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Why do firms exist The Economist

Summary of Why Do firms exists? from The Economist. This article is written in celebration of the 100th birthday of Ronald Coase.

The main question for management theorist is Why do firms exists, why is not everything done by the market?. Classical economists say very little about this question: they prefer to focus on the sea rather than on the islands. Adam Smith talked about a pin factory but nobody continued this story.

Until Coarse picked up the pin factory and restored it to its rightful place. He published many articles but it wasnt until he was 80 that he was rewarded a Nobel prize. His central insight was that firms exists because going to the market all the time can impose heavy transaction costs. He was one of the few to look inside the black box that the firm is.

He is known for his critics on his colleagues because he thought that they were too theoretical: they should look at what was really going on in the business instead of looking in their textbooks.

Mr Coases narrow focus on transaction costs provides only a partial explanation of the power of the firms. It has led to a fierce backlash of management theorists who argue that activities are conducted within firms not only because markets fail, but also because firms succeed: they can marshal a wide range of resources like corporate culture and collective knowledge, that markets cannot access. This is aligned with the resource-based theory. So Coases theory of market failure should be complemented by a theory of organizational advantages.

Smith, 1776

Summary: An Inquiry into the Nature and Causes of the Wealth of Nations: BookI by Adam SmithAn Inquiry into the Nature and Causes of the Wealth of Nationsis widely considered to be the first modern work in the field of economics. The work is also the first comprehensive defense of free market policies

Chapter 1 Of the Division of LabourThe greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.The effects of the division of labour, in the general business of society, will be more easily understood by considering in what manner it operates in some particular manufactures. It is commonly supposed to be carried furthest in some very trifling ones; not perhaps that it really is carried further in them than in others of more importance: but in those trifling manufactures which are destined to supply the small wants of but a small number of people, the whole number of workmen must necessarily be small; and those employed in every different branch of the work can often be collected into the same workhouse, and placed at once under the view of the spectator. In those great manufactures, on the contrary, which are destined to supply the great wants of the great body of the people, every different branch of the work employs so great a number of workmen that it is impossible to collect them all intothe same workhouse. We can seldom see more, at one time, than those employed in one single branch. Though in such manufactures, therefore, the work may really be divided into a much greater number of parts than in those of a more trifling nature, the division is not near so obvious, and has accordingly been much less observed.To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving, the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exertedthemselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth

part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.In every other art and manufacture, the effects of the division of labour are similar to what they are in this very trifling one; though, in many of them, the labour can neither be so much subdivided, nor reduced to so great a simplicity of operation. The division of labour, however, so far as it can be introduced, occasions, in every art, a proportionable increase of the productive powers of labour. The separation of different trades and employments from one another seems to have taken place in consequence of this advantage.This great increase of the quantity of work which, in consequence of the division of labour, the same number of people are capable of performing, is owing to three different circumstances; first, to the increase of dexterity in every particular workman; secondly, to the saving of the time which is commonly lost in passing from one species of work to another; and lastly, to the invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.First, the improvement of the dexterity of the workman necessarily increases the quantity of the work he can perform; and the division of labour, by reducing every man's business to some one simple operation, and by making this operation the sole employment of his life, necessarily increased very much dexterity of the workman. The different operations into which the making of a pin, or of a metal button, is subdivided, are all of them much more simple, and the dexterity of the person, of whose life it has been the sole business to perform them, is usually much greater. The rapidity with which some of the operations of those manufacturers are performed, exceeds what the human hand could, by those who had never seen them, be supposed capable of acquiring.Secondly, the advantage which is gained by saving the time commonly lost in passing from one sort ofwork to another is much greater than we should at first view be apt to imagine it. It is impossible to pass very quickly from one kind of work to another that is carried on in a different place and with quite different tools. Independent, therefore, of his deficiency in point of dexterity, this cause alone must always reduce considerably the quantity of work which he is capable of performing.Thirdly, and lastly, everybody must be sensible how much labour is facilitated and abridged by the application of proper machinery. Men are much more likely to discover easier and readier methods of attaining any object when the whole attention of their minds is directed towards that single object than when it is dissipated among a great variety of things. But in consequence of the division of labour, the whole of every man's attention comes naturally to be directed towards some one very simple object. It is naturally to be expected, therefore, that some one or other of those who are employed in each particular branch of labour should soon find out easier and readier methods of performing their own particular work, wherever the nature of it admits of such improvement.

Coase (1937) - The nature of the firm - foundation of transaction cost economics

Coase defines two types of coordination:

Transactions that take place across markets (through the price mechanism).

Transactions that take place within the firm (the entrepreneur-coordinator allocates the factorsof production between the different uses)

According to Coase (1937) firms exist because there is a cost of using the pricesystem. The cost to find out what the relevant prices are and a cost to draw up aseparate contract for each market transaction (in a firm the number of contractsis greatly reduced: long term, transparent prices, lower perceived risk). Undersome circumstances (e.g. high uncertainty) it may be hardly possible orextremely costly to reach a contractual agreement which may serve as a basisfor a market transaction. Therefore, the relative cost of transacting under themarket or the firm determines which type of coordination is used; transactionswill be executed at the lowest cost.

