Dabbawala : The organization and emerge of food systems

Dabbawala : The organization and emerge of food systems
[NOVEMBER
The Nature of the Firm
By R. H. COASE
ECONOMIC theory has suffered in the past from a failure
to state clearly its assumptions. Economists in building
up a theory have often omitted to examine the foundations
on which it was erected. This examination is, however,
essential not only to prevent the misunderstanding and
needless controversy which arise from a lack of knowledge
of the assumptions on which a theory is based, but also
because of the extreme importance for economics of good
judgment in choosing between rival sets of assumptions.
For instance, it is suggested that the use of the word “ firm ”
in economics may be different from the use of the term
by the “plain man.”l Since there is apparently a trend
in economic theory towards starting analysis with the
individual firm and not with the industry,2 it is all the
more necessary not only that a clear definition of the word
“firm ” should be given but that its difference from a
firm in the “ real world,” if it exists, should be made clear.
Mrs. Robinson has said that “the two questions to be
asked of a set of assumptions in economics are: Are they
tractable ? and : Do they correspond with the real world ? ”3
Though, as Mrs. Robinson points out, “ more often one set
will be manageable and the other realistic,” yet there may
well be branches of theory where assumptions may be
both manageable and realistic. It is hoped to show in
the following paper that a definition of a firm may be obtained
which is not only realistic in that it corresponds to what
is meant by a firm in the real world, but is tractable by
two of the most powerful instruments of economic analysis
developed by Marshall, the idea of the margin and that of
substitution, together giving the idea of substitution at
1 Joan Robinson, I~corro~rrzcs as a Serious Subjecr, p. 12.
2 See N. Kaldor, “The Equilibriuin of the Finn,” hcommzc Jourml, March, 1934
3 Op. cit., p. 6.
386
387 THE NATURE OF THE FIRM 19371
the margin.’ Our definition must, of course, “relate to
formal relations which are capable of being conceived
exactly.”2
I
It is convenient if, in searching for a definition of a firm,
we first consider the economic system as it is normally
treated by the economist. Let us consider the description
of the economic system given by Sir Arthur Salter.3 “ The
normal economic system works itself. For its current
operation it is under no central control, it needs no central
survey. Over the whole range of human activity and human
need, supply is adjusted to demand, and production to
consumption, by a process that is automatic, elastic and
responsive.” An economist thinks of the economic system
as being co-ordinated by the price mechanism and society
becomes not an organisation but an organism.4 The economic
system “works itself.” This does not mean that there is
no planning by individuals. These exercise foresight and
choose between alternatives. This is necessarily so if there
is to be order in the system. But this theory assumes that
the direction of resources is dependent directly on the price
mechanism. Indeed, it is often considered to be an objection
to economic planning that it merely tries to do what is
already done by the price me~hanism.~ Sir Arthur Salter’s
description, however, gives a very incomplete picture of
our economic system. Within a firm, the description does
not fit at all. For instance, in economic theory we find
that the allocation of factors of production between different
uses is determined by the price mechanism. The price
of factor A becomes higher in X than in Y. As a result,
A moves from Y to X until the difference between the
prices in X and Y, except in so far as it compensates for
other differential advantages, disappears. Yet in the real
world, we find that there are many areas where this does
not apply. If a workman moves from department Y to
department X, he does not go because of a change in relative
prices, but because he is ordered to do so. Those who
1 J. M. Keynes, Essays in Biography, pp. 223-4.
2 L. Robbins, Nazure and Signijcance of Eronorntc Science, p. 63.
3 This description is quoted with approval by D. H. Robertson, Control of IndustTy,
p. 85, and by Professor Arnold Plant, “ Trends in Business Administration,” ECONOMICA,
February, 1932. It appears in Allied Shipping Control, pp. 16-17.
4 See F. A. Hayek. “The Trend of Economic Thinking,” ECONOMICA, >lay, 1933.
See F. .A. Hayek. op. cit.
388 ECONOMICA [NOVEMBER
object to economic planning on the grounds that the problem
is solved by price movements can be answered by pointing
out that there is planning within our economic system
which is quite different from the individual planning
mentioned above and which is akin to what is normally
called economic planning. The example given above is
typical of a large sphere in our modern economic system.
Of course, this fact has not been ignored by economists.
Marshall introduces organisation as a fourth factor of
production ; J. B. Clark gives the co-ordinating function
to the entrepreneur ; Professor Knight introduces managers
who co-ordinate. As D. H. Robertson points out, we find
islands of conscious power in this ocean of unconscious
co-operation like lumps of butter coagulating in a pail of
buttermilk.”l But in view of the fact that it is usually
argued that co-ordination will be done by the price mechanism,
why is such organisation necessary ? Why are there these
“ islands of conscious power ” ? Outside the firm, price
movements direct production, which is co-ordinated through
a series of exchange transactions on the market. Within
a firm, these market transactions are eliminated and in
place of the complicated market structure with exchange
transactions is substituted the entrepreneur-co-ordinator,
who directs production.2 It is clear that these are alternative
methods of co-ordinating production. Yet, having regard
to the fact that if production is regulated by price movements,
production could be carried on without any organisation
at all, well might we ask, why is there any organisation 7
Of course, the degree to which the price mechanism is
superseded varies greatly. In a department store, the
allocation of the different sections to the various locations
in the building may be done by the controlling authority
or it may be the result of competitive price bidding for
space. In the Lancashire cotton industry, a weaver can
rent power and shop-room and can obtain looms and yarn
on credit.3 This co-ordination of the various factors of
production is, however, normally carried out without the
intervention of the price mechanism. As is evident, the
amount of “ vertical ” integration, involving as it does
66 *
1 Op. cit., p. 85. * In the rest of this paper I shall use the term entrepreneur to refer to the person Or
persons who, in a compehti;e system, take the place of the-price mechanism in &direction
of resources.
Survey of Textile Idustries, p. 26.
19371 THE NATURE OF THE FIRM 389
the supersession of the price mechanism, varies greatly
from industry to industry and from firm to firm.
It can, I think, be assumed that the distinguishing mark
of the firm is the supersession of the price mechanism.
It is, of course, as Professor Robbins points out, “ related
to an outside network of relative prices and costs,”1 but
it is important to discover the exact nature of this relationship.
This distinction between the allocation of resources
in a firm and the allocation in the economic system has
been very vividly described by Mr. Maurice Dobb when
discussing Adam Smith’s conception of the capitalist :
“ It began to be seen that there was something more
important than the relations inside each factory or unit
captained by an undertaker; there were the relations of
the undertaker with the rest of the economic world atside
his immediate sphere . . . . the undertaker busies himself
with the division of labour inside each firm and he plans
and organises consciously,” but “he is related to the much
larger economic specialisation, of which he himself is merely
one specialised unit. Here, he plays his part as a single cell in a
larger organism, mainly unconscious of the wider rale he fills.”*
In view of the fact that while economists treat the price
mechanism as a co-ordinating instrument, they also admit
the co-ordinating function of the “ entrepreneur,” it is
surely important to enquire why co-ordination is the work
of the price mechanism in one case and of the entrepreneur
in another. The purpose of this paper is to bridge what
appears to be a gap in economic theory between the assumption
(made for some purposes) that resources are allocated
by means of the price mechanism and the assumption
(made for other purposes) that this allocation is dependent
on the entrepreneur-co-ordinator. We have to explain
the basis on which, in practice, this choice between alternatives
is effe~ted.~
1 Op. cit., p. 71. 2 Capiialisr Enterprise and Social Progress, p. 20. Cf., also, Henderson, Supply and Demand,
PP. 3-5. 3 It 1s easy to see when the State takes over the direction of an industry that, in planning
it, it is doing something which was previously done by the price mechanism. What is
usually not realised is that any business man in organising the relations between his departments
is also doing something which could be organised through the price mechanism. There
is therefore point in Mr. Durbin’s answer to those who emphasise the problems involved
in economic planning that the same problems have to be solved by business men in the
competitive system. (See “ Economic Calculus in a Planned Economy,” Economic Journal,
December, 1936.) The important difference between these two cases is that economic
planning is imposed on industry while firms arise voluntarily because they represent a more
efficient method of organising production, In a competitive system, there is an “ optimum ”
amount of planning !
