Langlois@UConnVM.UConn.edu
http://vm.uconn.edu/~langlois
Office: Room 322 Monteith
Office hours by appointment
Points to remember.
 Come to class.
 Check online syllabus
regularly for new links
and materials.
2
Competition.
What is
competition?
Why is it good?
3
Two views of competition.
 Competition as a process.
 Meaning of ordinary language.
 Competition as active striving, rivalry.
 Competition as a state of affairs.
 Formal, technical view.
 Lack of power over price.
P  f(Q)
4
The competitive spectrum
Oligopoly
Monopoly
Atomism
?
Only one seller, who
is effectively
insulated from
competition.
A handful of sellers,
each one able to affect
price but affected in
turn by the behavior of
competitors.
Many sellers, each
one too small to
affect market price.
5
Perfect competition.
 Large number of “small”
buyers and sellers.


None large enough to
affect market price.
“Atomism.”
 Homogeneous product.
 Each product a perfect
substitute for all others.
 A subjective, not objective,
criterion. (Eyes of the buyer.)
6
Perfect competition.
 Productive resources
freely mobile.


Free entry and exit.
No “barriers to entry.”
 Perfect knowledge.
 Everyone knows all buyers
and sellers.
 Everyone uses best practice
technology.
 Implies all firms identical.
7
Analysis of perfect competition.
MC
$/q
 Perfect competitor is a “price taker.”
AC
P1
d1

Faces a perfectly horizontal demand curve.
.
 Chooses quantity q* so that MR = MC.
q*
q/t

For perfect competitor, P = MR.
 If P > AC at q*, firm makes a profit.

Π = (P1 – AC)q*


In the short run, when no new firms can enter.
An economic profit.
Marshall: quasi-rents.
8
Analysis of perfect competition.
MC
$/q
S1
D
d1
.
S2
$/q
AC
P1
MC
q/t
AC
P1
P2
q*
$/q
P2
Q1 Q2
q/t
d2
q*
q/t
 In the long run, profit attracts entry.
 Addition of new firms shifts out market supply curve.
 Entry continues until price is bid down to minimum point
of individual firm’s AC curve.
 Price of output now exactly equal to the opportunity cost of
resources used in production.
9
Competition as a process.
 Older view – before Adam Smith
 Competition as striving, rivalry.
 Firms can compete at any size.
 Firms can compete by changing the product.
Adam Smith (17231790). Author of the
Wealth of Nations
(1776). Picture
courtesy of the Warren
J. Samuels Portrait
Collection at Duke
University.
 Knowledge never perfect.
 Knowledge a result of -- not a
requisite to -- competition.
 Competition as a discovery
procedure.
 Free entry still essential.
F. A. Hayek (1899-1992)
10
A comparison.
Structure
Perfect competition
Process competition
Atomism is a
desirable goal.
Any market
structure can be
competitive.
11
A comparison.
Product differentiation
Perfect competition
Undesirable
Process competition
May be a form
of competition.
12
A comparison.
Contractual practices
Perfect competition
Typically undesirable. Evidence
of “market power.”
Process competition
May be evidence of
competition or requisites
to competition.
13
A comparison.
Free entry
Perfect competition
Process competition
Necessary.
Necessary.
14
A comparison.
Knowledge
Perfect competition
Process competition
Should be “perfect.” Diversity
of knowledge can create
“market power.”
Competition as generating
knowledge. Dispersion of
knowledge desirable.
15
Monopoly.
Two systems of belief about monopoly.
 Interventionist monopoly.
 Competition tends to eliminate market
power unless there are government barriers.
 True monopoly is a creature of the state.
 Spontaneous monopoly.
 “Natural tendency” for
monopolies to arise and persist.
 Need for active antitrust policy.
16
Analysis of monopoly.
$/Q
 Firm’s demand curve is the market demand curve.
 MR falls faster than demand.
 Why? Suppose monopolist lowers price.
Loss in revenue from
lowering price to existing
(inframarginal) customers.
P1
P2
Gain in revenue from
attracting new customers.
D=AR
Q1 Q2
No price
discrimination.
Q/t
17
Analysis of monopoly.
$/Q
 Monopolist chooses Qm so that MR = MC.
 Demand curve determines monopoly price Pm.
 Not true that a monopolist
can set “any price it wants.”
Pm
MC=AC
A monopolist
operates on the
elastic part of
the demand
curve.
D=AR
Qm
Q/t
MR
18
What’s wrong with monopoly?
$/Q
 A perfectly competitive industry
would choose Qc where D = MC.
 Economic profit would be zero.
 Shaded area is consumers’ surplus.
MC=AC
Pc
D=AR
Qc
Consumer’s
surplus is the
difference
between what
the consumer is
willing to pay
and what he or
she has to pay.
Q/t
19
What’s wrong with monopoly?
$/Q
CS
Pm
 Monopoly restricts output and raises price
relative to the competitive benchmark.
 Some consumers’ surplus becomes
producer’s surplus (profit).
 Is this what is wrong
with monopoly?
PS
MC=AC
Pc
Transfers of
surplus can be
regressive or
progressive.
D=AR
Qm
Qc
Q/t
MR
20
What’s wrong with monopoly?
$/Q
CS
Pm
 Monopoly restricts output and raises price
relative to the competitive benchmark.
 As a result, some potentially beneficial
gains from trade don’t take place.
 Total surplus is diminished by the
extent of the deadweight-loss triangle.
PS
DWL
MC=AC
Pc
Total (social) surplus
is CS + PS.
D=AR
Qm
Qc
Q/t
MR
21
Pareto efficiency.
 A minimalist criterion of
efficiency.
Vilfredo Pareto
(1848-1923)
 A change is Pareto
improving if it leaves at
least one person better off
and no one worse off.
22
Pareto efficiency.
An allocation is not Pareto efficient if …
23
Pareto efficiency.
There is any
left on the table.
Could make one
better off without
making the other
worse off.
24
What’s wrong with monopoly?
$/Q
 Monopoly is not Pareto efficient.
CS
 Why?
Pm
 Let’s make a deal.
PS
DWL
MC=AC
Pc
D=AR
Qm
Qc
Q/t
MR
25
What’s wrong with monopoly?
A
$/Q
 Consumers ask monopolist to
produce at the competitive level Qc.
 Consumers’s surplus
expands to APcB.
Pm
B
Pc
MC=AC
D=AR
Qm
Qc
Q/t
MR
26
What’s wrong with monopoly?
$/Q
 In exchange, consumers “bribe” the
monopolist by transferring back:
 all producer’s surplus,
 plus (say) half of the DWL.
Pm
 Now both are better off.
MC=AC
Pc
Ah, but
transaction
costs!
D=AR
Qm
Qc
Q/t
MR
27
The competitive spectrum
Oligopoly
Monopoly
Atomism
?
Only one can affect
price. Behavior not
constrained, but only
one “rational” result.
Price and quantity
depend on interaction
among firms.
Expectations matter.
No one can affect
price. Behavior
perfectly predictable.
28
The prisoners’ dilemma.
 Two suspects – Smith and
McAlpin – apprehended for
bank robbery.
 Police have little evidence, so
they arrest them on lesser charges
and attempt to get confessions.
 Suspects taken into separate
interrogation rooms and offered
plea-bargain deals.
29
The prisoners’ dilemma.
McAlpin
Don’t Confess
Smith
Confess
Don’t
Confess
-1, -1
-10, 0
Confess
0, -10
-6, -6
 Difficulty of
coordination.
 Difficulty of
commitment.
30
Oligopoly pricing.
Firm B
PB = $130
PA = $130
Firm A
PA = $105
PB = $105
 Joint profit
maximization.
111, 111 57, 122
 Incentive to
cheat on cartel.
122, 57
 Nash
equilibrium.
95, 95
31
The Cournot model.
 Nash equilibrium:
“A set of strategies is called a Nash equilibrium if,
holding the strategies of all other firms constant, no
firm can obtain a higher payoff (profit) by choosing
a different strategy. Thus, in a Nash equilibrium, no
firm wants to change its strategy.” (Carlton & Perloff, p. 157.)
John F. Nash, Jr (1928-)
 Cournot model.
 Firms compete by choosing quantity.
 Firms can’t coordinate or commit.
 Firms calculate optimal response to
all possible moves by opponents.
 Cournot-Nash equilibrium.
Antoine Augustin Cournot (1801-1877)
32
The Cournot model.
 The Lerner index of market power.
Abba P. Lerner
(1903-1982)
P - MC
L=
P
L = 0 is socially
optimal – no
market power.
 Cournot model with n identical firms.
1
L=
nε
ε is elasticity of demand.
Antoine Augustin Cournot (1801-1877)
 L  0 as n  .
 Market power a smooth
declining function of
number of firms.
 Market concentration
equals market power.
33
Oligopoly pricing.
How secure
is the
relationship
between
concentration
and market
power?
π2
Profit possibilities frontier
On the frontier means
joint-monopoly pricing.
Cournot
Assumptions
are everything.
Stackelberg
Bertrand
At the origin means
efficient pricing.
π1
Carlton & Perloff (1999, p. 164).
34
Oligopoly behavior.
The Harvard School
 Structure largely
determines market power.
 “Tacit” collusion.
Edward H. Chamberlin, 1899-1967
 Unexamined assumptions
about expectations and
transaction costs.
35
Oligopoly behavior.
The Chicago School
 Incentive to cheat on cartel.
 Collusion isn’t free.
 Costs of coordinating.
 Costs of policing.
George J. Stigler, 1911-1991.
 Using transaction-cost
reasoning to address the
problem of interdependence.
36
Oligopoly behavior.
Secret price cutting most likely when:





Number of sellers high.
Products heterogeneous.
Large differences in costs.
Orders lumpy and infrequent.
Price information is secret.
 Role of trade associations.
Elbert H. Gary (1846-1927), founder
of U. S. Steel and convener of the
famous “Judge Gary dinners” at which
Steel industry competitors set
production quotas and collusive prices.
 “Social structure” not conducive
to collusion.
37
Appraising oligopoly.
 Why do we like perfect
competition?
William
Stanley
Jevons,
1835-1882
"The problem of economics may, as it
seems to me, be stated thus: -- Given, a
certain population, with various needs and
powers of production, in possession of
certain lands and other sources of material:
required, the mode of employing their
labour which will maximize the utility of
the produce." (Theory of Political
Economy, 4th ed., p. 267.)


The last unit of output is
earning exactly the
opportunity cost of the
resources that went into it.
Static resource allocation.
 But is that all we might
ask for in appraising
industry structure?
38
Appraising oligopoly.
Two themes.
 Is the setting of optimal
price and quantity the only
economic problem firms are
trying to solve?


The “inhospitability tradition.”
Example: Can collusion in highthroughput industries (like steel) also
lower costs by reducing uncertainty?
 Is static efficiency the
right (or the only)
criterion of efficiency?
39
Appraising oligopoly.
 Economic growth:




Secular increase in output.
Lower prices.
Creation of new products.
Development of new technologies.
 Is there a conflict between
the goal of static resource
allocation and the goal of
economic growth?
40
Schumpeterian competition.
Joseph A. Schumpeter
(1883-1950), author of
Capitalism, Socialism,
and Democracy (1942)
“As soon as we go into details and inquire into
the individual items in which progress was
most conspicuous, the trail leads not to the
doors of those firms that work under conditions
of comparatively [atomistic] competition but
precisely to the doors of the large concerns —
which, as in the case of agricultural machinery,
also account for much of the progress in the
competitive sector — and a shocking suspicion
dawns upon us that big business may have had
more to do with creating [the modern] standard
of life than with keeping it down” (p. 82).
41
Schumpeterian competition.
Creative destruction.
“[T]he problem that is usually being visualized
is how capitalism administers existing
structures, whereas the relevant problem is how
it creates and destroys them” (p. 84)
Joseph A. Schumpeter
(1883-1950), author of
Capitalism, Socialism,
and Democracy (1942)
“… competition from the new commodity, the new technology, the
new source of supply, the new type of organization (the largestscale unit of control for instance) — competition which commands
a decisive cost or quality advantage and which strikes not at the
margins of the profits and the outputs of the existing firms but at
their foundations and their very lives. This kind of competition is
as much more effective than the other as a bombardment is in
comparison with forcing a door, and so much more important that
it becomes a matter of comparative indifference whether
competition in the ordinary sense functions more or less promptly;
the powerful lever that in the long run expands output and brings
down prices is in any case made of other stuff” (pp. 84-85).
42
Schumpeterian competition.
The “Schumpeterian hypothesis.”
Joseph A. Schumpeter
(1883-1950), author of
Capitalism, Socialism,
and Democracy (1942)
 Do big firms (or firms with market
power?) innovate more than small firms?
 A relatively confused and arid debate.
 Empirical evidence: oligopolies are more
innovative than either perfect competitors
or monopolists.
 Do firms innovate well because they are
big – or do they get big because they
innovate well?
43
Barriers to entry.
 Monopoly model and
Cournot model both
assume no threat of entry.
 But economic profits
are a lure to potential
entrants.
 Barriers to entry.
 What are they?
44
Barriers to entry.
Bain.
Joe S. Bain, 1912-
Barriers to entry: “the extent to
which, in the long run, established
firms can elevate their selling prices
above the minimal average costs of
production and distribution …
without attracting potential entrants
to enter the industry.” (Industrial
Organization. New York: Wiley,
1968, p. 252).
45
Barriers to entry.
Bain.
Examples:
 High capital costs.
 Large advertising
expenditures.
 Everything but
the kitchen sink.
Joe S. Bain, 191246
Relative cost advantages.
 Can factors like capital
costs or advertising
expenditures be barriers
just because they are
high?
 Assume all firms have
identical costs but that
average costs are declining.
47
Relative cost advantages.
Deterring
small-scale
entry
But what
deters
large-scale
entry?
$
D
Incumbent can set a limit
price PL to deter entry at
any scale less than MES.
AC
PL
QE
MES
Q/t
48
Relative cost advantages.
 Entry is not always, or even usually,
about small entrants challenging
large incumbents.
 Entry of large-scale competitors
with complementary assets.
 Example: Bowmar Brain.
 Entry from a different
technological base.
 Example: locomotives.
49
Strategic entry deterrence.
 Can an incumbent use strategy
to deter large-scale entry?

Remember: we are assuming
firms have identical costs.
 Sylos postulate:
 Incumbent firms threaten to
maintain their output in the
face of entry.
 Entrants left with “residual”
demand curve.
50
Strategic entry deterrence.
Incumbent(s)
choose a limit
price PI that
ensures that the
entrant can do
no better than
break even.
So, is the shape
of the cost curve
a barrier to
entry?
$
Remember that entrant has
same cost curve as incumbent.
D
AC
PI
PE
QE
QI
Residual demand
Q/t
51
Strategic entry deterrence.
(πM, 0)
Stay out
Entrant
Fight
Enter
πM > πS > 0 > πW
(πW, πW)
Incumbent
Share
(πS, πS)
 A potential entrant who believes the threat to maintain output will
be deterred.
 But the Sylos postulate is not a credible threat, since incumbent
has no incentive to carry it out once entry has occurred.