Authority of entrepreneurs allocate resources inside the firm. Economists arguethat this is still done on the base of price theory (agency theory). In the end,make or buy decisions include the transaction costs economics as well. Make orbuy decisions are about integrating a business activity either down- or upstream.

Why, if by organizing one can eliminate certain costs and in fact reduce the cost of production, arethere any market transactions at all?

As firms get larger, there may be decreasing returns to the entrepreneur function. As the transactions which are organized increase, the entrepreneur fails to place the factors of

production in the uses where their value is greatest (fails to make the best use of the factors ofproduction)

The supply price of one or more of the factors of production may rise, because the otheradvantages of a small firm are greater than those of a large firm.

___________________________________________________________________________2e SamenvattingCoase: "The Nature of the Firm"Themes:

Why do firms exist? What determines the scale and scope of firms?

In introductory and intermediate economics, firms are assumed to exist, and are characterized by production functions, cost curves, demand curves, etc.

Observations:

Firms transform inputs into outputs...but so do individuals. Firms are characterized by employers and employees..but in a way so are

market transactions. Firms are legal entities...but this is an uninteresting definition that we

won't address.One can imagine production w/o firms: individual traders exhanging capital and labor for payment, these being combined and marketed.

Organizations may seem to form "from a distance" -- cartel-types of trade made on a consistent basis to achieve some purpose, but we would probably not characterize these as firms.

We normally understand firms as embodying some kind of institutional structure.

Coordination of economic activity in these imaginary worlds would be via prices/bargaining.

Coase's observation: There are costs to using the price mechanism for coordinating economic activity. "transaction costs" or "marketing costs"

Given this, alternative institutional arrangements may coordinate economic activity at a lower cost. For example, it may be less costly for an individual to direct how resources should be used.

(imagine the costs of bargaining within a firm every time your boss tells you to dosomething upon which you have not previously agreed!)

Firms exist to economize on the cost of coordinating economic activity.Firms are characterized by the absence of the price mechanism.

Sources of transaction costs:

costs of learning prices cost of negotiating contracts cost of writing contracts, etc.

This is a transaction-based theory. If it is more efficient for a transaction to be conducted under alternative institutions, price mechanism will not be used. Coordination by fiat.

This is an important insight that has been applied toward explaining many institutions other than firms. Institutions arise in order to economize on transaction cost (Williamson, etc.) For example, bank clearing houses, commoditymarkets, vertical integration, etc.

Scope of the Firm

Follows from above.

If it is more efficient for a transaction to take place within the firm than under some other institutional arrangement, then it will take place within the firm.

If not, then it will take place under some other institutional arrangement:

in another firm mediated by the market.

What limits the scope of the firm?

increasing marginal costs of organizing more transactions within the firm. decreasing returns of managerial ability (knowledge, computation limits..)

So the scope of the firm is determined at the margin.

MC of organizing one more transaction within the firm equals the cost of using alternative institutional arrangements.

So, important questions to which Coase's theory provides a set of answers:

Why do firms exist? What, according to Coase, characterizes firms? What determines their scale and scope?

But even this theory leaves some gray areas...

Under Coase's definition of the firm, do traveling salesmen who sell the products of only one firm and get paid solely on commission count as employees? Or are they independent contractors working for themselves?

How about temps (secretaries and receptionists)? Do they work for a firm? Which one?

Movie theater chains and distributors are often under the same firm name (under the legal definition). However, when movies come out, they are offered to exhibitors on a non-discriminatory basis. United Artists theaters must bid for the right to show motion pictures distributed by United Artists.By Coase, are they the same firm?

In the Soviet Union, capital was often allocated across firms by governmental direction. By Coase, were the individual productive enterprises firms?

How about the different divisions of Bell which used transfer prices to allocate goods? Does it matter if the price was a market price or set internally?

Some examplesHow would one form a Coaseian explanation for the Disney-ABC/Cap Cities merger?

The cost of coordinating the economic activity within Disney and ABC separately was higher than the cost of doing so together under the direction of Disney's management. Furthermore, it is less costly to do everything that Disney does managing by fiat than mediated through the price mechanism.

What is a similar explanation for GM's spinning off EDS?

The cost of coordinating economic activity of these firms separately is lower than the cost of doing so together under GM's direction.

Alchian, A. A. and Demsetz, H. 1972. Production, Information Costs, and EconomicOrganization. American Economic Review , 62

It is a delusion to think that the firm owns all the inputs. A firm doesnt. it has no power of fiat, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting between any two people.

To speak of managing, directing, or assigning workers to various tasks is a deceptive way of noting that the employer continually is involved in renegotiationof contract on terms that must be acceptable to both parties.

What is the difference between a boss and his employee from a boss and his customer?

- It is in a team use of inputs and a centralized position of some party in the contractual arrangements of all other inputs. It is the centralized contractual agent in a team productive process not some superior authoritarian directive or disciplinary power.

1. The Metering problem

Two key demands are placed on an economic organization metering input productivity and metering rewards. Metering problems sometimes can be resolved well through the exchange of product across competitive markets.

The classic relationship in economics that runs from marginal productivity to the distribution of income implicitly, assumes the existence of an organization, be it in the market or the firm, that allocates rewards to resources in accord with their productivity.

The problem of economic organization is that analysis tends to assume tends to assume sufficiently economic or zero costs means, as if productivity automatically created its reward.