390 EcONOMICA [ N OVEM BE R
I1
Our task is to attempt to discover why a firm emerges
at all in a specialised exchange economy. The price
mechanism (considered purely from the side of the direction
of resources) might be superseded if the relationship which
replaced it was desired for its own sake. This would be
the case, for example, if some people preferred to work
under the direction of some other person. Such individuals
would accept less in order to work under someone, and
firms would arise naturally from this. But it would appear
that this cannot be a very important reason, for it would
rather seem that the opposite tendency is operating if one
judges from the stress normally laid on the advantage of
“ being one’s own ma~ter.”~ Of course, if the desire was
not to be controlled but to control, to exercise power over
others, then people might be willing to give up something
in order to direct others ; that is, they would be willing
to pay others more than they could get under the price
mechanism in order to be able to direct them. But this
implies that those who direct pay in order to be able to
do this and are not paid to direct, which is clearly not true
in the majority of cases2 Firms might also exist if purchasers
preferred commodities which are produced by firms to
those not so produced; but even in spheres where one
would expect such preferences (if they exist) to be of negligible
importance, firms are to be found in the real world.3
Therefore there must be other elements involved.
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. The most obvious cost of “ organising ”
production through the price mechanism is that of discovering
what the relevant prices are.4 This cost may be reduced
but it will not be eliminated by the emergence of specialists
who will sell this information. The costs of negotiating and 1 Cf. Harry Dawes, ‘’ Labour Mobility in the Steel Industry,” Economic Journal, March,
1934, who instances “ the trek to retail shopkeeping and insurance work by the better paid
of skilled men due to the desire (often the main aim in life of a worker) to be independent ”
2 None the less, this is not altogether fanciful. Some small shopkeepers are said to earn
less than their assistants.
3 G. F. Shove, ‘‘ The Imperfection of the Market : a Further Note,” Economic Journal,
March, 1933, p. 116, note I, points out that such preferences may exist, although the
example he gives is almost the reverse of the instance given in the text.
4 According to N. Kaldor, “ A Classificatory Note of the Determinateness of Equilibrium,”
Rwim of Economic Studies, February, 1934, it is one of the assumptions of static theory
that “All the relevant prices are known to all individuals.” Rut this is clearly not true
of the real world.
(P. 86).
391
concluding a separate contract for each exchange transaction
which takes place on a market must also be taken into
acc0unt.l Again, in certain markets, e.g., produce exchanges,
a technique is devised for minimising these contract costs ;
but they are not eliminated. It is true that contracts are
not eliminated when there is a firm but they are greatly
reduced. A factor of production (or the owner thereof)
does not have to make a series of contracts with the factors
with whom he is co-operating within the firm, as would be
necessary, of course, if this co-operation were as a direct
result of the working of the price mechanism. For this
series of contracts is substituted one. At this stage, it is
important to note the character of the contract into which
a factor enters that is employed within a firm. The contract
is one whereby the factor, for a certain remuneration (which
may be fixed or fluctuating), agrees to obey the directions
of an entrepreneur within certain Zimits.2 The essence of
the contract is that it should only state the limits to the
powers of the entrepreneur. Within these limits, he can
therefore direct the other factors of production.
There are, however, other disadvantages-or costsof
using the price mechanism. It may be desired to make
a long-term contract for the supply of some article or service.
This may be due to the fact that if one contract is made
for a longer period, instead of several shorter ones, then
certain costs of making each contract will be avoided.
Or, owing to the risk attitude of the people concerned,
they may prefer to make a long rather than a short-term
contract. Now, owing to the difficulty of forecasting, the
longer the period of the contract is for the supply of the
commodity or service, the less possible, and indeed, the
less desirable it is for the person purchasing to specify what
the other contracting party is expected to do. It may well
be a matter of indifference to the person supplying the
service or commodity which of several courses of action
is taken, but not to the purchaser of that service or commodity.
But the purchaser will not know which of these
several courses he will want the supplier to take. Therefore,
19371 THE NATURE OF ’THE FIRM
1 This influence was noted by Professor Usher when discussing the development of capitalism.
He says : “The successive buying and selling of partly finished products were sheer waste
of energy.” (Introduction to the Industrial History of England, p. 13). But he does not
develop the idea nor consider why it is that buying and selling operations still exist.
9 It would be possible for no limits to the powers of the entrepreneur to be fixed. This
would be voluntary slavery. According to Professor Batt, 7he Lazu of Master and Smant.
p. 18, such a contract would be void and unenforceable.
ECONOMICA [NOVEMBER 392
the service which is being provided is expressed in general
terms, the exact details being left until a later date. All
that is stated in the contract is the limits to what the persons
supplying the commodity or service is expected to do.
The details of what the supplier is expected to do is not
stated in the contract but is decided later by the purchaser,
When the direction of resources (within the limits of the
contract) becomes dependent on the buyer in this way,
that relationship which I term a ” firm ” may be obtained.’
A firm is likely therefore to emerge in those cases where a
very short term contract would be unsatisfactory. It is
obviously of more importance in the case of serviceslabour-than
it is in the case of the buying of commodities.
In the case of commodities, the main items can be stated
in advance and the details which will be decided later will
be of minor significance.
We may sum up this section of the argument by saying
that the operation of a market costs something and by
forming an organisation and allowing some authority (an
” entrepreneur “) to direct the resources, certain marketing
costs are saved. The entrepreneur has to carry out his
function at less cost, taking into account the fact that he
may get factors of production at a lower price than the
market transactions which he supersedes, because it is
always possible to revert to the open market if he fails
to do this.
The question of uncertainty is one which is often considered
to be very relevant to the study of the equilibrium of the
firm. It seems improbable that a firm would emerge without
the existence of uncertainty. But those, for instance,
Professor Knight, who make the mode of payment the
distinguishing mark of the firm-fixed incomes being
guaranteed to some of those engaged in production by a
person who takes the residual, and fluctuating, incomewould
appear to be introducing a point which is irrelevant
to the problem we are considering. One entrepreneur may
sell his services to another for a certain sum of money,
while the payment to his employees may be mainly or
wholly a share in profits.2 The significant question would
1 Of course, it is not possible to draw a hard and fast line which determines whether
there is a firm or not. There may be more or less direction. It is similar to the legal
question of whether there is the relationship of master and servant or principal and agent.
See the discussion of this problem below.
4 The views of Professor Knight are examined below in more detail.
19371 393 THE NATURE OF THE FIRM
appear to be why the allocation of resources is not done
directly by the price mechanism.
Another factor that should be noted is that exchange
transactions on a market and the same transactions organised
within a firm are often treated differently by Governments
or other bodies with regulatory powers. If we consider the
operation of a sales tax, it is clear that it is a tax on market
transactions and not on the same transactions organised
within the firm. Now since these are alternative methods
of ” organisation “-by the price mechanism or by the
entrepreneur-such a regulation would bring into existence
firms which otherwise would have no raison d’itre. It would
furnish a reason for the emergence of a firm in a specialised
exchange economy. Of course, to the extent that firms
already exist, such a measure as a sales tax would merely
tend to make them larger than they would otherwise be.
Similarly, quota schemes, and methods of price control
which imply that there is rationing, and which do not apply
to firms producing such products for themselves, by allowing
advantages to those who organise within the firm and not
through the market, necessarily encourage the growth of
firms. But it is difficult to believe that it is measures such
as have been mentioned in this paragraph which have
brought firms into existence. Such measures would, however,
tend to have this result if they did not exist for other
reasons.
These, then, are the reasons why organisations such as
firms exist in a specialised exchange economy in which it
is generally assumed that the distribution of resources is
” organised ” by the price mechanism. A firm, therefore,
consists of the system of relationships which comes into
existence when the direction of resources is dependent on
an entrepreneur.