πS > π W
52
Strategic entry deterrence.
Credible commitments.
 To make a threat credible, a player must make an
irreversible commitment that changes his or her
incentives or constrains his or her action.
Thomas C. Schelling, 1921-
 Ulysses and the Sirens.
 The Doomsday Device.
Ulysses and the Sirens by John William Waterhouse
(British, 1849-1917), National Gallery of Victoria,
Melbourne, Australia.
Peter Sellers in
Dr. Strangelove
(1964).
53
Strategic entry deterrence.
(πM-C, 0)
Stay out
Entrant
Fight
Enter
(πW, πW)
Incumbent
Share
(πS-C, πS)
 Incumbent invests C (a sunk cost) in (for example) excess
production capacity useful only in the event of a price war.
 The threat is now credible if πW > πS-C.
 The threat is worth making if πM-C > πS.
 So choose C so that πM- πS > C > πS- πW.
54
Strategic entry deterrence.
(πM-C, 0)
Stay out
Entrant
Fight
Enter
(πW, πW)
Incumbent
Share
(πS-C, πS)
 Does this mean that strategic commitments save
the Bain-Sylos account of barriers to entry?
 Notice that, because of the
commitment, the incumbent no longer
has the same costs as the entrant.
55
Absolute cost advantages.
Stigler.
“A barrier to entry may be defined as a
cost of producing (at some or every
rate of output) which must be borne by
a firm which seeks to enter an industry
but is not borne by firms already in the
industry.” (The Organization of
Industry. Homewood, Ill.: R. D. Irwin,
1968, p. 67.)
George J. Stigler, 1911-1991.
56
Absolute cost advantages.
Stigler.
Examples:
 High capital costs are not a
barrier unless the incumbent
didn’t also have to pay them.
 Capital market “imperfections.”
George J. Stigler, 1911-1991.
 Ditto large advertising
expenditures.
57
Absolute cost advantages.
$
ACE
ACI
 Not all absolute cost
barriers are policy
relevant.


A barrier is policy relevant if
removing the barrier will
improve economic efficiency.
Example: Superior
knowledge or technology.
Q/t
58
Raising rivals’ costs.
 Investing resources to
create cost advantages.

It may pay to raise rivals’
costs even if it means raising
your own.
 Example: the strategic
use of regulation.

Margarine and whiskey.
59
Barriers and property rights.
Are there barriers
 All cabs must hold a taxi
to entry in the
medallion.
New York taxicab
 Limited by law to 12,187.
business?
 But incumbents do not
have a cost advantage.
 Insider-outsider distinction
fails to identify a barrier.
60
Barriers and property rights.
Average Annual Medallion Prices 1947, 1950, 1952, 1959, 1960 and annually since 1962. Source: Schaller Consulting.
61
Barriers and property rights.
Demsetz.
 Barriers to entry ultimately
reduce to rights over assets.
 Do the benefits of the barrier
(right) outweigh the costs?
 Rights (barriers) solve
problems of externality.


Harold Demsetz, 1930-

Ordinary property rights.
Taxi medallions?
Transferable pollution quotas.
62
Barriers and property rights.
M
$
S'
Maker of widgets
doesn’t have to pay
full cost of production.
S

An externality.

Example:
pollution.

S is “apparent”
supply curve.

S' is “true”
supply curve.
P'
P
D (demand for widgets).
Pollution quota limits output
by restricting a scarce input.
Q'
Q
Q/t
Industry produces “too many” widgets.
63
Barriers and property rights.
M
$
S'
S
P'
 Original owners
of pollution
rights receive a
scarcity rent.
 Rent is capitalized
into the value of the
rights when they
are exchanged.
P
D (demand for widgets).
Q'
Q
Q/t
64
Scarcity rents.
David Ricardo
(1772-1823)
Image courtesy of the
Warren J. Samuels
Portrait Collection at
Duke University.
Economic rent.
Payments made to a factor that are in
excess of what is required to elicit the
supply of that factor.
• Greater than the opportunity cost.
Alfred
Marshall
(1842-1924)
Quasirents.
Payments made to a factor that are in
excess of what is required to elicit the
supply of that factor in the short run.
• Can be bid away in the long run.
65
Scarcity rents.
$/Q
 Scarcity rents or
monopoly power?
 Assume:
D
MR
 All factors used in
fixed proportions.
 All but one factor
available in perfectly
elastic supply (CRTS).
 One factor
constrained.
Q/t
This analysis follows Winter (1995, pp. 159-167).
66
Scarcity rents.
$/Q
Rent goes to the factor owner.
PA
C
MR
QA
This analysis follows Winter (1995, pp. 159-167).
 Constrained input limits
the production of output.
 Price is above cost, but
firm has no incentive to
restrict output.
 (PA – C)QA is a scarcity rent.
 If the firm owns all of the
constrained factor, it
D
keeps the rent.
 If the firm has to buy the
factor on a competitive
Q/t
market, it bids the factor
price up to (PA – C).
67
Scarcity rents.
$/Q
The difference between the profit and
the scarcity rent is the monopoly rent.
PA
PB
PD
C
 Suppose now that the input
suffices to produce QD.
 A competitive industry
would set price PD and
scarce factor would earn
rent (PD – C)QD .
 But a firm that controls all
the factor would also want
to restrict output to QB .
D
MR
QA
QB
QD
This analysis follows Winter (1995, pp. 159-167).
Q/t
 There is now deadweight
loss.
 The firm’s profit is now
(PB – C)QB .
68
Scarcity rents.
Distinctive knowledge as a scarce factor.
 Kinds of knowledge inputs.


Explicit knowledge as a public good.
Tacit and poorly understood routines.

May also be linked to specific asset or site.
 Can the innovator replicate the input?
 Can competitors imitate the input?


Patents and secrecy.
Complexity and ambiguity.
69
Scarcity rents.
Efficiency-enhancing innovation
Replicable by innovator?
NO
YES
Incentive to restrict output?
NO
Scarcity
(Ricardian)
rents
YES
Imitable?
NO
Scarcity rents + monopoly rents
This analysis follows Winter (1995, pp. 159-167).
YES
Quasirents or
Schumpeterian
rents
70
Barriers to entry.
Conclusion:
 Barriers to entry always
reduce to property rights
over a scarce factor.
 Efficiency or inefficiency
of a barrier depends on:


Costs/benefits
of exclusion.
Demand and
cost conditions.
71
Intellectual property rights.
 Patent.

Origins in medieval and early
modern royal grants.

Letters patent vs. letters close.
 Copyright.
Letters patent of
Queen Elizabeth II, 1964

Protects artistic expression.
 Trademark.