If economic organization meters poorly, with rewards and productivity only loosely correlated, then productivity will be smaller; but if the economic organization meters well productivity will be greater.

2. Team production

Usual explanations of the gains from cooperative behavior rely on exchange and production in accord with the comparative advantage specialization principle withseparable additive production.

Team production is product in which 1) several types of resources are used 2) the product is not a sum of separable outputs of each cooperating resource. An additional factor creates a team organization problem 3) not all resources used inteam production belong to one person.

In team production, marginal product of cooperative team member are not so directly and separably observable.

Clues to each inputs productivity can be secured by observing behavior of individual inputs.

With detection, policing, monitoring, measuring or metering costs, each person will be induced to take more leisure, because the effect of relaxing on his realizedrate of substitution between output and leisure will be less than the effect on the true rate of substitution.

Market competition could monitor some team production. But completely effective control cannot be expect from individualized market competition for tworeasons.

1. For this competition to be completely effective, new challenges for team membership must know where, and to what extent, shirking is a serious problem, know they can increase net output as compared with the inputs they replace.

2. Assume the presence of detection costs, and assume that in order to secure a place on the teama new input owner must accept a smaller share of rewards

3. The classical firm

One method of reducing shirking is for someone to specialize as a monitor to check the input performance of team members.

- But who will monitor the monitor?

- Give him title to the net earnings of the team, net of payments to other inputs.

The added incentive for the monitor is the residual product. The monitor earns hisresidual through the reduction in shirking that he brings about, not only by the prices that he agrees to pay the owners of the inputs, but also by observing and directing the actions or uses of these inputs.

Managing or examining the ways to which inputs are used in team production is amethod of metering the marginal productivity of individual inputs to the teams output.

The monitor has an entire bundle of rights:

1. To be a residual claimant

2. To observe input behavior

3. To be the central party common to all contract with inputs

4. To alter the membership of the team

5. To sell these rights that defines the ownership of the classical firm.

Two necessary conditions exist for the emergence of the firm on the prior assumption that more pecuniary wealth enter utility functions:

1. It is possible to increase productivity through team-oriented production, a production technique for which it is costly to directly measure the marginal output of the co-operating inputs. This makes it more difficult to restrict shirking through simple market exchange between cooperating inputs

2. It is economical to estimate marginal productivity by observing or specifying input behavior.

Simultaneous these two preconditions leads to the contractual organization of inputs known as the classical capitalist firms with a) joint input productions, b) several input owners c) one party who is common to all the contracts of the joint inputs d) who has rights to renegotiate any inputs contract independently of contract with other input owners e) who holds the residual claim f) who has the right to sell his central contractual residual status.

Other theories of the firm

Their view of the firms is not necessarily inconsistent with Coases, but they attempt to go further and identify refutable implications.

Team production, team organization, difficulty in metering outputs, and the problem of shirking are important in their explanation but not in Coases. Neither the residual claimant status nor the distinction between employee and subcontractor status is mentioned by Coase.

The measurement of marginal productivity, which now involved interactions between workers, especially though their joint use of machines, become more difficult though contract negotiating cost was reduced, while managing behavior of inputs become easier because of the increased centralization of activity.

Blau, Scott 1962 Formal Organization: A Comparative Approach

What is the specific and differentiating criterion implicit in out intuitive distinctionof organzations from other kinds of social groupings or institutions?

- It has something to do with how human conduct becomes socially organized, but it is not, whether or not social controls order and organize the conduct of individuals, since such social controls operate in both types of circumstances.

Social organization: the ways in which human conduct becomes socially organized, that is, to the observed regularities in the behavior of people that are due to the social conditions in which they find themselves rather than to their physiological or psychological characteristics as individuals.

Two main types can influence social conditions:

1. The structure of social relations in a group or larger collectivity of people

2. The shared beliefs and orientations that unite the members of the collectivity and guide their conduct.

The conception of structure of system implies that the component units stand in some relation to one another and that the relations between units add new elements to the situation.

A network of social relations transforms an aggregate of individuals into a group and the group is more than the sum of the individuals composing it since the structure of social relations is an emergent element that influences the conduct of individuals.

Social relation involve:

1. Patterns of social interaction

2. Social relations entail peoples sentiments to one another

The differential distribution of social relations in a group defines its status structure.

Relations also develop between group, not only between individuals within groups.

The networks of social relations between individuals and groups and the status structure defined by them, constitute the core of the social organization to a collectivity, but not the whole of it.

Other main dimension of social organization is a system of shared beliefs and orientations, which serve as standard for human conduct.

Common notions arise as to how people should act and interact and what objectives are worthy of attainment:

1. Common values crystallize

2. Social norms develop

Aside from the norms differential role expectations also emerge.

The two dimension of social organization the networks of social relations and the shared orientations are often referred to as the social structure and the culture.

The prevailing cultural standards and the structure of social relations serve to organize human conduct in the collectivity.

Since the distinctive characteristic of some organizations is that they have been formally established for the explicit purpose of achieving certain goals, the term formal organization is used to designate them.

Formal and informal organization

In every formal organization there arise informal organizations. The constituent groups of the organization develop their own practices, values, norms and social relations as their members live and work together.