The approach which has just been sketched would appear
to offer an advantage in that it is possible to give a scientific
meaning to what is meant by saying that a firm gets ‘larger
or smaller. A firm becomes larger as additional transactions
(which could be exchange transactions co-ordinated through
the price mechanism) are organised by the entrepreneur
and becomes smaller as he abandons the organisation of
such transactions. The question which arises is whether
it is possible to study the forces which determine the size
of the firm. Why does the entrepreneur not organise one
394 E CO N 0 MICA [NOVEMBER
less transaction or one more ? It is interesting to note
that Professor Knight considers that :
“ the relation between efficiency and size is one of the
most serious problems of theory, being, in contrast with
the relation for a plant, largely a matter of personality
and historical accident rather than of intelligible general
principles. But the question is peculiarly vital because
the possibility of monopoly gain offers a powerful incentive
to continuous and unlimited expansion of the firm, which
force must be offset by some equally powerful one making
for decreased efficiency (in the production ‘of money
income) with growth in size, if even boundary competition
is to exist.”l
Professor Knight would appear to consider that it is impossible
to treat scientifically the determinants of the size of the
firm. On the basis of the concept of the firm developed
above, this task will now be attempted.
It was suggested that the introduction of the firm was
due primarily to the existence of marketing costs. A
pertinent question to ask would appear to be (quite apart
from the monopoly considerations raised by Professor
Knight), why, if by organising one can eliminate certain
costs and in fact reduce the cost of production, are there
any market transactions at all ?2 Why is not all production
carried on by one big firm ? There would appear to be
certain possible explanations.
First, as a firm gets larger, there may be decreasing
returns to the entrepreneur function, that is, the costs of
organising additional transactions within the firm may
rise.3 Naturally, a point must be reached where the costs
of organising an extra transaction within the firm are equal
to the costs involved in carrying out the transaction in
the open market, or, to the costs of organising by another
entrepreneur. Secondly, it may be that as the transactions
which are organised increase, the entrepreneur fails to
place the factors of production in the uses where their value
1 Risk, Uncertainty aiid Profit, Preface to the Re-issue, London School of Economics Series
of Reprints, No. 16, 1933.
2 There are certain marketing costs which could only be eliminated by the abolition of
‘. consumers’ choice ” and these are the costs of retailing. It is conceivable that these costs
might be so high that people nould be willing to accept rations because the extra product
obtained was worth the loss of their choice.
3 This argument assumes that exchange transactions on a market can be considered as
homogeneous; This complication is taken into account
below.
which is clearly untrue in fact.
‘9371 THE NAI’UKE Oh’ THE FIRM 395
is greatest, that is, fails to make the best use of the factors
of production. Again, a point must be reached where the
loss through the waste of resources is equal to the marketing
costs of the exchange transaction in the open market or
to the loss if the transaction was organised by- another
entrepreneur. Finally, the supply price of one or more of
the factors of production may rise, because the ” other
advantages ” of a small firm are greater than those of a
large firm.l Of course, the actual point where the expansion
of the firm ceases might be determined by a combination
of the factors mentioned above. The first two reasons
given most probably correspond to the economists’ phrase
of ” diminishing returns to management.”2
The point has been made in the previous paragraph that
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. But if the firm stops its expansion at a point below
the costs of marketing in the open market and at a point
equal to the costs of organising in another firm, in most
cases (excluding the case of ” combination “9, this will
imply that there is a market transaction between these
two producers, each of whom could organise it at less than
the actual marketing costs. How is the paradox to be
resolved ? If we consider an example the reason for this
will become clear. Suppose ‘A is buying a product from
B and that both A and B could organise this marketing
transaction at less than its present cost. B, we can assume,
is not organising one process or stage of production, but
several. If A therefore wishes to avoid a market transaction,
he will have to take over all the processes of production
controlled by B. Unless A takes over all the processes of
1 For a discussion of the variation of the supply price of factors of production to firms
of varying size, see E. A. G. Robinson, The Structure of Comperitive Industry. It is sometimes
said that the supply price of organising ability increases as the size of the firm increases
because men prefer to be the heads of small independent businesses rather than thc heads
See Jones, The Trust Problem, p. 531, and Macgregor,
],&strial Combination, p. 63. This is a common argument of those who advocate Rationalsation.
It is said that larger units would he more eflicient. but owing to the individualistic
spirit of the smaller entrepreneurs, they prefer to remain independent, apparently in spite
of the higher income which their increased efficiency under Rationalisation makes possible.
For a more thorough discussion
of this particular problem, see N. Kaldor, ” The Equilibrium of the Firm,” E~-uuomic Journal,
March, 1934, and E. A. G. Robinson. “The Problem of JIiins~cmcnt ;ind thc Sizc of the
Firm,” Economic journal^ June, 1934.
departments in a large, business.
2 This discussion is, of course, brief and incomplete.
3 Al definition of this term is given below.
3 90 EC o N 0 M t c A [NOVEMBER
production, a market transaction will still remain, although
it is a different product that is bought. But we have
previously assumed that as each producer expands he
becomes less efficient ; the additional costs of organising
extra transactions increase. It is probable that A’s cost
of organising the transactions previously organised by
B will be greater than B’s cost of doing the same thing.
A therefore will take over the whole of B’s organisation
only if his cost of organising B’s work is not greater than
B’s cost by an amount equal to the costs of carrying out
an exchange transaction on the open market. But once
it becomes economical to have a market transaction, it
also pays to divide production in such a way that the cost
of organising an extra transaction in each firm is the same.
Up to now it has been assumed that the exchange transactions
which take place through the price mechanism are
homogeneous. In fact, nothing could be more diverse
than the actual transactions which take place in our modern
world. This would seem to imply that the costs of carrying
out exchange transactions through the price mechanism
will vary considerably as will also the costs of organising
these transactions within the firm. It seems therefore
possible that quite apart from the question of diminishing
returns the costs of organising certain transactions within
the firm may be greater than the costs of carrying out the
exchange transactions in the open market. This would
necessarily imply that there were exchange transactions
carried out through the price mechanism, but would it
mean that there would have to be more than one firm ?
Clearly not, for all those areas in the economic system
where the direction of resources was not dependent directly
on the price mechanism could be organised within one
firm. The factors which were discussed earlier would seem
to be the important ones, though it is difficult to say whether
diminishing returns to management ” or the rising supply
price of factors is likely to be the more important.
Other things being equal, therefore, a firm will tend
to be larger:
(a) the less the costs of organising and the slower these
costs rise with an increase in the transactions organised.
(b) the less likely the entrepreneur is to make mistakes
and the smaller the increase in mistakes with an increase
in the transactions organised.
66
193 71 397 THE NATURE OF THE FIRM
(c) the greater the lowering (or the less the rise) in
the supply price of factors of production to firms of larger
size.
Apart from variations in the supply price of factors of
production to firms of different sizes, it would appear that
the costs of organising and the losses through mistakes will
increase with an increase in the spatial distribution of the
transactions organised, in the dissimilarity of the transactions,
and in the probability of changes in the relevant
prices.l As more transactions are organised by an entrepreneur,
it would appear that the transactions would tend
to be either different in kind or in different places. This
furnishes an additional reason why efficiency will tend to
decrease as the firm gets larger. Inventions which tend
to bring factors of production nearer together, by lessening
spatial distribution, tend to increase the size of the firm.2
Changes like the telephone and the telegraph which tend
to reduce the cost of organising spatially will tend to increase
the size of the firm. All changes which improve managerial
technique will tend to increase the size of the firm.3-4
It should be noted that the definition of a firm which
was given above can be used to give more precise meanings
to the terms “ combination ” and “ integration.”B There
is a combination when transactions which were previously
This aspect of the problem is emphasised by N. Kaldor, op. cit. Its importance in
this connection had been previously noted by E. A. G. Robinson, 7he Strucfure .f Comperztiae
Industry, pp. 83-106. This assumes that an increase in the probability of price
movements increases the costs of organising within a firm more than it increases the cost
of carrying out an exchange transaction on the market-which is probable.
2 This would appear to be the importance of the treatment of the technical unit by
E. A. G. Robinson, op. cit., pp. 27-33. The larger the technical unit, the greater the
concentration of factors and therefore the firm is likely to be larger.
3 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.