Encourages investment in
reputational capital.
72
The economics of patents.
The invention-motivation
theory of patents.
 Firm expends resources on
R&D to create a new product.
 Expenditures are a sunk cost
equal (in flow terms) to IJKL.
I
J
L
K
73
The economics of patents.
$/Q
A
 Successful innovation
creates a new demand curve.
CS
B
 This generates total
social surplus PcAC.
Pm
PS
DWL
C
Pc
MC
D
D=AR
Qm
Qc
Q/t
MR
74
The economics of patents.
$/Q
A
 A patent confers
monopoly power
for 17 years.
CS
I
J
L
K
B
Pm
PS
DWL
C
Pc
MC
D
D=AR
Qm
Qc
Q/t
 An ideal patent
would exactly
compensate the
firm for sunk
costs of R&D.
 PcPmBD = IJKL.
MR
75
The economics of patents.
$/Q
A
 Consumers still
benefit by PmAB.
CS
I
J
L
K
B
Pm
PS
DWL
C
Pc
MC
D
D=AR
Qm
Qc
 But DWL (area
DBC) is the price
of creating an
incentive to
innovate.
Q/t
MR
76
The economics of patents.
$/Q
A
 Without a patent,
competitors
would bid price
down to Pc
CS
I
?
L
Pc
C
Qc
J
K
 Consumers
(society) would
MC
benefit in principle,
but firms would
have no incentive to
D=AR
expend resources on
Q/t
innovation.
77
Intellectual property rights.
Issues:


A letters patent of
Queen Elizabeth II, 1964

Other mechanisms for
appropriating the returns to
innovation.
Is research seeking the same
idea or many diverse ideas?
Differences in technology and
in the process of technical
advance.
78
Appropriation mechanisms.
Tacit knowledge.
Trade secrets.
First-mover
advantages.
Complementary
assets.
79
Patent races.
Invention-motivation theory assumes inventors
are not competing for the same ideas.
 Patent races and
overfishing models.
 Generating “too much”
research effort.
 But how frequent are
patent races?
James Watson and Francis Crick
with a model of DNA
80
Topography of technological advance.
Science-based
industries.
Cumulative systems
industries.
81
Topography of technological advance.
Science-based
industries.




Discovery of a single explicit
“idea.”
Knowledge is “slippery.”
Invention-motivation theory
works reasonably well.
Example: pharmaceutical
patents and the price of drugs.
82
Topography of technological advance.
Cumulative systems
industries.



Technical advance depends
on small improvements in
an interconnected system.
Knowledge is tacit.
Examples: automobiles,
radio, airframes.
83
Intellectual property rights.
Patent scope.


A letters patent of
Queen Elizabeth II, 1964
General ideas vs. specific
processes.
Example: the Selden patent.
Blocking patents.

The “anticommons.”
Patent pools.
84
Advertising.
 Information or persuasion?
 Assumptions about the
nature and role of
knowledge.



World 1: knowledge free and
perfect.
World 2: information costly.
World 3: open-ended
possibilities.
85
World 1.
 If knowledge is free and
perfect, advertising can
have no informational role.

Assumptions of perfect
competition.
 The only role left for
advertising is to influence
preferences.
86
World 1.
In this world, advertising
is persuasion: it increases
consumer demand.
$
 Does advertising
create brand
loyalty?
 Is advertising a
barrier to entry?
P'
P
D'
D
Q
Q/t
87
World 1.
$
P
Alternatively, advertising
might decrease demand
elasticity.
D
 Increases market
power of firms.
 Makes industry
less competitive?
D'
Q/t
88
World 2.
$/hour
Information is costly.
 Consumers
know which
products exist,
but it is costly
to find (say) the
MCs
lowest price.
 Advertising
reduces search
costs.
MBs'
MBs
S'
S
Search time (hours)
89
World 2.
Benham: the effect
of advertising
restrictions on
prices.
 States varied in restrictions
on the advertising of
prescription eyeglasses
(1963 and before).
 Prices in restrictive states
higher by 25 to 100 per cent
than in laissez-faire states.
 NC: $37.48; Texas and DC:
$17.98.
90
World 2.
Brand loyalty
more important
when advertising
is forbidden.
 States varied in restrictions
on the advertising of
prescription eyeglasses
(1963 and before).
 Prices in restrictive states
higher by 25 to 100 per cent
than in laissez-faire states.
 NC: $37.48; Texas and DC:
$17.98.
91
World 2.
Advertising tends
increase rather
than decrease
demand elasticity.
 States varied in restrictions
on the advertising of
prescription eyeglasses
(1963 and before).
 Prices in restrictive states
higher by 25 to 100 per cent
than in laissez-faire states.
 NC: $37.48; Texas and DC:
$17.98.
92
Truth in advertising.
 If advertising is truthful,
does it ever reduce welfare?

If advertising changes tastes,
which set of tastes do we use
to evaluate it?
 If information is costly, can
advertising mislead
consumers?
93
Truth in advertising.
 Three kinds of goods.
Search goods.
 Experience goods.
 Credence goods.

 Actual goods may have
characteristics of two
or more types.
94
Truth in advertising.
 Search goods.

Qualities can be determined
prior to purchase.


Consumer can cheaply verify
the truth of claims about search
characteristics.


Size, ripeness, color, etc.
Incentive to target ads
to the right consumers.
Misleading advertisement of
search characteristics costly to
advertiser.
95
Truth in advertising.
 Experience goods.


Qualities can be determined
only after purchase.
Direct information about quality
harder to verify (and thus less
valuable to consumers).


Non-specific claims of quality
or no quality claims at all.
Indirect information.


Advertising as a signal.
Advertising and reputational
capital.
96
Truth in advertising.
 Credence goods.

Qualities can’t be determined
even after purchase.




Medical care, car repair.
Consumers uncertain about
both amount and quality.
Producers have scope to sell
“too much” or cheat on quality.
But this has little to do
with advertising.

Information costs and the
“optimal amount of fraud.”
97
World 3.
 Do people have a complete list
of all possible products in their
heads?
 Advertising as competition for
scarce attention.
 The medium is the message:
value of advertising is the fact
of advertising not the message.
 As number of products increase,
will advertising have to yell
louder?
98
Network effects.
A network is a
system of
complementary
nodes and links.
See the Dictionary of Terms in Network Economics.
99
Network effects.
Physical connection
networks.
Mark Twain
had one of
the first
telephones
in Hartford.
“Virtual” networks.
 Hardware-software
networks.
100
Network effects.
Standards:
The set of rules
that assure
compatibility
between nodes
and links in the
network.
The great Baltimore fire of 1904.
101
Network effects.
Network effects:
See the Dictionary of Terms in Network Economics.
Membership in the
network becomes more
valuable in proportion
to the number of other
people who are already
members (or who are
expected to become
members).
102
Path-dependence and “lock-in.”
Paul A. David, 1935-
A path-dependent sequence of economic
changes is one of which important
influences upon the eventual outcome can
be exerted by temporally remote events,
including happenings dominated by
chance elements rather than systematic
forces. (David 1985, p. 332).
 Example: the QWERTY keyboard.
The Sholes & Glidden
Type Writer (1874)
103
Path-dependence and “lock-in.”
The story of QWERTY.
Paul A. David, 1935-
The Sholes & Glidden
Type Writer (1874)
 Christopher Latham Sholes 1868.
 Remington produces first model 1874.
 The QWERTY layout:
 Marketing gimmick?
 Attempt to slow typing speed?
 Crucial typing contest in Cincinnati 1888.
 The invention of touch typing.
 A historical accident that QWERTY won?
104
Path-dependence and “lock-in.”
Typing as a virtual network.
 Hardware: the keyboard layout.
Paul A. David, 1935-
The Sholes & Glidden
Type Writer (1874)
 Software: touch-typing skills.
 Technological interrelatedness.
 High conversion costs.
 Positive feedback.
 “Tipping” to a dominant standard.
105
Path-dependence and “lock-in.”
Are we “locked in” to an
inefficient keyboard standard?
Paul A. David, 1935-
The Sholes & Glidden
Type Writer (1874)
The
QWERTY
keyboard.
The Dvorak
keyboard.
106
Path-dependence and “lock-in.”
 The choice of QWERTY
not entirely historical
accident.