Unofficial norms are apt to develop that regulate performance and productivity.

For informal organizations develop in response to the opportunities created and the problems posed by their environment, and the formal organization constitutes the immediate environment of the groups within it.

Formal instituted and informally emerging patterns are inextricably intertwined.

The term informal organization does not refer to all types of emergent patterns ofsocial life but only to those that evolve within the framework of a formally established organization.

Social institutions evolve without explicit design.

The terms large-scale or complex organization for formal organization are misleading because:

1. Firms vary in size and complexity

2. Their size and complexity do not rival those of the social organization of a modern society.

Term bureaucratic organization is also often used. But wide variations have been found in the degree of bureaucratization in organizations, as indicated by the amount of effort devoted to administrative problems, the proportion of administrative personnel, the hierarchical character of the organization, or the strict enforcement of administrative procedures and rigid compliance with them.

Art. 7: Kogut & Zander (1992): Knowledge of the firm, combinative capabilities, and the replication of technology.

The view in this article is differs radically from that of a firm as a bundle of contracts that serves to allocate efficiently property rights. Rather, they suggest that organizations are social communities in which individual and social expertiseIs transformed into economically useful products and services by the application of a set of higher-order organizing principles Firms exist because they provide a social community of voluntaristic action structured by organizing principles thatare not reducible by individuals.

[1] This article state that firms share and transfer knowledge of individuals and groups within an organization better than markets can. This knowledge consist information (i.e. who knows what) and of know-how (i.e. how to organize a research team). Firms differ in their information and know-how and these differences, when they are economically interesting, have persisting effectson relative performance. Thus, a central characteristic to be explained is the persisting difference in capabilities, that is, the difficulty in their transfer and imitation. This can be analyzed over two dimensions: codifiability and complexity.Codifiability and complexity are related, but not identical.

Central to their argument is that knowledge is held by individuals, but is also expressed in regularities by which members cooperate in social community (i.e. groups, organization, or network). If knowledge is only held on individual level, then firms could change simply by employer turnover. Because we now thathiring new workers is not equivalent to changing the skills of a firm, an analyses of what firms can do must understand knowledge as embedded in the organizational principles by which people cooperate within organizations.

A paradox is identified: efforts by a firm to grow by the replication of its knowledge (i.e. simplification and codification) enhance the potential for imitation. While knowledge transfer is a desired strategy in the replication and growth of the firm, imitation is a principal constrain. In other words, for a firm to growth, it must develop organizing principles and a widely held and shared code by which to orchestrate large numbers of people and functions. Whereas the advantage of reducing costs of intra-or inter-firm technology transfer encourage

codification of knowledge, such codification runs the risk of encouraging imitation.

[2] By considering how firms can deter imitation by innovation, they develop a more dynamic view of how firms create new knowledge. Creating new knowledge does not occur in abstraction from current abilities. Rather, new learning, such as innovations, is a product of a firms combinative capabilities to generate new applications from existing knowledge. It is local search that generates a condition commonly called path dependence, that is, the tendencyfor what a firm is currently doing to persist in the future. The reason that knowledge advances by recombination is because firms capabilities cannot be separated from how it is currently organized. The ability to build on current technology is instrumental in the deterrence of the imitation of firms knowledge by competitors. In an environment where there is on-going competition, there is ashort-term consideration, i.e. at what speed and cost can a firm replicate its current technology and imitate others. Long-term survival involves a complex tradeoff between current profitability and investing in future capabilities.

Because new ways of cooperating cannot be easily acquired, growth occurs by building social relationship that currently exists in the firm. What a firm has done before tends to predict what it can do in the future. In this sense, the cumulative knowledge of the firm provides options to expand in new but uncertain markets in the future.

Hodgson, 1998 Competence and contract in the theory of the firm

Summary Hodgson (1997): Competence and contract in the theory ofthe firm There is no consensus among economists on the factors that may explain theexistence, boundaries, structure, and development of the firm. There canhowever be made a distinction between two perspectives:

1. The contractual perspective: emphasizes the cost of making and monitoring transactions.

2. The competence perspective: believes the existence, structures, and boundaries of the firm aresomehow explained by individual or team competences that are fostered and maintained bythe organization. Individual or team competences are captured in skills and tacit knowledge.

The competence perspective produces the basis for evolutionary and non-equilibrium theories of industrial competition and development.

Genesis of the competence-based theory of the firm: Adam Smith > wealth ofnations. The division of labour leads to the enhancement of skills throughlearning by doing. This already was an insight of dynamic growth anddevelopment, in which individual skills are progressively enhanced. The rise ofneoclassical economics shifted attention away from processes of productiontowards the market. Choice, contract, and exchange became central concepts foreconomic theory.

Dissatisfaction with this standard analysis has led to a revival of the competence-based approach. Hodgson aims to explain the nature of the firm usingcompetences rather than an exclusively transaction cost framework. However, hedoes not deny the potential role of transaction cost since these may help toexplain some phenomena. His aim is the following: to show that the competence-based approach can answer the key questions concerning the nature of the firmas least as well as the transaction cost and other contractarian theories. Forfuture purposes, it is needed to develop a research program in which the twoapproaches are conjointly evaluated and tested. This points to the possibility ofhybrid explanations.