4 An illustration of these dynamic forces is furnished by Maurice Dobb, Russian Economic
Development, p. 68. “With the passing of bonded labour the factory, as an establishment
where work was organised under the whip of the overseer, lost its raison d’& until this
was restored to it with the introduction of power machinery after 1846.” It seems important
to realise that the passage from the domestic system to the factory system is not a mere
historical accident, but is conditioned by economic forces. This is shown by the fact that
it is possible to move from the factory system to the domestic system, as in the Russian
example, as well as aicc O‘CTS(I. It is the essence of serfdom that the price mechanism is
not allowed to operate. Therefore, there has to be direction from some organiser. When,
however, serfdom passed, the price mechanism was allowed to operate. It was not until
machinery drew workers into one locality that it paid to supersede the price mechanism
and the firm again emerged. * This is often called “ vertical integration,” combination being termed “ lateral integratbrr.”
398 ECOMOMICA [NOVLMBEIC
organised by two or more entrepreneurs become organised
by one. This becomes integration when it involves the
organisation of transactions which were previously carried
out between the entrepreneurs on a market. A firm can
expand in either or both of these two ways. The whole
of the “ structure of competitive industry ” becomes tractable
by the ordinary technique of economic analysis.
I11
The problem which lias been investigated in the previous
section has not been entirely neglected by economists and
it is now necessary to consider why the reasons given above
for the emergence of a firm in a specialised exchange economy
are to be preferred to the other explanations which have
been offered.
It is sometimes said that the reason for the existence
of a firm is to be found in the division of labour. This is
the view of Professor Usher, a view which has been adopted
and expanded by Mr. Maurice Dobb. The firm becomes
“ the result of an increasing complexity of the division of
labour . . . . The growth of this economic differentiation
creates the need for some integrating force without which
differentiation would collapse into chaos ; and it is as the
integrating force in a differentiated economy that industrial
forms are chiefly ~ignificant.’~l The answer to this argument
is an obvious one. The “ integrating force in a differentiated
economy ” already exists in the form of the price mechanism.
It is perhaps the main achievement of economic science
that it has shown that there is no reason to suppose that
specialisation must lead to chaos.* The reason given by
Mr. Maurice Dobb is therefore inadmissible. What has
to be explained is why one integrating force (the entrepreneur)
should be substituted for another integrating force (the
price mechanism).
The most interesting reasons (and probably the most
widely accepted) which have been given to explain this
fact are those to be found in Professor Knight’s Risk,
Uncertainty and Pro&. His views will be examined in
some detail.
‘ Op. cit.,. p. 10. Professor Usher’s viena .ire to Le found in his Iirlroducfron 10 ~bc
2 Cf. J. B. Clark, Disrnburzon of Wealth, p. 19, who speaks of the theory of e~change a5
Iizdustrwl Ifaslory of England, pp. 1-18.
being the “ theory of the organisation of industrial society.”
‘9371 ‘THE NATURE OF 1HE FIRM 399
Professor Knight starts with a system in which there
acting as individuals under absolute freedom but
without collusion men are supposed to have organised
economic life with the primary and secondary division
of labour, the use of capital, etc., developed to the point
familiar in present-day America. The principal fact
which calls for the exercise of the imagination is the
internal organisation of the productive groups or establishments.
With uncertainty entirely absent, every individual
being in possession of perfect knowledge of the situation,
there would be no occasion for anything of the nature
of responsible management or control of productive
activity. Even marketing transactions in any realistic
seiise would not be found. The flow of raw materials
and productive services to the consumer would be entirely
automatic.”l
Professor Knight says that we can imagine this adjustment
as being “ the result of a long process of experimentation
worked out by trial-and-error methods alone,” while it
is not necessary “to imagine every worker doing exactly
the right thing at the right time in a sort of ‘ pre-established
harmony ’ with the work of others. There might be managers,
superintendents, etc., for the purpose of co-ordinating the
activities of individuals,” though these managers would
be performing a purely routine function, “ without responsibility
of any sort.”2
is no uncertainty : cc
Professor Knight then continues :
“ With the introduction of uncertainty-the fact of
ignorance and the necessity of acting upon opinion rather
than knowledge-into this Eden-like situation, its character
is entirely changed . . . . With uncertainty present doing
things, the actual execution of activity, becomes in a
real sense a secondary part of life ; the primary problem
or function is deciding what to do and how to do it.”5
This fact of uncertainty brings about the two most
“In the first place, goods are produced for a market,
on the basis of entirely impersonal prediction of wants,
not for the satisfaction of the wants of the producers
themselves. The producer takes the responsibility of
important characteristics of social organisation.
1 Risk, Uncerfainty and Profit, p. 267.
2 Op. cit., pp. 267-8. Op. cit., p. 268.
C
400 ECONOMICA [NOVEMBER
forecasting the consumers’ wants. In the second place,
the work of forecasting and at the same time a large
part of the technological direction and control of production
are still further concentrated upon a very narrow class
of the producers, and we meet with a new economic
functionary, the entrepreneur. . . . . When uncertainty
is present and the task of deciding what to do and how
to do it takes the ascendancy over that of execution the
internal organisation of the productive groups is no
longer a matter of indifference or a mechanical detail.
Centralisation of this deciding and controlling function
is imperative, a process of ‘ cephalisation ’ is inevitable.”l
The most fundamental change is :
“ the system under which the confident and venturesome
assume the risk or insure the doubtful and timid by
guaranteeing to the latter a specified income in return
for an assignment of the actual results. . . . With human
nature as we know it it would be impracticable or very
unusual for one man to guarantee to another a definite
result of the latter’s actions without being given power
to direct his work. And on the other hand the second
party would not place himself under the direction of
the first without such a guarantee. . . . The result of
this manifold specialisation of function is the enterprise
and wage system of industry. Its existence in the world
is the direct result of the fact of ~ncertainty.”~
These quotations give the essence of Professor Knight’s
theory. The fact of uncertainty means that people have
to forecast future wants. Therefore, you get a special
class springing up who direct the activities of others to
whom they give guaranteed wages. It acts because good
judgment is generally associated with confidence in one’s
j~dgrnent.~
Professor Knight would appear to leave himself open
to criticism on several grounds. First of all, as he himself
points out, the fact that certain people have better judgment
or better knowledge does not mean that they can only
get an income from it by themselves actively taking part
in production. They can sell advice or knowledge. Every
business buys the services of a host of advisers. We can
imagine a system where all advice or knowledge was bought
1 Op. cit., pp. 268-95.
3 Op. cit., p. 270.
a Op. cit., pp. 26970.
19371 THE NATURE OF THE FIRM 401
as required. Again, it is possible to get a reward from
better knowledge or judgment not by actively taking part
in production but by making contracts with people who
are producing. A merchant buying for future delivery
represents an example of this. But this merely illustrates
the point that it is quite possible to give a guaranteed
reward providing that certain acts are performed without
directing the performance of those acts. Professor Knight
says that “with human nature as we know it it would be
impracticable or very unusual for one man to guarantee
to another a definite result of the latter’s actions without
being given power to direct his work.” This is surely
incorrect. A large proportion of jobs are done to contract,
that is, the contractor is guaranteed a certain sum providing
he performs certain acts. But this does not involve any
direction. It does mean, however, that the system of
relative prices has been changed and that there will be a
new arrangement of the factors of production.1
that Professor Knight mentions that the “ second party
would not place himself under the direction of the first
without such a guarantee ” is irrelevant to the problem
we are considering. Finally, it seems important to notice
that even in the case of an economic system where there
is no uncertainty Professor Knight considers that there
would be co-ordinators, though they would perform only
a routine function. He immediately adds that they would
be “ without responsibility of any sort,” which raises the
question by whom are they paid and why I It seems that
nowhere does Professor Knight give a reason why the price
mechanism should be superseded.
IV
It would seem important to examine one further point
and that is to consider the relevance of this discussion to
the general question of the “ cost-curve of the firm.”
It has sometimes been assumed that a firm is limited
in size under perfect competition if its cost curve slopes
upward,B while under imperfect competition, it is limited
The fact ,
1 This shows that it is possible to have a private enterprise system without the existence
of firms. Though, in practice, the two functions of enterprise, which actually influences
the system of relative prices by forecasting wants and acting in accordance with such forecasts,
and management, which accepts the system of relative prices as being given, are
normally carried out by the same persons, yet it seems important to keep them separate
in theory. This point is further discussed below.
a See Kaldor, op. cit., and Robinson, The Problem of Management and the Size of the Firm.