There were many
competing typewriters.
There were many typing
contests like the one in
Cincinnati.
Liebowitz and
Margolis criticize the
QWERTY story.
 Dvorak is not greatly
superior to QWERTY.


The Navy study.
The importance of rhythm.
107
Path-dependence and “lock-in.”
 Sensitivity to starting
point.
 But no inefficiency.
 Examples:


First degree
path dependency.
Liebowitz and Margolis (1995).
Language.
Side-of-the-road
driving conventions.
108
Path-dependence and “lock-in.”
 Sensitivity to starting
point.
 Imperfect information.
 Outcomes are
regrettable ex post.
 But no inefficiency, in
the sense that no better
decision could have
been made at the time.
Second degree
path dependency.
Liebowitz and Margolis (1995).
109
Path-dependence and “lock-in.”
 Sensitivity to starting
point.
 Inferior outcome.
 Inefficient, in the
sense that the inferior
outcome could have
been avoided.
 Error is remediable.
Third degree
path dependency.
Liebowitz and Margolis (1995).
110
Path-dependence and “lock-in.”
 Technology B is superior.

Table from Arthur (1989).
Produces highest value in the long term.
 But Technology A has higher short-term payoffs.

Example: QWERTY stops mechanical keys from jamming.
 Conclusion: choice of – and lock-in to – wrong standard.
111
Path-dependence and “lock-in.”
Table from Arthur (1989).
 But this result depends on imperfect information.
 If users could correctly forecast, they would adopt B.
 The real issue: which institutional structure will choose
best under poor information?
 Do markets choose badly?
112
Path-dependence and “lock-in.”
 The role of a technology “champion.”

Table from Arthur (1989).
Someone who “owns” a system has an incentive to see it adopted.
 Champions who forecast higher long-term payoffs can
subsidize adoption in the short term.

MS-DOS versus Apple and other examples.
 Competing champions and local knowledge.
113
Standards as barriers.
Types of Standards:
 Open versus closed.


Some “semi-open.”
Example: Windows
 Proprietary versus nonproprietary.


Economics of networks predicts a single
dominant standard, not necessarily a
single monopoly owner.

Privately proprietary
(IBM 360).
“Collectively” owned
(fax standards).
Unowned (stereo
systems, Linux?)
114
Anatomy of a network product.
Product 1
Product 2
Ease of use
Ease of use
Style
Style
Autarky
value
Durability
Durability
Maintenance
costs
Maintenance
costs
Compatibility
Synchronization
value
115
Standards as barriers.
 If someone “owns” a
standard, he or she
has a property right
to a restricted input.

The compatibility
attribute.
 Microsoft and the
“applications barrier
to entry.”
116
Standards as barriers.
 Standards as “essential
facilities.”


U. S. v. Terminal Railroad
Association (1912).
Ski slopes and copier parts.
 Standards and “serial
monopoly.”


Schumpeterian competition.
Is (temporary) monopoly necessary to
encourage champions to subsidize
valuable standards?
117
Crafts production.
A1
A2
B1
C1
B2
B3
C2
A4
B4
C3
D1
E1
A3
E2
D2
D3
E3
A5
B5
C4
D4
E4
C5
D5
E5
Time
118
Crafts production.
A1
A2
B1
C1
B2
B3
C2
A4
B4
C3
D1
E1
A3
E2
D2
D3
E3
Time
A5
B5
C4
D4
E4
C5
D5
E5
 Artisans work at their own
pace.
 Differences in absolute and
comparative skill across tasks.
 Ease of “systemic” change in
product.

Uniqueness of crafts-made goods.
 Need for “wide” human capital.

Skilled artisan must master many
different tasks.
119
Factory production.
A1
B2
A1
C3
B2
A1
D4
C3
B2
A1
E5
D4
C3
B2
A1
E5
D4
C3
B2
E5
D4
C3
E5
D4
E5
Time
120
Factory production.
A1
B2
A1
C3
B2
A1
D4
C3
B2
A1
D4
C3
B2
A1
Time
 Shift from parallel to series.
E5
E5
D4
C3
B2

E5
D4
C3
E5
D4

E5

Time phasing of inputs.
Workers work at pace of team.
Workers complements not
substitutes.
 Product standardized.


Difficulty of systemic change.
Ease of “autonomous” change
and learning by doing.
121
Factory production.
A1
B2
A1
C3
B2
A1
D4
C3
B2
A1
D4
C3
B2
A1
Time
 Physical capital saving.
E5
E5
D4
C3
B2

E5
D4
C3

E5
D4
E5
Need only one set of tools.
Economizes on work-in-process
(buffer) inventories.
 Human capital saving.



“Deskilling.”
Workers sorted by comparative
advantage.
Human capital “deepening”
instead of widening.
122
The division of labor.
 Improvement in “skill and
dexterity.”

Charles Babbage
(1791-1871).
Learning by doing.
 Spread fixed set-up costs.

Less “sauntering” between tasks.
 Increased innovation.


Operative focused on and benefits
from “abridging labour.”
Specializing in invention.
 Assign operatives according to
comparative advantage.
Adam Smith (1723-1790).
Author of the Wealth of Nations
(1776). Picture courtesy of the
Warren J. Samuels Portrait
Collection at Duke University.
123
The division of labor.
Howe pin-making machine, about
1840. (Smithsonian Institution.)
 Adam Smith (1776): ten men could
make 48,000 pins a day, or almost
5,000 per person per day.
 Karl Marx (1867): one woman or girl
could supervise four machines, each
making 145,000 pins per day, for
almost 600,000 per person per day.
 Pratten (1980): one person could
supervise 24 machines, each making
500 pins a minute, or about 6 million
pins per person per day.
124
The problem of organization.
A1
B2
C3
D4
E5
 But the division of labor by itself doesn’t say
anything about the boundaries of the firm.
 Are the stages of production each a separate
firm, or are some stages within a single firm?
 Vertical integration.
125
The problem of organization.
X1
X2
X3
black box
Q
 The theory of the firm we’ve
learned so far doesn’t help much.
 The firm as a black box.
 Boundaries of the firm assumed.
126
Why are there firms?
The master gun-maker -- the entrepreneur -- seldom possessed a factory or workshop. ...
Usually he owned merely a warehouse in the gun quarter, and his function was to acquire
semifinished parts and to give those out to specialized craftsmen, who undertook the
assembly and finishing of the gun. He purchased material from the barrel-makers, lockmakers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture makers, and, if he
were engaged in the military branch, from bayonet-forgers. All of these were
independent manufacturers executing the orders of several master gun-makers. ... Once
the parts had been purchased from the "material-makers," as they were called, the next
task was to hand them out to a long succession of "setters-up," each of whom performed
a specific operation in connection with the assembly and finishing of the gun. To name
only a few, there were those who prepared the front sight and lump end of the barrels;
the jiggers, who attended to the breech end; the stockers, who let in the barrel and lock
and shaped the stock; the barrel-strippers, who prepared the gun for rifling and proof; the
hardeners, polishers, borers and riflers, engravers, browners, and finally the lock-freers,
who adjusted the working parts. [G. C. Allen, The Industrial Development of Birmingham and
the Black Country, 1906-1927. London, 1929, pp. 56-57.]
127
Why are there firms?
 “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.”
Ronald H.
Coase (1910-)

Cost of discovering the relevant prices.


Costs of negotiating and concluding a separate
contract for each exchange.