Limitations of contractarian approaches

There are three key features of existing contractarian approaches:

1. Given individuals (typically with given preference functions) are assumed. This feature thereforeleads to a neglect of two things:

a. The limits of contracts and exchange, and the necessity of some non-contractual relations,involving (moral) norms and (tacit) rules. All market-based contractual systems somehow rely onessentially non-contractual elements (e.g. moral norms + trust) to function.

- Key difference between contractual and competence-based theories of the firm: Coase(contractual) regards all managerial and entrepreneurial competences as potentiallycontractible, whereas Knight (competence) denies that they can all be. In a context ofuncertainty some competences cannot be bought or hired.

b. The processes of radical individual transformation, development, and cognitive learning.Contractual models fail to acknowledge that for information to become knowledge it must be

interpreted, and different interpretations are always possible, even with the same set ofinformation. The very act of learning means that not all information is possessed, which wouldrule out the assumption of rationality within contractual theories > limited to equilibrium. Withinfirms there is interdependence of individual knowledge. Knowledge is embedded in socialstructures, and is not immediately transparent. Organizational knowledge interacts with individualknowledge but is more than the sum of the individual parts. It is context-dependent, culture-bound and institutionalized.

2. Technology and production are neglected. Uniformity of technology is assumed, so whilegovernance models are evaluated, production costs and technology are ignored. Primary emphasis isthus on the choice of governance structures and the efficient allocation of given resources. It is acommon mistake to treat production as an extension of exchange. There is a key difference betweenproduction and exchange: in contrast to a contract involving the exchange of goods, productioninvolves the use of labour and the ongoing intentional involvement of a worker. A relationshipbetween buyer and seller necessarily endures after the contract is agreed, which extends its socialand non-contractual dimension. Trust and loyalty can however not be modelled adequately in anexclusively contractarian framework.

3. The focus on comparative static explanations overlooks key dynamic aspects of the problem, notablylearning, innovation, and technological development. This is the most serious problem since theability of the firm to foster human learning, technological innovation, and research and developmentare important for survival. Dynamic efficiency is essentially about learning and innovation, and,because of this uncertainty, cannot be reduced simply to static terms. Recognition of the firm as ameans of coping with uncertainty is therefore crucial. Uncertainty is not only about future eventsthemselves, but also about the opportunities available. A dynamic and open-ended approachchallenges the relevance of a long-run equilibrium and admits an ongoing diversity of outcomes.

The viability of competence-based theories

The following definition of the firm is proposed: an integrated and durableorganization of people devoted to the production of goods or services that areowned as property under law by the firm.

Corporate culture and learning

Principal argument in this essay: an important but not exclusive factor explainingthe existence, boundaries, nature, and development of the firm is the capacity ofsuch an organization to protect and develop the competences of the groups andindividuals contained with it, in a changing environment. Accordingly, the firm isable to form and integrate the individual perceptions, preferences, abilities, andactions of its personnel.

Individuals cannot always be relied upon to cooperate together in a way whichserves the objectives of the organization as a whole. The firm survives andfunctions based on formal and informal relations: legal contracts to keep the firmtogether as a unit and to motivate the individuals within it, and informal relations(cultural + moral norms) vital to the integrity of the firm.

Learning depends on acquired cognitive frameworks, but at the same time it is anessentially open-ended, provisional, and potentially fallible process. A learningprocess therefore involves mistakes which become opportunities to learn.Organizational learning depends on corporate culture, which is more than shared

information. It is formed by both group and individual competences. Firms make itable to create a richer culture of often tacit norms, routines, and cognitive frames.It can form human preferences and actions so that a degree of loyalty and trust inregard to specific activities is ensured. However, markets and exchange also relyon types of measures of trust. The type and extent of trust generated within thefirm facilitates its organizational integration and its capacity to learn.

It would be a mistake to completely let trust substitute for transaction costs.Instead, trust is seen as a variable aspect of a dynamic corporate culture. Thatculture is a basis for organizational learning and dynamic growth. It is the overalland dynamic advantage of the organization of the firm that has to be emphasized,rather than snapshot comparisons of efficiency.

The firm has to generate a unifying culture to survive. The coherence of its culturereflects the administrative unity of the firm. Decision making and learning can bedecentralized, but strategic activities are centralized to provide coherence.Strategic activities are used to exploit opportunities for innovation and growth. Thecentral and divisional corporate cultures together affect the storage andtransmission of information, the acquisition and retention of knowledge, theframing of decisions and the nature and extent of human learning. However, hereis a negative side to such conformism. While a common corporate culture helps toprovide the coherence of the firm, there are dangers of inertia and resistance tochange. A key point in the competence-based approach is that new competenceshave to be managed and organized for much of their potential to be realized.

Due to its static framework, an exclusively transaction cost approach cannotcapture such a symbiosis. The costs of one governance structure are less thananother, and hence one survives.

The existence of the firm

Individual-to-individual relations are more intensive and last longer within the firmthan in exchange or markets (even despite migration of labour). The cohesivenessand longevity of the firm facilitates the transmission of information and thegeneration of practical knowledge > competences. These competences can onlyexist in the body of an organized group of individuals only: it would not survive in aworld of just individual agents. The capacity of the firm to safeguard and enhanceboth group and individual competences can explain its existence: firms existbecause they can more efficiently coordinate collective learning processes thanmarket organization is able to do. These efficiency advantages can however bepath-dependent.