402 ECONOMICA [NOVEMBER
in size because it will not pay to produce iiioie than the
output at which marginal cost is equal to marginal revenue.’
But it is clear that a firm may produce more than one product
and, therefore, there appears to be no prima facie reason
why this upward slope of the cost curve in the case of perfect
competition or the fact: that marginal cost will not always
be below marginal revenue in the case of imperfect competition
should limit the size of the firm.2 Mrs. Robinson3
makes the simplifying assumption that only one product
is being produced. But it is clearly important to investigate
how the number of products produced by a firm is determined,
while no theory which assumes that only one product is
in fact produced can have very great practical significance.
It might be replied that under perfect competition, since
everything that is produced can be sold at the prevailing
price, then there is no need for any other product to be
produced. But this argument ignores the fact that there
may be a point where it is less costly to organise the exchange
transactions of a new product than to organise further
exchange transactions of the old product. This point can
be illustrated in the following way. Imagine, following
von Thunen, that there is a town, the consuming centre,
and that industries are located around this central point
in rings. These conditions are illustrated in the following
diagram in which A, B and C represent different industries.
1 Mr. Kobinson calls this the Imperfect Competition solution for the survival of the small firm.
J Nr. Robinson’s conclusion, op. cit., p. 249, note I, would appear to be definitely wrong.
He is followed by Horace J. White, Jr., “ Monopolistic and Perfect Competition,” American
Economic Review, December, 1936, p. 6!5, note 27. Xr. White states “It is obvions that
the size of the firm is limited in conditions of monopolistic competition.”
3 Economics of Imperfect Competition.
19371 403 THE NATURE OF THE FIRM
Imagine an entrepreneur who starts controlling exchange
transactions from x. Now as he extends his activities in
the same product (B), the cost of organising increases until
at some point it becomes equal to that of a dissimilar product
which is nearer. As the firm expands, it will therefore
from this point include more than one product (A and C).
This treatment of the problem is obviously incomplete,l
but it is necessary to show that merely proving that the
cost curve turns upwards does not give a limitation to the
size of the firm. So far we have only considered the case
of perfect competition ; the case of imperfect competition
would appear to be obvious.
To determine the size of the firm, we have to consider
the marketing costs (that is, the costs of’using the price
mechanism), and the costs of organising of different entrepreneurs
and then we can determine how many products
will be produced by each firm and how much of each it
will produce. It would, therefore, appear that Mr. Shoves
in his article on “ Imperfect Competition ” was asking
questions which Mrs. Robinson’s cost curve apparatus
cannot answer. The factors mentioned above would seem
to be the relevant ones.
V
Only one task now remains ; and that is, to see whether
the concept of a firm which has been developed fits in with
that existing in the real world. We can best approach the
question of what constitutes a firm in practice by considering
the legal relationship normally called that of “ master and
servant ” or “ employer and em~loyee.”~ The essentials
of this relationship have been given as follows :
“ (I) the servant must be under the duty of rendering
personal services to the master or to others on behalf
1 As has been shown above, location is only one of the factors influencing the cost of
organising.
8 G. F. Shove, “The Imperfection of the Market,” Economic Journal, March, 1933, p. 115.
In connection with an increase in demand in the suburbs and the effect on the price charged
by suppliers, Mr. Shove asks I‘. . . . why do not the old firms open hranches in the
suburbs ? ” If the argument in the test is correct, this is a question which Mrs. Robinson’s
apparatus cannot answer. a The legal concept of ‘I employer and employee ” and the economic concept of a firm
are not identical, in that the firm may imply control over another person’s property as well
as over their labour. But the identity of these two concepts is sufficiently close for an
examination of the leaal concept to he of value in appraising the worth of the economic
concept.
ECONOMICA [NOVEMBER 404
of the master, otherwise the contract is a contract for
sale of goods or the like.
(2) The master must have the right to control the
servant’s work, either personally or by another servant
or agent. It is this right of control or interference, of
being entitled to tell the servant when to work (within
the hours of service) and when not to work, and what
work to do and how to do it (within the terms of such
service) which is the dominant characteristic in this
relation and marks off the servant from an independent
contractor, or from one employed merely to give to his
employer the fruits of his labour. In the latter case,
the contractor or performer is not under the employer’s
control in doing the work or effecting the service; he
has to shape and manage his work so as to give the result
he has contracted to effect.”l
We thus see that it is the fact of direction which is the
essence of the legal concept of “ employer and employee,”
just as it was in the economic concept which was developed
above. It is interesting to note that Professor Batt says
further :
“ That which distinguishes an agent from a servant is
not the absence or presence of a fixed wage or the payment
only of commission on business done, but rather the
freedom with which an agent may carry out his employment
.”a
We can therefore conclude that the definition we have given
is one which approximates closely to the firm as it is considered
in the real world.
Is it manageable ?
This ought to be clear. When we are considering how
large a firm will be the principle of marginalism works
smoothly. The question always is, will it pay to bring an
extra exchange transaction under the organising authority ?
At the margin, the costs of organising within the firm
will be equal either to the costs of organising in another
firm or to the costs involved in leaving the transaction to
be “ organised ” by the price mechanism. Business men
will be constantly experimenting, controlling more or less,
and in this way, equilibrium will be maintained. This
gives the position of equilibrium for static analysis. But
Our definition is, therefore, realistic.
Batt, The Law of Master and Seroant, p. 6. * Op. cit., p. 7.
19371 THE NATURE OF THE FIRM 405
it is clear that the dynamic factors are also of considerable
importance, and an investigation of the effect changes have
on the cost of organising within the firm and on marketing
costs generally will enable one to explain why firms get
larger and smaller. We thus have a theory of moving
equilibrium. The above analysis would also appear to have
clarified the relationship between initiative or enterprise
and management. Initiative means forecasting and operates
through the price mechanism by the making of new contracts.
Management proper merely reacts to price changes, rearranging
the factors of production under its control. That the
business marl normally combines both functions is an obvious
result of the marketing costs which were discussed above.
Finally, this analysis enables us to state more exactly what
is meant by the ” marginal product ” of the entrepreneur.
But an elaboration of this point would take us far from
our comparatively simple task of definition and clarification.

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American Economic Association
Markets and Hierarchies: Some Elementary Considerations
Author(s): Oliver E. Williamson
Source: The American Economic Review, Vol. 63, No. 2, Papers and Proceedings of the
Eighty-fifth Annual Meeting of the American Economic Association (May, 1973), pp. 316-325
Published by: American Economic Association
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ORGANIZATIONAL FORMS AND
INTERNAL EFFICIENCY
Markets and Hierarchies:
Some Elementary Considerations
By OLIVER E. WILLIAMSON*
The principal purposes of this paper are
to examine the factors which induce a
shift of transactions from market to internal
organization and, within internal
organization, to explain the types of
hierarchical relations that predictably
emerge. It is generally acknowledged that
a prima facie case for the development of
nonmarket (or quasi-market) forms of
economic organization can be said to exist
whenever the market, if used to complete
a set of transactions, experiences “frictions.”
But this is only a rebuttable presumption.
As R. Coase has emphasized
repeatedly, the problems of efficient economic
organization need to be examined in
a comparative-institutional way (1960, pp.
17-18; 1964, p. 195). Concern with the
study of market failures should thus be
expanded to include “institutional failures”
(of internal organizational, political,
and judicial types) more generally.
As compared with the study of market
failures, the analysis of the sources and
consequences of internal organizational
failures is at a very primitive stage of
development. I submit, however, that
substantially the same factors that are
ultimately responsible for market failures
also explain failures of internal organization.
If this contention is correct, the
study of alternative modes of economic
organization can proceed in a symmetrical
fashion. Rather than having to devise a
separate apparatus for each organizing
mode, a common language and conceptual
apparatus can be brought systematically
to bear across modes.
I. Markets and Market Failures
It will be argued here that the interesting
problems of economic organization are
mainly to be explained by reference to the
conjunction of a set of human attributes
with a related set of (largely nontechnological)
transactional factors. Inasmuch as
economics is a social science concerned
with exchange, this is perhaps unsurprising.
Discussions of economic organization
nevertheless are frequently dominated by
references to technology.