Not completely eliminated by intermediaries.
Employment contract vs. spot contract.
Costs of coordinating when tasks are uncertain.
128
The parable of the secretary.
 Why not pay for office services
by the piece?

$1 per letter typed, etc.
 Manager unlikely to know in
advance which services needed.
 Manager pays for the secretary’s
time, and decides tasks later.

Contract for “job description.”
129
The size of the firm.
A1
B2
C3
D4
E5
Ronald H.
Coase (1910-)
 The size of the firm not its output (Q)
but the number of transactions or
activities within its boundaries.
130
The size of the firm.
 Why doesn’t the firm expand
forever?
 V. I. Lenin: “The whole of
society will have become one
office and one factory.”
 But: diminishing returns to
internal coordination.

Management as a fixed factor.
131
The size of the firm.
Ronald H.
Coase (1910-)
“A firm will tend to expand until the
costs of organising an extra transaction
within the firm become equal to the
costs of carrying out the same
transaction by means of an exchange
on the open market or the costs of
organising in another firm.” (Coase 1937, p. 395.)
132
The size of the firm.
$
CPS + CAC
Costs of
administrative
coordination.
Costs of the
price system.
T*
Size of the firm.
Number of transactions
(ordered from most to least costly to
execute through the price mechanism). 133
The size of the firm.
“It should be noted that most inventions will
Ronald H.
Coase (1910-)
change both the costs of organising and the
costs of using the price mechanism. In such
cases, whether the invention tends to make
firms larger or smaller will depend on the
relative effect on these two sets of costs. For
instance, if the telephone reduces the costs of
using the price mechanism more than it reduces
the costs of organising, then it will have the
effect of reducing the size of the firm.”
(Coase 1937, p. 397n.)
134
The nature of the firm.
Armen Alchian
(1919-)
Harold Demsetz
(1930-)
 But is a firm something
different from a market?
 “Telling an employee to type this
letter rather than to file that document
is like my telling a grocer to sell me
this brand of tuna rather than that
brand of bread.” (Alchian and Demsetz 1972, p. 777.)
 The firm as a nexus of contracts.
135
Transaction costs.
 The “costs of using the price system”
came to be called transaction costs.
 Ex ante transaction costs.
Ronald H.
Coase (1910-)

The costs of finding trading partners,
negotiating, coordinating.
 Ex post transaction costs.

The costs of opportunism after the deal
is made.

Oliver E.
Williamson (1932-)

“Self-interest seeking with guile.”
Asset specificity versus moral hazard.
136
Composite quasirent.
Alfred Marshall
(1842-1924)
Indeed, in some cases and for some purposes, nearly the whole
income of a business may be regarded as a quasi-rent, that is an
income determined for the time by the state of the market for its
wares, with but little reference to the cost of preparing for their
work the various things and persons engaged in it. In other
words it is a composite quasi-rent divisible among the different
persons in the business by bargaining, supplemented by custom
and by notions of fairness … Thus the head clerk in a business
has an acquaintance with men and things, the use of which he
could in some cases sell at a high price to rival firms. But in
other cases it is of a kind to be of no value save to the business
in which he already is; and then his departure would perhaps
injure it by several times the value of his salary, while probably
he could not get half that salary elsewhere.
(Marshall 1961, VI.viii.35.)
137
Asset specificity.
 The “fundamental transformation.”

Oliver E.
Williamson (1932-)
Incentives change once
the contract is signed.
 One party may have an
incentive to “hold up” the other.

Transfer some of the
quasirents of cooperation.
138
Asset specificity.
 One party owns a generic asset.

High value outside of the
transaction (next best use).
 The other party owns a
highly specific asset.


Low value outside the transaction.
Next best use is as a boat anchor.
 Assume also that parties cannot
recontract until “next season.”
139
Asset specificity.
 Cooperation nets $50,000.

Oliver E.
Williamson (1932-)
Agree to split 50/50.
 Once the contract is signed, the
party with the generic asset
threatens to pull out of the
contract.


Demands $49,000 of the
quasirents of cooperation.
“Post contractual opportunism.”
140
Asset specificity.
 Foreseeing such “contractual
hazards,” parties will be reluctant
to cooperate.

Or will choose less specialized but
therefore less efficient technology.
 Vertical integration solves
the hold-up problem.


The two parties jointly own both assets.
Incentives now properly aligned.
141
Asset specificity.
 Choice between markets and
internal organization.

Oliver E.
Williamson (1932-)


Markets promote high-powered
incentives.
Markets can aggregate demands
and realize economies of scale.
But internal organization can
sometimes solve problems of
opportunism.
142
Asset specificity.
The model.
β(k) = bureaucratic costs of internal
governance.
M(k) = governance costs of markets.
k = index of asset specificity.
Oliver E.
Williamson (1932-)
β(0) > M(0) because advantages of markets
not offset by costs of asset specificity.
But β declines faster than M as k increases
(M' > β'  k).
ΔG(k) = β(k) - M(k).
143
Asset specificity.
 As asset specificity
increases, ΔG becomes
negative.
 At critical value of k,
internal organization
preferred to market.
Cost
β0
ΔG
_
k
k
144
Asset specificity.
Economies of scale and scope.
Markets can aggregate demands and take
advantage of economies of scale and scope.
Production-cost penalty for internal
organization.
Oliver E.
Williamson (1932-)
ΔC = steady-state production-cost difference
between producing to one’s own
requirements and the steady-state cost of
procuring the same item in the market.
ΔC always positive but decreasing in k.
145
Asset specificity.
Cost
ΔC + ΔG
ΔC
β0
ΔG
_
k
Market procurement has
advantages in both scale
economies and governance
when optimal asset
specificity is slight.
^
k
k
146
Asset specificity.
Cost
ΔC + ΔG
ΔC
β0
ΔG
_
k
Internal organization has
advantages when optimal
asset specificity substantial.
Little aggregation benefits
when assets highly specific.
^
k
k
147
Asset specificity.
Cost
ΔC + ΔG
ΔC
β0
ΔG
_
k
Mixed governance for
intermediate levels of asset
specificity: some make,
some buy, and all are
dissatisfied.
^
k
k
148
Asset specificity.
Cost
Since ΔC always greater
than zero, firm will
never integrate for
production-cost reasons
alone
ΔC + ΔG
ΔC
β0
ΔG
_
k
^
k
k
149
The hostage model.
Oliver E.
Williamson (1932-)
But sometimes markets can
solve problems of asset
specificity without
integration if cooperating
parties can make credible
commitments before the
contract is signed.
150
The hostage model.
(¼π, ¼π)
Use non-specialized
technology
Party A
Use specialized
technology
Don’t
hold up
(½π, ½π)
Don’t
give in
Party B
(0, -C)
Hold up
Party A
Give in
(0.9π, 0.1π)
 The hold-up threat in extensive form.
 Party A incurs a sunk cost C once the contract is signed.
 Party A’s optimal strategy is to use the lessefficient technology. (Why?)
151
The hostage model.
(¼π, ¼π)
Use non-specialized
technology
Party A
Use specialized
technology
Don’t
hold up
(½π, ½π)
Don’t
give in
Party B
(-h, αh-C)
Hold up
Party A
 Now suppose that Party B
supplies a hostage of value
αh before the game begins.
Give in
(0.9π, 0.1π)
 The hostage — a credible commitment — is
forfeit in the event of contract breach.
152
The hostage model.
(¼π, ¼π)
Use non-specialized
technology
Party A
Use specialized
technology
Don’t
hold up
(½π, ½π)
Don’t
give in
Party B
(-h, αh-C)
Hold up
Party A
 h is the value of the hostage
to B; α is the fraction of h
that has value to A.
Give in
(0.9π, 0.1π)
 A money bond would have α = 1. But is an
in-kind hostage a more credible commitment?
153
The hostage model.
(¼π, ¼π)
Use non-specialized
technology
Party A
Use specialized
technology
Don’t
hold up
(½π, ½π)
Don’t
give in
Party B
(-h, αh-C)
Hold up
Party A
 If αh-C > 0.1π, A will
choose the more efficient
specialized technology.
Give in
(0.9π, 0.1π)
 Even if α = 0, B may have no incentive to
hold up A. Hostage as a signal.
154
Fisher Body.
 Fisher Body pioneers
closed car body.
 GM acquires 60 percent of
Fisher Body in 1919 and
initiates long-term contract.
 In 1926, GM fully
integrates with Fisher.
 Why?
155
Fisher Body.
Klein.
Benjamin Klein
 Closed bodies required more firm-specific
investment than open bodies.
 Contract worked well until 1925, when
GM demand increased.
 Fisher brothers increased short-term profit
by not making new investment.
 Integration (plus side payments) solved
contractual hold-up problem.
156
Fisher Body.
Other explanations.
 GM was trying to ensure
access to specialized human
capital.
 Provisions giving the
Fishers power and incentive
to hold up ended in 1924.
 Did the Fisher brothers hold
up GM after the merger?
157
Moral hazard and monitoring.
 Moral hazard: the incentive to cheat in the
absence of penalties for cheating.