The formation of the firm

Knight: by grouping together activities with uncertain outcomes in a single firmprovides an incentive both to set up a firm and to extend its scale for largeroperations.

The boundaries of the firm

In a disequilibrium situation the boundaries of the firm could be moving and arethus unsettled. So the question is what causes the boundaries to shrink or grow.Path-dependency is important for this matter: the firm should not be understood asan optimal organizational configuration, but via an appreciation of its history.

Within the competence paradigm, the boundaries of the firm should be understoodin terms of not only transaction costs, but also in terms of learning, pathdependencies, technological opportunities, selection, and complementary assets.

Conclusion

The competence based perspective emphasizes on both dynamic as staticefficiency, and on both production and allocation. This approach differs from Coaseand Williamson, since they explain the existence of the firm exclusively bytransaction costs. They focus on the diminution of costs related to transactionsbetween given individuals. The problem is then that the existence of the firmshould be viewed as a dynamic process (cost advantages spread through time),and can thus not be captured by an equilibrium based analysis. It is thereforedangerous to reduce the character of the firm to contracts and costs alone. Anemphasis on learning should supplement transaction cost explanations. Thishowever implies that individuals cannot be taken as given while selectingcoordination and governance mechanisms. Learning capacities are related tocultural development and transmission within organizations, and this provides analternative explanation for the existence of the firm. Learning should thereforetake a central place in the analysis of the firm. The relative efficiency anddynamism of the firm is thus explained not simply in terms of the summation oflower costs of atomistic transactions, but significantly also by the dynamicadvantages and efficiency of the firm as a whole.

Study questions:

1. What is according to Adam Smith (1776) the cause of the increase of welfare in industrialized countries? What are the three factors that lead to it?

2. Why do firms exist according to (1) Coase (1937), (2) Alchian & Demsetz (1972), (3) Blau & Scott (1962), and (4) Kogut & Zander (1992)? How do the explanations offered by these various authors differ?

3. How do contractual theories of the firm (of which Coase (1937) and Alchian& Demsetz (1972) are examples) and competence theories of the firm (of which Kogut & Zander (1992) is an example) differ from each other (cf. Hodgson, 1998)?

Week 2

Eisenhardt (1989) - Agency Theory: An Assessment and Review

Agency theory describes the relationship between one party (the principal)who delegates work to another (the agent), who performs that work, usingthe metaphor of a contract. Agency theory is concerned with resolving twoproblems that can occur in agency relationships:

1. The agency problem which arises when (a) the desires or goals ofthe principal and agent conflict and (b) it is difficult or expensive forthe principal to verify what the agent is actually doing.

2. The problem of risk sharing that arises when the principal and agenthave different attitudes towards risk.

The focus of the theory is on determining the most efficient contractgoverning the principal-agent relationship given assumptions aboutpeople, organizations and information. Agency problem: arises withincomplete principal information, agent may shirk. two options: buycontrol systems or reward outcome. However is a behavior-orientedcontract more efficient than an outcome-oriented contract?

Key idea: Principal-agent relationships should reflectefficient organization of information andrisk-bearing costs.

Unit of analysis: Contract between principal and agent.Human assumptions: Self-interest.

Bounded rationality. Risk aversion.

Organizationalassumptions:

Partial goal conflict amongparticipants. Efficiency as the effectivenesscriterion. Information asymmetry betweenprincipal and agent.

Informationassumption:

Information as a purchasable commodity.

Contractingproblems:

Agency (moral hazard and adverseselection). Risk sharing.

Problem domain: Relationships in which the principal andagent have partly differing goals and riskpreferences.

Positivist Agency TheoryFocus on identifying situations in which there are conflicting goals andthen describing the governance mechanisms that limit the agents self-serving behavior. There are two propositions:1) When the contract between the principal and agent is outcome-based,the agent is more likely to behave in the interests of the principal.2) When the principal has information to verify agent behavior, the agentis more likely to behave in the interests of the principal.

Agency Theory and the Organizational LiteratureThe heart of agency theory is the goal conflict inherent when individualswith differing preferences engage in cooperative effort, and the essentialmetaphor is that of the contract. It assumes the pursuit of self-interest atthe individual level and goal conflict at the organizational level.Information asymmetry is linked to the power of lower order participants.In agency theory, goal conflicts are resolved through coalignment ofincentives.

Contributions of Agency TheoryAgency theory reestablishes the importance of incentives and self-interestin organizational thinking. The theory makes two contributions toorganizational thinking:

1. Information is regarded as a commodity; it has a cost and can bepurchased. Information systems have an important role.Organizations can invest in such systems in order to control agentopportunism. Boards can be used as monitoring devices forshareholder interests. When boards provide richer information:

a. Compensation is less likely to be based on firm performance,and more based on knowledge of executive behaviors.

b. Top executives are more likely to engage in behaviors that areconsistent with stockholders interests.

2. Agency theory extends organizational thinking by pushing theramifications of outcome uncertainty to their implications forcreating risk. Uncertainty is viewed in terms of risk/reward trade-offs. Outcome uncertainty coupled with differences in willingness toaccept risk should influence contracts between principal and agent.