To be sure, technological indivisibilities
or nonseparabilities in production processes
sometimes exist and have important
organizational implications. Inasmuch,
however, as exclusive reliance on such
considerations would permit only relatively
simple forms of economic organization
to be explained, whereas actual firms
and markets are often highly complex and
subtle instruments, other (nontechnological)
factors are presumably operative.
To these we now turn.
* University of Pennsylvania. Research on this paper
has been supported by a grant from the National Science
Foundation. Comments on the paper by Jeffrey
Harris and Hugh Davies are gratefully acknowledged.
316
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VOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 317
A. Human Factors
But for the existence of one or more of
the following three factors, there would
appear to be little reason to supplant
market organization with some form of
nonmarket organization.
1. Bounded Rationality
Bounded rationality refers to rate and
storage limits on the capacities of individuals
to receive, store, retrieve, and
process information without error. The
reasons why the absence of unlimited
computational capacity prevents comprehensive
contracting of the sort required
for the standard theorems on the existence
and optimality of a competitive equilibrium
to go through have been examined by
R. Radner (1968). Certain specific problems
of interfirm (but, more generally, of
autonomous) contracting are also examined
in my discussion of vertical integration
(1971, pp. 115-18).
2. Opportunism
Opportunism is an effort to realize individual
gains through a lack of candor or
honesty in transactions.’ It can take either
of two forms. The most commonly recognized
is the strategic disclosure of
asymmetrically distributed information by
(at least some) individuals to their advantage.
Original negotiations may be
impaired on this account.
The second type manifests itself during
contract execution and renewal. The impossibility
of extracting what can be confidently
regarded as self-enforcing promises
to behave “responsibly” requires that
agreements be monitored and may pose
problems, due to first-mover advantages,
at the contract renewal interval where
by a first-mover advantage I mean that
winners of original bids acquire firmspecific
experience which places them at a
cost advantage in relation to nonwinners
on subsequent rounds of negotiation
(0. Williamson, 1971, p. 116). (The consequences
of this are discussed further in
conjunction with the small numbers issue
below.)
3. A tmosphere
Individuals are not (all) given to the
strict maximization of expected pecuniary
gain but also consume “atmosphere.”
Modes of organization or practices which
would have superior productivity consequences
if implemented within, and thus
would be adopted by, a group of expected
pecuniary gain maximizers may be modified
or rejected by groups with different
values. For one thing, favorable productivity
consequences may no longer obtain.
In addition, preferences for atmosphere
may induce individuals to forego material
gains for nonpecuniary satisfactions if the
modes or practices are regarded as oppressive
or otherwise repugnant.
This does not lead to a uniform preference
for one mode of organization over
another, however. Individuals who value
independence highly may favor markets
over hierarchy, while others may favor internal
organization because of associational
satisfactions which they derive. The
institutional design problem requires that
requisite variety be supplied so as to permit
individuals to allocate themselves appropriately
among alternative modes.
B. Transactional Factors
Whether markets experience contractual
problems as a result of bounded rationality
and opportunism turns on a related set of
transactional factors. Thus the consequences
of bounded rationality are less
severe if the transactions in question are
uncomplicated and experience little un-
1 Returns attributable to productive advantages (e.g.,
a unique location or differential skill) are not to be
regarded as opportunistic. Strategic representations are
required for opportunism to obtain.
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318 AMERICAN ECONOMIC ASSOCIATION MAY 1973
certainty. Similarly, opportunism is restricted
if competition reliably obtains or
if information asymmetries can be overcome
at little cost.
1. Uncertainty
The effects of uncertainty on economic
behavior are extensive and pervasive
(K. Arrow, 1969, 1971; Radner, 1968,
1970). Of particular interest to us here is
that, inasmuch as a full set of contingent
claim markets is infeasible (by reason of
bounded rationality), adaptive, sequential
decision-making procedures need be devised.
Vulnerable as market exchange is to
opportunism in these circumstances, hierarchical
forms of organization are apt
often to be favored.
2. Small Numbers
If a large number of traders are roughly
equally qualified to supply the good or
service in question-not merely at the
outset but also (inasmuch as environmental
uncertainty and bounded rationality
render once-for-all contracts uneconomical)
at contract renewal intervalscompetition
will obtain, trading ranges
will be narrowly restricted, and market
exchange will be attractive. But while
frequently a large numbers condition will
seem to obtain at the outset, this may be
illusory or may not continue into contract
renewal stages.
The illusion is that implicit homogeneity
assumptions may not be satisfied. Nonhomogeneity
coupled with information
impactedness and opportunism pose serious
disclosure problems. Not only can
markets shrink on this account, but they
may vanish altogether (see G. Ackerlof).
In addition, although large numbers
homogeneity conditions may obtain at the
outset, this may no longer hold at the
contract renewal interval. If parity among
suppliers is upset by first-mover advantages,
so that winners of original bids
subsequently enjoy nontrivial cost advantages
over nonwinners, the joining of
users and suppliers under a sales relationship
will predictably give rise to small
numbers haggling and associated maladaptations.

The argument has relevance not only
for examining when separable components
will be made internally rather than purchased,
but also when the work flow between
successive individuals will be exchanged
under an employment rather than
a sales relationship. Transaction-specific
human capital is not all that uncommon
(P. Doeringer and M. Piore) and favors
hierarchy.
3. Information Impactedness
Information impactedness is partly an
information asymmetry condition: one of
the agents to a contract has deeper knowledge
than does the other (Arrow 1969,
p. 55). But more than asymmetry is implied
by our use of the term impactedness.
It is also costly for the party with less information
to achieve information parity.
To the extent that it is difficult to distinguish
between agents who disclose the
impacted information to which they
have access in an opportunistic (selective
or distorted) manner from those who make
good faith representations, agents of the
latter type may be induced to withdraw
from the market.
C. An Example
Although most of the problems of markets
(including public goods, externalities,
markets for information (including invention),
etc.) can be traced to the conjunction
of the human and transactional factors
described above (in that, absent these, the
problems would vanish), it is beyond the
scope of this paper to attempt such a
showing here. Insurance, however, offers a
simple illustration. Risk aversion will be
assumed and the question is whether a
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VOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 319
group of individuals who are exposed to
independent risks will be able to pool
these successfully with an insurer.
Assume that the members of the group
are uniformly distributed over the risk
interval p, to P2, where pl < P2 and p
denotes the probability for a particular individual
that the contingency to be insured
will eventuate. (Since this probability
will vary depending on the riskmitigating
actions taken by an individual,
assume that p reflects efficient risk mitigation.)
Whereas individuals will be assumed
to know their risk characteristics exactly,
the insurer is unable, at low cost, to distinguish
one member of the group from
another. Information impactedness thus
obtains. Assume also that the highest
premium that an individual of risk class p
will pay is (p+E)D, where E <(P2-P1)/2,
and D is the (common) damage that will be
incurred if the contingency obtains.
In the absence of other information, and
assuming transaction costs to be negligible,
insurers would break even if they could
sell insurance to all members of this group
at a premium of [(pl+p2)/2]D, which is
the mean loss. Such a premium will be
regarded as excessive, however, by those
risk types for whom p+E < (Pl+P2)/2. Inasmuch
as these preferred risks cannot
easily establish that they are honestly entitled
to a lower premium-since (opportunistic)
poor risk types can make the
same representations and insurers are unable
(except at great cost) to distinguish
between them-they will withdraw. Breakeven
then requires that remaining parties
be charged a higher premium; the system
will stabilize eventually at a premium of
(p2-E)D. Information impactedness and
opportunism thus result in what is commonly
referred to as the “adverse selection”
problem.