Armen Alchian
(1919-)
Harold Demsetz
(1930-)
Origins in insurance.
 Another kind of “plasticity” of behavior after
contract is signed.
 If monitoring is costly, agents have incentive
to supply less effort than they agreed to.
 Alchian and Demsetz: costly monitoring
explains the organization of the firm.
158
Moral hazard and monitoring.
 Marginal products of team
members not separately measurable.

Team
production.
Members paid on the basis
of the whole team’s output.
 Incentive to shirk.

Each member receives all the benefits
of shirking (leisure) but can spread the
costs of shirking to other members.
 Inefficiency.

Since everyone has the same incentives,
all shirk, and the team ends up in a lowoutput equilibrium no one wants.
159
Moral hazard and monitoring.
 Solution.

Team
production.
One team member becomes
the “boss” and specializes in
monitoring the others.
 But who guards the guardian?

“Boss” also becomes the owner
— the residual claimant — and
is monitored by the market.
 Did Chinese bargemen hire
someone to whip them?
160
Separation of ownership and control.
Adolf A. Berle (1895-1971)
with John F. Kennedy
 Big modern firms are not
owner managed (as in Alchian
and Demsetz story).
 Adolf A. Berle and Gardiner C.
Means, The Modern Corporation
and Private Property (1932).


Separation of ownership and control.
Managers “plunder” stockholders.
161
Agency theory.
Michael C.
Jensen (1939-)
An agency relationship is a
contract under which one or more
persons (the principals) engage
another person (the agent) to
perform some service on their
behalf that involves delegating
some decision making authority to
 Divergence
the
agent. of interest
between principal and agent.
162
Agency theory.
Agency costs are the sum
of:
 Monitoring expenditures by the
Michael C.
Jensen (1939-)
principal.
 Bonding expenditures by the
agent.
 The residual loss of misaligned
incentives.
163
Separation of ownership and control.
 Agency costs of separation small
compared to increased capital supply.

Michael C.
Jensen (1939-)
Risk diversification benefits
of passive ownership.
 Modern corporation has
mechanisms to reduce agency costs.




Stock market.
Takeover market.
Managerial labor market.
Expert boards.
164
Who owns the firm?
 Owners are those persons who share two
formal rights: the right to control the firm
and the right to appropriate the firm’s
residual earnings.

Henry B.
Hansmann
(1945-)

Formal not de facto rights.
It is often efficient to assign the formal right of
control to persons who are not in a position to
exercise that right very effectively.


Because giving those rights
to others would create worse incentives.
For example: why managers
don’t have formal ownership rights.
165
Who owns the firm?
 Ownership falls to a class of patrons.



Henry B.
Hansmann
(1945-)



Capital suppliers.
Customers.
Input suppliers.
Workers.
Government.
No one (but non-profits have donors).
 All ownership structures are really coops.
166
Who owns the firm?
Henry B.
Hansmann
(1945-)
 Which patrons should own the
firm?
 Balance the costs of contracting
(with non-owning patrons) and
the costs of ownership (for
owning patrons).
167
Who owns the firm?
Costs of contracting (with non-owners).
 Monopoly or monopsony.

Henry B.
Hansmann
(1945-)
Example: bottleneck stage.
 Contractual lock-in.

Relation-specific assets.
 Asymmetric information.

One party has specialized knowledge
that is costly to transmit to others.
168
Who owns the firm?
Costs of ownership.
 Monitoring (agency) costs.

Henry B.
Hansmann
(1945-)
All else equal, patrons who are least-cost
monitors are most efficient owners.
 Collective decision-making.

How to aggregate the interests
of members of a patron class?
 Risk bearing.

Which class in the best position to bear risk?
169
Who owns the firm?
 A “capitalists cooperative.”
 Because of asymmetric information,
all other patrons have higher agency
costs.
 Risk diversification benefits
of investor ownership.
The
 Common denominator of profit
public
reduces costs of decision-making.
corporation.
170
Who owns the firm?
 Retail coops rare.


Customers not homogeneous.
Campus bookstores and monopoly.
 Most customer cooperatives
are at the wholesale level.

Customer
cooperatives.

Ace, True Value, IGA, Associated
Press, Sunbeam Bread.
Monopoly supply stage.
 Coops and franchises.
 Financial and insurance mutuals.
171
Who owns the firm?
 Analogous to customer coops.
 Monopsony processing stage.
 Common in agriculture.


Supplier
cooperatives.
Ocean Spray, Land o’ Lakes, Cabot,
Sunkist, much of French wine.
The electric power grid?
 Problems of collective decisionmaking and flexibility?
172
Who owns the firm?
 Proletarian coops rare.

Unskilled workers easier
to monitor than other patrons.
 Most worker-owned firms
in professional services.



Workerowned firms.
Law, medicine, consulting.
Professionals can monitor one another
more cheaply than can outsiders.
Little physical capital per worker.
 Are professional firms consumer coops?

Independent firms sharing common assets.
173
Who owns the firm?
 Some kinds of transactions
pose special agency problems.


Non-profit
firms.
Payments to third parties to provide
goods and services (United Way)
Support of public goods (PBS).
 Customers (donors) are
the natural residual claimants.
 But monitoring by donors costly.
 Ownership by other patrons creates
incentives to appropriate donor resources.
174
Who owns the firm?
 So managers “hold the firm
in trust” for the donors.
 No residual claims – but that
needn’t mean no profit.

Reliance on formal rules and bureaucracy.


Non-profit
firms.
Because market control mechanisms absent.
Boards of directors chosen
for impartiality not expertise.

Important donors sit on board.
 Are non-profits really donors coops?
175
The transaction-cost dichotomy.

Producing.
 Standard price theory.
 Knowledge free and perfect.

Production
knowledge as
“blueprints.”
Transacting.
 Fraught with hazards.
 Knowledge asymmetric and imperfect.