The conclusions are that agency theory offers unique insight into information systems, outcome uncertainty, incentives, and risk and is an empirically valid perspective.

Incentive life-cycles: learning and the division of value in firms, Obloj & Sengul 2012This paper argues about the individual and organizational learning mechanisms leading to the evolution of the division of value between economic actors under agiven contractual arrangement.

In on-going, long term relationships the division of value is ultimately determined by contractual arrangements. Organizational incentives are concerned both with incentivizing intended actions (value creation) and specifying the conditions of value appropriation by employees, they can be seen as an explicit contract specifying the division of value between a firm and its employees.

The existing work assumes that although the equilibrium division of value can change per contract, it is static.

However, organizations and individuals can learn how to better respond to a given incentive regime over time. This provides the possibility that the effectiveness of that incentive regime as an organizational design instrument is likely to evolve, even without external changes in the environment. They learn how to me productive and know how to exploit it.

There are 2 learning mechanisms:

1. Productive learning: employees learn over time and gain experience how to better and more efficiently conduct tasks induced by incentive instruments, positively contributing to organizational performance. Leading to a greater value creation.

2. Adverse learning: employees learn over time and gain experience how to exploit a given incentive design for their own benefit at the expense of the organization. Employees will appropriate a greater part of the value that they create.

a. Seen as opportunistic behaviour. But adverse learning, or gaming, is different as it can be learned, not a behavioural trait.

Under a given incentive regime over time, the organizations share of the total value created will follow an evolutionary trajectory. The introduction of a new incentive regime will trigger productive and adverse learning that are specific to a given set of incentives. as the relative attractiveness of productive and adverseresponses to employees changes over time, the evolution of these two mechanisms will follow different trajectories: productive learning is likely to be more pronounced than adverse learning early on in the incentive life-cycle, but over time, their relative prominence should be reversed, and adverse learning should dominate productive learning. As a result, adverse responses will outweigh productive responses, and a greater proportion of the value created willbe forfeited due to agency costs.

ORGANIZATIONAL INCENTIVES AND THE DIVISION OF VALUE IN FIRMS

The objective of every incentive regime is to align the employees and organizations objectives, as to create as much as value for the organization as possible. But employees try to devise and incentive regime that will let them

appropriate as much as possible value. The division of value within a firm in the regimes lifecycle is static. The division of value between a firm and its employees can evolve under an incentive regime. When changing to another incentive regime both the firm and the employees need to learn which activities, attention and effort will be optimal for them.

Evolution of value creation and appropriation by employees under a newincentive regimeProductive learning affects the evolution of value creation and appropriation under a given incentive regime, as it contributes positively to both value creation and appropriation by the employees.

Incentive regime changes trigger productive learning, and therefore will disrupt value creation.

Evolution of the division of value under a new incentive regimeWhile the presence of productive and adverse learning provides an explanation for how value creation value appropriation evolve under a new incentive regime, this study aims to explain the evolution of the relative division of value between afirm and its employees. The ability to appropriate value for both the firm and its employees determines the division of value, which will change over time.

The firms ability to create more value and appropriate more of this value will likely increase over time following an incentive regime change, not only because the regime it designed to do so but also because firms learn how to make the new incentive regime more functional.

The employees ability to appropriate more of the value created will likely increase over time as well, because of the productive and adverse learning in which they will become more efficient over time due to experience. They will choose or productive learning or adverse learning, depending on what will allow them to appropriate more of the value created.

Early in the life-cycle of the incentive regime, the marginal reward for advancing along the productive learning curve is higher than adverse learning. Later in the life-cycle adverse learning provides a higher marginal reward than productive learning curve.

Therefore, employees accumulate more experience along the productive dimensions in the early stages and later accumulates more experience on learning along the gaming dimension. There are several reasons why:

1. Institutional barriers such as control systems prevent unwanted, adverse learning, behaviour. Also the strength of these barriers is stronger in the beginning.

2. Organizations make productive learning more attractive, for example through training or instructions

3. Informal organization facilitates both productive and adverse learning, but its facilitating effect on adverse learning lags its effect on productive learning. Learning

across employees is more likely to support productive learning because institutionally supported knowledge (facilitating productive knowledge) is likely to be exchanged through the informal network prior to the exchange of non-legitimate practices.

4. It is relatively harder to take advantage of experience gained from prior incentive regimes along the adverse dimension that on the productive dimension. It will be faster, easier, and less costly to apply knowledge from prior incentive regimes for productive learning than for adverse learning.

So formal organization (control systems and institutional support) promotes productive learning and suppresses adverse learning. Informal organization (including interaction with other employees) and prior experience promotes both productive and adverse learning.

Changes in formal organization follow an incentive regime change, changes in informal organizations follow the changes in the formal organization with a lag.

Therefore organizational adjustment and productive learning in the early period after the incentive regime change than adverse learning, with the adverse learning increasing over time.

Therefore, the value appropriated of the organization will be higher in the beginning, then reach a plateau, and then decrease over time.

DISCUSSION AND CONCLUSIONS

This paper shows that the total value created, the share appropriated by the organization follows and evolutionary trajectory over time, the incentive life-cycles. After the introduction of a new incentive regime the banks share of the total value created increased at a decreasing rate and decreased over time and with experience. Organizational incentives trigger 2 sorts of learning, which change over time over the life-cycle, which both increase over time and with experience.

