Table Of ContentADVANCED TEXTBOOKS
IN ECONOMICS
VOLUME 21
Editors:
C.J. BLISS
M.D. INTRILIGATOR
Advisory Editors:
D.W. JORGENSON
M.C. KEMP
J.-J. LAFFONT
J.-F. RICHARD
NORTH-HOLLAND PUBLISHING COMPANY
AMSTERDAM · NEW YORK · OXFORD
THE ECONOMICS
OF ORGANIZATION
JAMES D. HESS
Claremont McKenna College, Claremont, California
1983
NORTH-HOLLAND PUBLISHING COMPANY
AMSTERDAM · NEW YORK · OXFORD
© NORTH-HOLLAND PUBLISHING COMPANY - 1983
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without the prior permission of the copyright owner.
ISBN: 0444 86589 6
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INTRODUCTION TO THE SERIES
The aim of the series is to cover topics in economics, mathematical economics
and econometrics, at a level suitable for graduate students or final year under-
graduates specializing in economics. There is at any time much material that has
become well established in journal papers and discussion series which still awaits
a clear, self-contained treatment that can easily be mastered by students without
considerable preparation or extra reading. Leading specialists will be invited to
contribute volumes to fill such gaps. Primary emphasis will be placed on clarity,
comprehensive coverage of sensibly defined areas, and insight into fundamentals,
but original ideas will not be excluded. Certain volumes will therefore add to
existing knowledge, while others will serve as a means of communicating both
known and new ideas in a way that will inspire and attract students not already
familiar with the subject matter concerned.
The Editors
ACKNOWLEDGEMENTS
I am deeply indebted to Kenneth Arrow. As the ideas for this book developed,
it was his ear that was bent and his encouragement which pushed the project
ahead. For several years we considered making this a collaborative effort, but
since the initial draft came off my pen, it seemed appropriate that I go ahead
and complete the manuscript. Ken may have difficulty recognizing the final
product, for my selection of topics has changed dramatically over the last two
years. Naturally all errors and stylistic difficulties are mine alone.
Jacob Marschak was an enthusiastic supporter of my work on organizations
and his death was a deep loss to me. Many ideas found here can be traced to
him. Roy Radner shaped my thinking on so many topics that it is hard to con-
ceive of this book without his creative work. Ted Groves' exciting contributions
on incentives was a major reason that I found the economics of organization so
interesting. My colleague during my years at USC, Bob Kalaba, was a tremendous
resource and I owe him more than I can ever repay.
Finally, the process of completing a significant project like this necessitates
sensitive, considerate personal support which was provided in abundance by
Frances and Courtney.
CHAPTER 1
INTRODUCTION
Seldom does a day pass when we do not make a purchase in a market, whether
it be at the corner newspaper stand, the cafeteria, or the gasoline service sta-
tion. Much of our working lives are spent in organizations, such as business firms,
government agencies, or non-profit institutions, carrying out the responsibilities
associated with our positions, responding to our supervisor's requests to perform
new tasks, and directing the activities of our subordinates. For many years econ-
omists have concentrated their investigations on the behavior of buyers and
sellers in markets, leaving it to social psychologists and management scholars to
investigate the internal functioning of organizations. It is the thesis of this book
that economics' dedication to the market allocation of resources is an artificial
and unsound view of social activity. The proper view should be that markets and
organizations are alternative social inventions which can both guide economic
decision-making. A study of either institution without comparison with its al-
ternative leads to a biased judgement of that institution's merits. This point is
often made by political economists who feel that reliance upon governmental
organizations ignores the advantages of markets in dealing with many economic
i problems. The objective of this book is to study the strengths and weaknesses of
organizations as private resource allocation institutions.