Limited effect on production costs.
176
The economics of organization.
 Asset specificity and holdup.
 Moral hazard and “plasticity.”
Ex post costs can affect
ex ante choice of technology.
177
Maintained assumption.
Oliver Williamson
“A useful strategy for explicating the
decision to integrate is to hold
technology constant across alternative
modes of organization and to
neutralize obvious sources of
differential economic benefit.”
— Williamson (1985, p. 88)
178
Missing elements.
Capabilities.
Qualitative
coordination.
179
Capabilities.
[I]t seems to me that we cannot hope
to construct an adequate theory of
industrial organization and in
particular to answer our question
about the division of labour between
firm and market, unless the elements
of organisation, knowledge,
experience and skills are brought back
to the foreground of our vision
(Richardson 1972, p. 888).
G. B. Richardson (1924-)
180
Capabilities.
Capabilities as the
“knowledge, experience,
and skills” of the firm.
Similar capabilities.
Complementary capabilities.
G. B. Richardson (1924-)
181
Capabilities.
“Where activities are both similar and
complementary they could be co-ordinated
by direction within an individual business.
Generally, however, this would not be the
case and the activities to be co-ordinated,
being dissimilar, would be the responsibility
of different firms. Co-ordination would
then have to be brought about either
through co-operation, firms agreeing to
match their plans ex ante, or through the
processes of adjustment set in train by the
market mechanism” (Richardson 1972, p. 895).
G. B. Richardson (1924-)
182
Capabilities.
 Production knowledge just as
imperfect (and tacit and sticky)
as knowledge in transacting.
 Loasby: standing on its head
Brian Loasby
the implicit presumption of
transaction-cost economics.
Transacting as a kind of production.
183
Coordination.
 As an entrepreneurial or
innovative, not (only) a
managerial or monitoring,
activity.
 As involving changes in the
structure of economic
knowledge.
185
Organization and economic change.
Oliver Williamson
“The introduction of innovation plainly
complicates the earlier-described
assignment of transactions to markets or
hierarchies based entirely on an
examination of their asset specificity
qualities. Indeed, the study of economic
organization in a regime of rapid
innovation poses much more difficult
issues than those addressed here.”
— Williamson (1985, p. 143)
186
Organization and economic change.
 Strength of the selection environment.

“Good enough” not “optimal.”
 Organizational form may depend on the past.

Path dependency.
 Organizational form may depend on the future.

Structural uncertainty.
187
“Dynamic” governance costs.
 The costs of negotiating with,
teaching, and persuading those
who control or can cheaply
create complementary
capabilities.
 The costs of not having the
capabilities you need when you
need them.
188
Two scenarios.
The Visible Hand.
The Vanishing Hand.
189
Scenario 1.
Creative destruction of
existing external capabilities.
Unified ownership and
coordination overcomes
"dynamic" transaction costs.
190
Antebellum America.
 High transportation
and transaction costs.
 Small, localized,
nonspecialized
production and
distribution.
191
The antebellum value chain.
Stage 1
Middleman
Stage 2
Middleman
Stage 3
192
Postbellum America.
 Increased
population and
higher per-capita
income.
 Lower
transportation and
communications
costs.
 the railroad.
 ocean shipping.
 the telegraph.
193
The rise of the large corporation.
Alfred D.
Chandler,
Jr., 1918-
“… modern business enterprise appeared for the first
time in history when the volume of economic activities
reached a level that made administrative coordination
more efficient and more profitable than market
coordination.
Such an increase in volume of activity came with new
technology and expanding markets. New technology
made possible an unprecedented output and movement
of goods. Enlarged markets were essential to absorb
such output. Therefore modern business enterprise first
appeared, grew, and continued to flourish in those sectors
and industries characterized by new and advancing
technology and by expanding markets.” (Chandler 1977, p.
8.)
194
Refrigerated meat packing.
Gustavus F.
Swift (18391903).
Great Union Stock
Yards, Chicago,
early 20th century.
 Before the railroads,
meat raised and
slaughtered locally
 Opening of the western
range led to economies
of scale in cattle raising.
 Live animals shipped to
eastern cities.
195
Refrigerated meat packing.
Gustavus F.
Swift (18391903).
Great Union Stock
Yards, Chicago,
early 20th century.
 Swift recognized
possibilities for additional
economies of scale.
 “Disassembly line” in
Chicago.
 Ship refrigerated dressed
meat to eastern cities.
196
Refrigerated meat packing.
Gustavus F.
Swift (18391903).
Great Union Stock
Yards, Chicago,
early 20th century.
 Systemic reorganization of
meat-packing industry.
 Required network of
refrigerated railroad cars,
ice houses, warehouses,
and retailing outlets.
 Swift forced to integrate
vertically to overcome
dynamic transaction costs.
197
The rise of the large corporation.
Cartel agreements and pools
Alfred D.
Chandler,
Jr., 1918-
Notoriously unstable
Holding company
Exchanging separate firm ownership for shares
in a meta-company
Multidivisional modern corporation
Rationalization and professional management
198
The Chandlerian value chain.
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
199
Why management?
“In the capital-intensive
industries the throughput
needed to maintain minimum
efficient scale requires careful
coordination not only of the
flow through the processes of
production but also of the flow
of inputs from suppliers and
the flow of outputs to
intermediaries and final users.”
(Chandler 1990, p. 24.)
200
Why management?
 Product-flow uncertainty.
 High fixed costs demand
high throughput.
 Thin markets lead to
internal coordination.
 Management as a way to “buffer” uncertainty.
 Product standardization “pushes uncertainty up the hierarchy.”
201
Scenario 2.
Creative destruction of
existing internal capabilities.
Development of institutions
to support market exchange.
202
The Visible Hand.
 Adam Smith:

Increasingly fine division of labor.

Coordination through markets.
 Alfred Chandler:

Visible hand of management
replaces markets.
203
The Visible Hand.
The managerial revolution
is actually a manifestation
of the division of labor.



Management becomes a profession.
The M-form decouples strategic functions
from day-to-day management.
Financial markets separate function of
capital provision from management.

Markets as a way to buffer uncertainty.
204
The Vanishing Hand.
 A new structural revolution?
 Increasing coordination
through markets, including
anonymous markets.
 Development of institutions,
including standards, to
support exchange.
 The visible hand is fading
into a ghostly translucence.
205
The Vanishing Hand hypothesis.
 The Smithian process of the division of labor always
tends to lead to finer specialization of function and
increased coordination through markets.
 But the components of that process —technology,
organization, and institutions — change at different
rates.
 The managerial revolution was the result of an
imbalance between the coordination needs of highthroughput technologies and the abilities of
contemporary markets and contemporary technologies
of coordination to meet those needs.
 With further growth in the extent of the market and the
development of exchange-supporting institutions, the
central management of vertically integrated production
stages is increasingly succumbing to the forces of
specialization.
206
The New Economy.
 Increasing population
and income thicken markets.


With the growth of knowledge,
complementary capabilities in the chain
of production become less similar.
Institutions emerge to support
specialized exchange.


Modularity standardizes
meta-rules, not products.
Financial and other innovations,
including new rights bundles.
207
The New Economy value chain.
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
208
Technology and the New Economy.
“It should be noted that most inventions will change both
the costs of organising and the costs of using the price
mechanism. In such cases, whether the invention tends to
make firms larger or smaller will depend on the relative
effect on these two sets of costs. For instance, if the
telephone reduces the costs of using the price mechanism
more than it reduces the costs of organising, then it will
have the effect of reducing the size of the firm.” (Coase 1937, p. 397n.)
But the division of labor is cumulative
not comparative static.
Internet increases extent of the market as well
as reducing transaction costs
210