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Why Business Organizations?
A striking aspect of contemporary market economies is the
importance of large, organized groups working together as
business firms. The self-employed individual who works alone
is the exception in our economy--only a small fraction of
those working fit into this category. There is a puzzle
here, because in the large firm the role of the market as a
coordinator of decisions is replaced by commands of a
hierarchical authority. From a worker's point of view, for
example, factory life in the market economy of the United
States is very similar to factory life in a command economy
such as that of the former Soviet Union. In both systems,
the number of people working at various tasks in a factory
as well as the schedule they must work is determined not by
a market, but by orders coming from above.
The division of labor provides one possible reason
for the existence of organized firms. If a complex task is
divided into a series of parts, and a specialist does each
part, much more can be produced than if everyone tries to do
the whole task alone. Adam Smith wrote a famous passage
emphasizing this point:
"To take an example, therefore, from a very
trifling manufacture; but one in which the division of
labour has been very often taken notice of, the trade of
the pin-maker; a workman not educated to this business
(which the division of labour has rendered a distinct
trade), nor acquainted with the use of the machinery
employed in it (to the invention of which the same
division of labour has probably given occasion), could
scarce, perhaps, with his utmost industry, make one pin a
day, and certainly could not make twenty. But in the way
in which this business is now carried on, not only the
whole work is a peculiar trade, but it is divided into a
number of branches, of which the greater part are
likewise peculiar trades. One man draws out the wire,
another straights it, a third cuts it, a fourth points
it, a fifth grinds it at the top for receiving the head;
to make the head requires two or three distinct
operations; to put it on, is a peculiar business, to
whiten the pins is another; it is even a trade by itself
to put them into the paper; and the important business of
making a pin is, in this manner, divided into about
eighteen distinct operations, which, in some
manufactories, are all performed by distinct hands,
though in others the same man will sometimes perform two
or three of them. I have seen a small manufactory of this
kind where ten men only were employed, and where some of
them consequently performed two or three distinct
operations. But though they were poor, and therefore but
indifferently accommodated with the necessary machinery,
they could, when they exerted themselves, make among them
about twelve pounds of pins in a day. There are in a
pound upwards of four thousand pins of middling size.
Those ten persons, therefore, could make among them
upwards of forty-eight thousand pins in a day. Each
person, therefore, making a tenth part of forty-eight
thousand pins, might be considered as making four
thousand eight hundred pins in a day. But if they had all
wrought separately and independently and without any of
them haveing been educated to this peculiar business,
they certainly could not each of them have made twenty,
perhaps not one pin in a day...."
However, the division of labor need not cause business
organizations; it could instead result in a series of
different professions. One could imagine the profession of
the wire drawer, who would sell his output to the wire
straighteners, who would sell their output to wire cutters,
etc. The market could coordinate their activities instead of
a manager. It would raise price for any good that was in
short supply and lower price for any good in surplus,
thereby encouraging people to produce each step in the
proper proportion. In fact in the earliest stages of the
industrial revolution, the textile industry was made up of
the separate professions of carder, spinner, weaver, etc.
and they worked separately in their own homes. Early in the
industrial revolution these trades were brought together
under the factory roof, and a system of hired workers
working under supervision replaced the individual
craftsmen.
One can also imagine a system in which one person owned
the pin-making equipment and contracts with people each day
to operate the equipment. With this method, which has been
used since antiquity in agriculture, the usual
employer-employee relationship does not exist. The hired
worker can agree to do a specific task, and pay for each
task can vary from day to day. A modern firm uses this
relationship when it hires the services of outside
consultants, lawyers, or accountants. The person hired is
not considered a normal employee because the power of the
employer to give orders--to direct his efforts to where the
employer sees fit--is very limited. The tasks that the
outside person does are agreed to in a market
transaction.
A second possible reason for business organizations is
that man is a social animal and that he would rather
work in groups than alone. A problem with this hypothesis is
that people do not just work together in groups, but they
work under the supervision and orders of a "boss." Few
people profess to enjoy obeying orders.
An interesting solution to this problem was suggested in
1937 by Ronald Coase. Coase argued that "...the main reason
why it is profitable to establish a firm is that there is a
cost of using the price mechanism." This cost may come from
the difficulty of discovering what the prices are, but a
more important source is in the problems of
negotiating a separate contract for each exchange
transaction. A simple contract, often for a fairly long
term, is agreed to instead. The exact tasks that the
employee is to do are nebulous, but the employee agrees to
obey the employer's orders to do a wide variety of
tasks.