Markets and organizations are substitutes and the replacement of one by the
other is a common event. A market displaces an organization when a travel agency
replaces its ticket delivery person with a messenger service. An organization
supplants a market when a firm begins photocopying its own circulars rather than
paying for the services of a printer. Given the ease with which the economic sys-
tem can flow from market to organization and back, it should be clear that there
is a need for a framework for comparing the two institutions. Comparative eco-
nomic systems is a branch of economic analysis but it traditionally investigates
public changes in the form of the economic system, capitalism versus socialism,
and leaves the private micro choice of institutions unexplored. This textbook
1
2 The economics of organization
examines a range of recent economic models which juxtapose market and orga-
nization and which consider their qualities as private institutions for allocating
resources.
Comparison must be preceded by discrimination. A market is an assemblage
of persons who want to arrange the exchange of property. An organization is
a group of persons deliberately united to advance the interests of the group. The
distinction between these institutions hangs on the term "united", for people
use the market to further their own goals of rearranging the ownership of prop-
erty and the members of an organization provide services and receive rewards, a
form of property exchange. To unite, the persons must exchange promises to act
in concert, but for such mutual promises to have value the promisors must anti-
cipate sanctions for reneging. An organization might be thought of as a system
of complicated "social" if not "legal" contracts between the participating par-
ties. Since contracts are an integral feature of market exchange, the distinction
between market and organization must lie in the form of the contract.
Consider the following situation. An individual, referred to as a coordinator,
believes that there are desires for hand sewn leather slippers which are not cur-
rently being satisfied. Although the coordinator knows little about leather work-
ing he decides to enter this industry. He advertises that he would like artisans
who can tan leather to process hides at a given payment per hide. The coordinator
also contacts artisans who can cut and sew slippers to produce a finished slipper
from leather he supplies. To minimize transportation the coordinator rents a
building which the artisans can use. Finally, he arranges to sell the hand-sewn
leather slippers to door-to-door salespersons for a specified number of dollars
per slipper. The coordinator matches the number of hides with the number of
slippers and buys hides to be delivered to his building. Production begins. The
coordinator's only role at this point is as an accountant to keep track of the
payment due to the workers.
Has the coordinator created an organization or a market? Is he an organizer
or marketeer? The coordinator has constructed a slipper "factory", but he has
only provided the workers with the plant, equipment, and materials and made
no attempt to instruct, supervise, manage, or administer. His final role was only
to verify that contracts were executed properly. The artisans and salespersons
have acted as "independent contractors" who have agreed to transform one
commodity into another but have not subordinated themselves to the coordi-
nator, any more than he subordinated himself to the suppliers of hides and
buildings. It will be argued below that there is no "united" organization in
this example, yet this is the picture of the firm that corresponds to the standard
economic model. Inputs of various kinds are hired, including different types of
labor, and once contracts are struck the firm's only role is as a contract moni-
tor.
Introduction 3
The crux of the illustration is that the coordinator has not purchased the
right to tell any person what actions should or should not be taken. All the ac-
tions are predetermined in the market. There has been no grant of authority by
the artisans or salespersons. The leather tanners have used hides owned by the
coordinator but they may work in their own fashion without interruption or
guidance from anyone. The coordinator may be a capitalist employer but he is
not a commander. The essence of an organization is presence of contracts where
persons are "united" by an authoritarian relation. Some members of the group
have been authorized to direct the activities of other members in order to further
the goals of the group. Simon (1951) made the case that the employment rela-
tion between worker and boss is different from the relation between the seller
and buyer of most property since the employer has purchased the right to
change the worker's tasks ex post. The worker has not relinquished all rights to
use his labor capability, but within broad limits he has authorized the employer
to decide his activities for him.
This distinction is not universally recognized. Alchian and Demsetz (1972)
argue that the relationship between a consumer and his grocer is not significant-
ly different than that between employer and employee. They feel that authority
is a deceptive concept because the employee always has the option of quitting
if the management requires labor which is unacceptable. In this respect they
have a point since courts generally will not enforce specific performance of a
personal service contract, feeling that this conflicts with constitutional safe-
guards against involuntary servitude. However, they push the argument too far
when they deny the existence of voluntarily granted authority. The worker
often accepts legitimate orders from the employer to perform tasks which are
unpleasant but still within the definition of the job requirements. The construc-
tion worker responds to his foreman's order to unload the truck even though he
would rather measure and cut lumber. One of the aims of this textbook is to
develop those reasons why workers choose to accept employment in authoritarian
organizations.