Moreover, the matter does not end here
if the extent of the losses incurred is influenced
by the degree to which insured
parties take steps designed to mitigate
losses. If promises were self-enforcing, insurers
need merely extract a promise from
insureds that, once insured, they will behave
responsibly. Alternatively, if it could
easily be discerned ex post whether efficient
contingency mitigating practices had or
had not been followed, insurers could supply
insureds with appropriate incentives
to behave responsibly by paying only
those claims that fell within the terms of
the agreement. If, however, such determinations
can only be made at great cost
and (some) insureds exploit ex post information
impactedness opportunistically,
the problem referred to in the insurance
literature as “moral hazard” obtains
(Arrow, 1971, pp. 142, 202, 243). Premiums
will be increased on this account
also. Note finally that responsible parties
who otherwise would be prepared to selfenforce
promises to take efficient lossmitigating
actions may find that such behavior
is not competitively viable and will
consequently be induced to imitate opportunistic
types by underinvesting in loss
mitigation as well.2
D. A dministrative Expense
Although information asymmetries may
initially be great, so that estimates of the
true characteristics of economic agents are
2 It is furthermore relevant in this connection to distinguish
between insurance claims attributable to excessive
exposure to hazard, for failure to take appropriate
protective actions, and the “over-utilizatioA” of insured
services (e.g., health care) because, given insurance, the
effective price is less than the market price. M. Pauly
contends that only the former and not the latter reflects
moral hazard, and describes the price responsiveness as
a result “not of moral perfidy, but of rational economic
behavior” (p. 535). Clearly, however, behavior of both
types could and would be eliminated if insurers could
extract self-enforcing promises from insureds not to
exploit ex post information impactedness opportunistically.
Inasmuch as ex post behavior of both types is
attributable to the impossibility of extracting such
guarantees, it seems artificial that one type should be
regarded as moral perfidy but not the other (Arrow
1971, pp. 220-21).
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320 AMERICAN ECONOMIC ASSOCIATION MAY 1973
subject to considerable uncertainty, these
can be reduced in a variety of ways. One is
to infer true characteristics from experience.
A simple performance record can be
maintained and a priori probabilities successively
revised. TIhis can often usefully
be supplemented by both precontract and
performance auditing. Performance audits
are especially important where outcomes
are jointly dependent on the state of
nature that obtains and the behavior of
the economic agent. Arrow refers to this
condition as the “confounding of risks and
decisions” (1969, p. 55). Absent a performance
audit, the true explanation for
the outcomes observed in these circumstances
cannot be accurately established.
Revising the terms of a contract to reflect
the additional information gleaned
from experience may be referred to as
experience rating. Ihe prospect that this
will be done serves to curb opportunism in
contract execution. Inferior agents will
nevertheless be able to exploit information
impactedness, however, unless original
terms are relatively severe (i.e., no
bargains are to be had on joining) or
parties are unable easily to opt out when
terms are adjusted adversely against them.
One way to accomplish the latter is for
markets to pool their experience so that
opportunistic types cannot secure better
terms by “quitting” and turning elsewhere.3
This requires that a common language
be devised for describing agent characteristics,
which will be greatly facilitated
if the behavior in question can be easily
quantified. Where instead the judgments
to be made are highly subjective, the costs
of communication needed to support a
collective experience rating system are
apt to become prohibitive. Internal organization
may be favored instead because
it affords economies of communication.4

II. Internal Organization and Hierarchy
lTo describe the transformation of internal
organization from simple peer
groups through intermediate hierarchical
stages to include eventually complex,
adaptive organization of the sort described
by S. Beer, in his cybernetic account of the
enterprise, is beyond the scope of this
paper. Ihe discussion here is accordingly
restricted to hierarchies of a comparatively
primitive sort. The shift from peer groups
to simple hierarchies, for bounded rationality
and experience rating reasons, and
thence to multistage hierarchies, for transactional
reasons, is all that will be attempted.

Inasmuch as individuals derive nonpecuniary
satisfactions from a wide variety
of nonwork group affiliations, while the
work group is distinguished by its productivity
attributes, the discussion proceeds
mainly along productivity lines. But
while this delimits the inquiry, it does not
imply that workers are schizophrenic with
respect to their economic and noneconomic
identities. Those social psychologists
who have been concerned with the
“human side of enterprise” have counseled
against this for years. Thus, although an
emphasis on productivity will be maintained,
an attempt will be made to display
sensitivity to the potentially oppressive
consequences of alternative modes of
organization by reference to on-the-job
atmosphere.
I This should not be read as a rationale for anticompetitive
collusion.
I To the extent that supervisors and experience raters
are one and the same individual, the need to rationalize
subjective assessments that are confidently held but difficult
to articulate is reduced. Thus the occasion to communicate
is less. In addition, interorganizational communication
on complex matters is often more costly
than is intraorganizational. Full-time membership in an
organization involves common training and experience
as well as recurrent interpersonal contacts. Informal
coding economies are realized naturally and subtle
nuances come across easily as a result.
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VOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 321
A. Peer Group A ssociations
So as to avoid imputing benefits to
hierarchy that can be had, in some degree,
by simple nonhierarchical associations of
workers, it will be useful to begin with an
examination of worker peer groups. I’hese
involve collective and usually cooperative
activity, provide for some type of income
sharing arrangement, but do not entail
subordination.
1. A dvantages
Peer group organization (possibly in the
nature of a cooperative) for which loose
metering has been expressly provided may
arise on account of indivisibilities, for
associational reasons, or because of riskbearing
advantages. Inasmuch as the
rationale for shifting from individual to
collective organization to reach requisite
size consistent with indivisibilities is
familiar, consider the associational and
risk-bearing issues.5
‘IThe associational gains of peer groups in
relation to markets are attributable to the
transformation of “involvement” relations
(in the sense of A. Etzioni) from a
calculative to a more nearly quasi-moral
mode. Such an affiliation may incur productivity
losses but nevertheless be valued
for itself. But it may also, for pure associational
reasons, yield productivity gains
by mobilizing energies which, even if they
could be monitored costlessly and priced
accordingly, could not be exacted in the
market by the assured prospect of pecuniary
reward. Vulnerable, however, as
loose-metering structures are to free-rider
abuses, membership restrictions designed
to cull out those who would exploit average
group productivity are to be expected.
Group affiliation may also be sought for
insurance purposes if membership can
provide income guarantees to buffer the
effects of unanticipated contingencies on
terms superior to that which market insurance
can provide. The advantage of the
group over the market here is presumably
due to its capacity to (1) limit membership
in a discriminating way, thus mitigating
problems of adverse selection attributable
to ex ante information impactedness and
opportunism on the part of insurance
purchasers, and (2) check malingering and
other ex post manifestations of moral
hazard. Lacking hierarchy, however, the
argument has only small group implications.

2. Limitations
Whether peer groups can fully realize
economies attributable to indivisibilities
turns partly on utilization. Consider, for
example, the problem of devising access
rules for an indivisible physical asset for
which simultaneous utilization is not
possible. Any of a number of rules may be
efficacious, but agreement on one must be
reached. While a full group discussion
may permit one of the efficient rules eventually
to be selected, how much simpler if
instrumental rules were to be “imposed”
authoritatively. Resort to hierarchy may
thus be favored on this account though
the “leader” in these circumstances may
merely be the first among equals.
More serious, probably, is the vulnerability
of peer groups to free-rider abuseswhere
these are due to the conjunction of
information impactedness and opportunism.
Such free-rider abuses can take either
of two forms: ex ante nondisclosure (disguise)
of true productivity attributes, and
ex post malingering. The parallel with the
insurance example should be noted.6
Thus let p in the insurance example now
refer to the potential productivity of an
individual. If members of the peer group I Indivisibilities can take either physical or informational
forms. Indivisibilities of the former type are
familiar. On the latter, see Radner 1970, p. 457. i This was called to my attention by Jeffrey Harris.
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322 AMERICAN ECONOMIC ASSOCIATION MAY 1973
are all rewarded by average group productivity
(fi) and if no individual is prepared
to accept less than a p-E return, the
peer group can be viable only if it can successfully
screen out low productivity applicants.
TIo the extent that the cost of ex
ante screening is high in relation to ex post
experience rating, where the latter involves
hierarchy, peer group organization is perforce
limited.
There is the further problem in the peer
group of checking malingering, which is an
employment manifestation of moral hazard.
Although informal peer group pressures
may be mobilized to discourage
malingering, supplementing these by experience
rating is apt often to be even more
efficacious.7 A shift to hierarchy is favored
on this account as well. Thus, although
peer groups afford associational gains, may
be efficient risk-bearing instruments, and
potentially permit economies attributable
to indivisibilities to be realized, the costs
of communicating and reaching joint decisions
are apt to be high and, by design,
peer groups lack a formal auditing and
experience rating capability.