Coase said that the firm will expand whenever the cost of
organizing a transaction within the firm is less than
carrying out the same transaction by an exchange in the
market. Development of the giant corporation can be
explained by the improvement in management technique. This
theme has been developed by Alfred Chandler, who examines
the growth of the managerial corporation in America in a
book entitled The
Visible Hand
(Belknap Press, 1977). The title refers to the
"invisible hand"
of Adam Smith, who discussed the capability of the market to
coordinate the actions of many individuals producing
different products. The visible hand refers to the role of
managers in coordinating the actions of many individuals,
each doing a specialized task.
The development of the assembly line is an example of a
discovery that made coordination by command cheaper.
Most people understand that an assembly line breaks a
complex task into a series of simple tasks and thus captures
benefits from the division of labor. But it also makes
monitoring workers easier. The manager can better see how
well each worker performs. Because the production process
flows from one task to the next, a worker who does a poor
job or a slow job will quickly become obvious. Poor
performance at one task will cause problems further down the
line. Further, there is a whole group of managers on the
floor--the foremen--who monitor, try to solve any problems
that do occur, and make decisions about where particular
people should be used.
Coordination in the firm is by command, although
persuasion and various sorts of exchanges may also be
important. A manager determines the exact task a person
performs. The manager's challenge is to decide how best to
use the available resources. Coordination in the market is
based on voluntary transactions. The ability of command to
coordinate is obvious, whereas the ability of the market to
coordinate is not so obvious. This difference is apparent
whenever the economy experiences a problem; there is always
a demand that the government "do something." In the 1930s,
it responded with massive public works. In the early 1970s,
when the public realized that inflation was a problem, the
clamor for action led to wage and price controls. The rapid
rise in oil prices in the late 1970s led to a mass of
regulations. In each of these cases and in a huge number of
others that could be cited, restrictions are placed on the
market. Instead of relying solely on coordination through
the market, the government decides to rely at least partly
on command. What is remarkable, however, is that in few of
the cases of government intervention is there convincing
evidence that the government action had its intended effect.
In a many of them, there is some evidence, although often
not conclusive, that the government action had harmful side
effects. The difficulty of achieving results through
government action may be largely due to the costs of using
command--the visible hand--as a means of coordination.
If there were no costs to using command, one would expect
the vision (or nightmare) of Karl Marx to be reality
today--monopoly capital. In Marx's vision, one capitalist
would gobble up another until in the end only a few giant
capitalists would own and run everything. Then, the
revolution would come. But this vision of the giant
capitalists ignores the costs of giving incentives to
workers, monitoring their behavior, and deciding how best to
use their skills. It is ironic that the closest
approximations to the monopoly capitalists that Marx
predicted were the centrally-planned states of Eastern
Europe and the Soviet Union. In their attempt to eliminate
the market, they organized their economies as a giant
state-run enterprise. The poor performances in satisfying
consumer wants that these economies experienced were largely
due to their use of command in places where the market was a
much cheaper way to organize.
Industries that have the ability to easily monitor
quality and speed will find coordination by command cheap.
Such industries will generally have increasing returns to
scale and thus large firms. Industries in which it is not
easy to monitor quality and speed will tend to have many
small firms. Agriculture is an example of this second sort
of industry. Attempts to farm on a large scale have not been
notably successful in the United States. In the former
Soviet Union and in other socialist countries, the
structuring of agriculture in large organized farms was
disastrous in terms of food production. Agriculture cannot
be made into an assembly-line process, and the many factors
that determine the success of the crop make it difficult to
determine responsibility if someone does shirk. As a result,
very large land owners in the United States more often rent
their land to independent farmers than hire farmers to
cultivate it.
In the abstract theory of exchange economics, the
internal world of the firm does not exist. All coordination
is through the price mechanism. However, the existence of
large organizations, established on a voluntary basis,
points out that coordination through the invisible hand
requires resources, and that those who find ways to
coordinate more cheaply can profit from their discoveries.
In a way, the existence of large firms is an irony in a
market economy. They indicate that a way to succeed in a
market economy is to find a better way to coordinate people
than market coordination, to replace the market by
command.
Perhaps a reason that team sports are so popular in a
country that so honors the individual is that they reflect a
paradox of the modern world: those groups that cooperate
best internally are best able to compete externally. Team
sports encourage both cooperation and competition; the two
are not incompatible. The often-heard criticism of
capitalism, that it encourages competition and thus
discourages cooperation, ignores the very existence of the
large coordinated enterprises that are most visible in the
economy.
Next we discuss screening
and signaling.
Copyright
Robert Schenk
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