Authority exists when a subordinate has agreed to an open-ended employ-
ment contract allowing the superior to adjust the tasks performed to best suit
the evolving circumstances. The authoritarian contract is not the only possible
form of an employment contract. Alternatively, the parties could enumerate all
the possible circumstances beforehand and negotiate an acceptable work assign-
ment for each contingency. If the worker does not like performing one particu-
lar task, he may refuse to accept such a contractual clause or accept it only for
additional compensation. Such a "contingency" contract eliminates authority.
The employer's role changes from a director to a monitor, because he has no
right to ask the worker to perform a task which is not already specifically as-
signed to the observed circumstance.
4 The economics of organization
Detailed contingency contracts are not generally used to arrange employment.
Contrary to Alchian and Demsetz's view, neither are contracts which call for a
renegotiation of the work assignment as new circumstances develop. Coase
(1937) observed that this replacement of market exchanges by organization is
economical because there are significant costs involved in negotiating and en-
forcing such contracts. The nature of the firm, in Coase's view, is the replace-
ment of markets by organizations due to significant transaction costs associated
with the markets. A large portion of this book is an extended analysis of those
factors which make the market a relatively costly institution for arranging work
compared with authoritarian organizations.
The major sources of labor market transaction difficulties are uncertainty and
informational asymmetries. If the world was certain to evolve in only one pat-
tern, the coordination of activities would easily be standardized. However, the
environment is a whirlwind of unpredictable events - rain falls out of season,
machine parts break without warning, and flu epidemics incapacitate the work
force. These uncertainties create a multitude of contingencies and therefore the
negotiation of complicated contractual plans for handling each possibility be-
comes very costly. Even if such contracts were economical to construct, natural
informational asymmetries make the enforcement of the planned responses dif-
ficult. The worker might for example find it very hard to verify if a machine on
the far side of the plant has malfunctioned and would be unable to assure that
the employer has stated the true situation.
Authority is not always placed in the hands of the employer. Workers are
given the responsibility of making decisions on behalf of the employer when in-
formation availability and experience dictate that the worker can make more ef-
fective choices. The salesperson in the field is in a better position to evaluate
what discounts and service commitments are opportune to guarantee a sale. The
relationship between employer and worker in such circumstances is called the
principal-agent relationship. The design of reward systems to guide the agent
toward choices in the interest of the principal are discussed in a separate chapter.
While organizations have a comparative advantage in situations where uncer-
tainty is large and informational difficulties exist, the construction and opera-
tion of organizations is costly. In a group of individuals with differing needs and
desires the goals of the group which provide direction for individual activities do
not spontaneously appear. The amalgamation of individual beliefs and tastes into
a coherent pattern of goals requires a governance system within the organization.
Arrow's (1951) study of the relationship between individual and social choice
provides a framework for investigating the difficulties which organizations may
face in choosing a formal governance system.
Once a governance system for the organization is in place the effectiveness
Introduction 5
of the system may be undermined by participants who want to manipulate the
groups goals and activities to suit their personal desires. The detection and
elimination of deception and malfeasance is particularly difficult because of
the uncertainties and informational asymmetries which give the organization
its advantage over markets. The design of incentive and control systems is per-
haps the most challenging aspect of organization.
The design of economic organizations faces other difficulties in addition to
governance and control. The organization has the ability to capture returns to
specialization in informational acquisition but this requires that many individuals
resolve small uncertainties in their particular work areas. The elimination of un-
certainty can be very valuable by improving the organization's response to varia-
tions in its environment, but the efficient use of information in coordinating ac-
tivities often demands complicated communication systems within the group.
The evaluation of communication systems is a central topic of several chapters
in this book.