B. Simple Hierarchies
1. A dvantages
The advantages of hierarchy for communicating
purposes are reasonably obvious
and have been developed elsewhere.
Consider, therefore, the auditing and experience
rating properties of simple hierarchies.

Often the most efficient way to discover
an individual’s true potential productivity
(p) is by observing his work product
rather than by preadmission audits. Accordingly,
the peer group can usefully be
supplanted by hierarchy. Not only can
easier admission standards be allowed if
one is confident that he can discern true
productivity ex post and pay the appropriate
discriminating wage, but the
prospect of being audited and experience
rated discourages malingering as well.
High productivity types and/or those who
would be prepared to self-enforce promises
not to malinger can thus be induced to
affiliate at a low wage by the assurance
that this condition will be rectified as
information accumulates and more discriminating
wage assignments can be
made. Correspondingly, those with low
productivity and/or high proclivities to
malinger will be unable long to exploit the
system. The leader who is charged with
auditing and experience rating, however,
is no longer merely first among equals; a
genuine supervisor-subordinate relation
now obtains.8
2. Limitations
The ideal manager in this model is one
who has talents for discovering and extinguishing
opportunistic behavior.9 Nothing
has been said about his risk-bearing
aptitudes, innovative characteristics, leadership
qualities, or differential decisionmaking
skills. Neither has the bounded
7 D. Hampton, C. Summer, and R. Webber describe
the group disciplinary effects of informal organization
in four stages (p. 283). The most casual involves cajoling
or ribbing. This failing, rational appeals to persuade the
deviant to conform are employed. The group then
resorts to penalties by withdrawing the social benefits
that affiliation affords. Finally overt coercion and ostracism
are employed.
I The issue here is similar to that examined by A.
Alchian and H. Demsetz in their interesting treatment
of what they refer to as the “classical capitalist firm.”
As they see it, technological nonseparabilities in production
are responsible for the emergence of hierarchy. As
the above discussion reveals, however, nonseparability
is not a necessary condition for hierarchy to evolve.
I That hierarchy of a supervisor-subordinate sort
facilitates auditing and experience rating does not, however,
imply that all such hierarchies need meter productivity
in the same degree. Differing attitudes among
workers toward metering intensity will permit enterprises
to specialize accordingly. Some will meter closely
and appeal to those who favor very tight correspondence
between rewards and deeds. Others will meter less
closely in support of a less calculative associational relationship.
Both types, given that workers allocate themselves
appropriately, can be fully viable.
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VOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 323
rationality problem been faced. Although
a complete theory of the firm must eventually
address all of these issues, such an
effort is beyond the scope of this paper.
Consider instead the following delimited
problem: What organizational relations
are to be expected if a set of technologically
separable work groups (each, say, organized
as a simple hierarchy) is engaged in
recurring exchange of a small numbers sort
for which suiccessive adaptations to uncertainty
are required?10
For reasons that can be traced ultimately
to the human and transactional
factors described in Section 1, neither long
term nor short-term interfirm contracts
have attractive properties in these circumstances
(Williamson 1971, pp. 115-
21). Consider therefore two hierarchical
alternatives: extend the span of control of
a single manager over the entire set of
transactionally-related activities; and inside
contracting, which is a hierarchical
variant (involving two or more stages) on
the manager as monitor model.
The first possibility can be dismissed on
bounded rationality grounds. Spans of control
can be progressively extended only by
sacrificing attention to detail. Neither
transactional economies nor effective monitoring
can be achieved if capacity limits
are exceeded. Thus suppose that inside
contracting were employed.
J. Buttrick has described the inside contracting
system as follows:
Under the system of inside cQntracting,
the management of a firm provided floor
space and machinery, supplied raw material
and working capital, and arranged
for the sale of the final product. The gap
between raw material and finished product,
however, was filled not by paid employees
arranged in [a] descending hierarchy
. .. but by [inside] contractors, to
whom the production job was delegated.
They hired their own employees, supervised
the work process, and received a
[negotiated] piece rate from the company.
[pp. 201-02]
The system developed among New England
manufacturing plants at the time of
the Civil War and was continued in many
of them until World War 1.
The inside contracting system had the
attractive attributes that it (1) provided
for the aggregation at a single location of a
series of primary work groups that were
involved in successive manufacturing processes,
thereby reducing transportation expense
and assuring that a cheek-by-jowl
association would develop, with corresponding
economies of communication;
(2) permitted the capitalist with relatively
little technical knowledge to employ his
capital productively while limiting his
involvement to negotiating contracts with
the inside department heads, inspecting
and coordinating the output of the various
departments, and taking responsibility for
final sales; and (3) provided the inside contractors
(first level monitors) with incentives
for efficient labor performance, in
both supervisory and process innovation
respects. In addition, although neither is
mentioned by Buttrick, (4) the monopoly
powers of the various inside contractors
were, in relation to supply by an exclusive
outside supplier, presumably limited by
the capitalist’s ownership of plant and
equipment, and (5) problems of information
impactedness, which might otherwise
inhibit new investment, were avoided.
The system nevertheless experienced numerous
difficulties (Buttrick, pp. 210-15):
(1) a bilateral monopoly position, albeit
restrained, developed between
the parties;
(2) the periodic renegotiation of rates
induced the contractor to hoard information
and strategically delay
innovations;
(3) the flow of components was difficult
to regulate;
10 Two work groups will be considered to be separable
if a buffer inventory would sever the interdependence
relation, between them. Most large groups can be decomposed
into a series of small groups in this way.
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324 AMERICAN ECONOMIC ASSOCIATION MAY 1973
(4) work-in-process inventories were excessive
and, since each stage incurred
only its own direct labor
costs, later stage processes were
wasteful of components on which
early stage work was completed;
and
(5) contractor incomes were sometimes
excessive in relation to those of the
capitalist, endangering the status of
company officials.
The system moreover was beset by defective
incentives in that:
(6) equipment was not utilized and
maintained with appropriate care;
(7) process innovations were biased in
favor of labor saving, as against materials
saving, innovations; and
(8) the incentives for product innovation
were insufficient.
Although some of these defects-namely,
4 and 7-might have been remedied by
making simple changes in the internal
pricing system, the other disabilities of
inside contracting appear really to be
immanent. Given uncertainty, whence the
occasion to make coordinated adaptations
between successive parts, and bounded
rationality, whence the infeasibility of a
flat (single stage) hierarchy, the defects
listed are manifestations of small numbers
bargaining relations in which opportunism
and information impactedness conditions
obtain.” Thus, the disabilities of yet another
organizational mode, this time inside
contracting, are explained in terms of the
human and transactional factors described
in Section 1.
C. Subordination of Functional
Departments
The reasons, I submit, why inside contracting
was displaced by a hierarchical
system in which department managers
were no longer semiautonomous contractors,
but were made to accept employee
status instead, are that this harmonized
interests, permitted fiat to be employed to
settle instrumental disputes that might
otherwise occasion costly haggling, and
allowed auditing and experience rating to
be brought more sytematically to bear. The
resulting transactional economies are examined
in my treatment of vertical integration
(1971). (For a discussion of the
human and transactional difficulties which
such functionally organized enterprizes
eventually encounter as firm size is progressively
scaled up, see Williamson,
1970.)
III. Concluding Remarks
The discussion of internal organization
in this paper deals with only elementary
forms of hierarchy and relatively simple
types of adaptive behavior. The management
of a complex firm, however, must
deal with such issues as the redeployment
of internal resources in response to environmental
disturbances in kind, strategic
planning, including innovation, and preserving
(or not degrading) intrafirm atmosphere
as firm size is scaled up. In addition,
the eventual limits of complex hierarchies
need to be assessed. While these
matters are beyond the scope of this
paper, my contention that the interesting
problems of organization in complex hierarchies
are likewise to be understood in
terms of the framework proposed in Section’
I is surely, at this stage, unsurprising.
11 Defect number 5 involves, in addition, a strain on
atmosphere. Upsetting the normal correspondence between
hierarchical position and income apparently poses
personal and functional status threats of a potentially
disruptive sort.
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VOL. 63 NO. 2 ORGANIZATIONAL FORMS AND INTERNAL EFFICIENCY 325
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