Contributions and future researchValue creation and appropriation co-evolve along the life-cycle of organizational incentives. This paper shows how and why the division of value can evolve over agiven contractual arrangement, especially learning in response to organizational incentives, what brings the life-cycle out of equilibrium. Changes in the organizational incentives trigger learning mechanisms: productive learning (increasing value creation) and adverse learning (increasing value appropriation by employees).

Changing a incentive regime might provide benefits (overcoming inertia and increase the value creation) but also disadvantages (disrupting organizational processes and thereby creating more risk, fixed costs of regime change, monitor and coordination cost, implementation cost, etc.). So too much change is not favourable.

But as organizations continuously become more effective and grow and their objectives change over time, so incentive regimes need to evolve with that and fit.

Changes to incentives occur because any given structure can trigger learning mechanisms that decrease the effectiveness of the incentive regime over time. Employees become better at gaming the regime, change of regime resets the adverse learning by employees.

Bowles, S. 2008. Policies designed for self-interested citizens may undermine "The Moral Sentiments": Evidence from economic experiments

Taxes, subsidies, tournaments, auctions and other incentives can be structured to induce selfregarding individuals to act in the common interest when market competition alone would fail to accomplish this. Constitutions and public policies should be designed for knaves motivated only by their private interest, but they may turn out to be counterproductive. Economic incentives may diminish ethical or other reasons for complying with social norms and contributing to the common good. The effects of material interests and moral sentiments on behavior are additive rather than interactive. This is called the assumption of separability.

Incentives and Market FailuresWhen individuals do not take into account the effects of their actions on others (external effects or spillovers), the result of private decentralized decision-making will be inefficient in the sense that by implementing some other feasible outcome, at least one individual could be made better off without anyone being made worse off. There are market failures. Complete contracts eliminate spillovers,internalize the external effects by assigning claims and liabilities so that each actor owns all of the benefits and costs resulting from his or her actions, including those conferred or imposed on others. Prices would do the work of morals. But, contracts are hardly ever complete, due to information asymmetry, team production processes and the voluntary provision of public goods. All of this is thecase in the labor and capital market: agency theory.

Mechanisms can be designed to find a way to assign to each actor the entire benefits and costs. Societies address market failures through some combination of incentive-based design and other regarding motives. The separability assumption commonly fails. Sometimes, explicit incentives and ethical motives are complementary, but in most cases incentives undermine ethical motives. Four reasons have been suggested for the failure of the separability assumption:

Framing. Incentives are part of a how a decision situation is represented and may signal appropriate behavior.

Endogenous preferences. Preferences are endogenous is ones experiences result in durable changes in motivations and hence a change in behavior in given situations. Incentives induce more self-interested behavior, even after they were withdrawn. Economies structured by differing incentives are likely to produce people with differing preferences. Incentives change preference because they affect key aspects of how we acquire our motivations.

Over determination. The introduction of explicit incentives may overjustify the activity and reduce the individuals sense of autonomy.

Information content of incentives. Principals select incentives based on their own objectives and their beliefs about how well the agent will performhis task under each possible incentive. The incentives selected reveal information about the principals preferences, the nature of the task and his beliefs concerning the agent. The fact that incentives reveal that the principal is untrusting or self-aggrandizing helps explain a common patternof experimental results. The most plausible explanation of the effectiveness of peer punishment is that when punished, those who have contributed less than others feel shame, which they redress by contributing more subsequently.

Why are Counterproductive Incentives common?Even if incentives reduce the total gains associated with a project, their use may give the principal a sufficiently larger slice of the small pie to motivate the principal to use them.

Why Moral Sentiments and Material Interests are not separable & DiscussionWhen ones person itself is the raw material and its transformation or affirmation is the objective, the presence of explicit economic incentives may have unintended effects. People want to cooperate but also want to make sure that others who did not cooperate would be punished. They do not wish to be exploited.

Larkin, I., Pierce, L., and Gino, F. 2012. The psychological costs of pay-for-performance: Implications for the strategic compensation of employees

As agency theory provides a useful framework for analysing compensation, it failsto consider several psychological factors that increase costs from performance based pay. The authors examine how psychological costs from social comparison and overconfidence reduce the efficacy of individual performance-based compensation, building a theoretical framework predicting more prominent use ofteam-based, seniority-based and flatter compensation.

This paper examines the strategic implications of compensation choices for nonexecutive employees, as agency theory falls short in this.

THE IMPLICATIONS OF THE INFREQUENCY OF INDIVIDUAL PAY-FOR-PERFORMANCEThe agency theory in broadly equating the effectiveness of different compensation, seeking the most efficient compensation system.

AT AND STRATEGIC COMPENSATIONIn agency theory costs arise due to differences between firms and employees in two crucial areas: objectives and information. Two potential costs arise from these differences: employees may not exert maximum effort and the firm may pay workers more than they are worth.

ObjectivesFirms seek to maximize profit, and increased compensation affects profitability bymotivating employee effort and attracting more highly skilled employees, while increasing wages.

Employees seek to maximize utility, influenced by compensation.

InformationTwo information asymmetries where the agent knows more than the principal: about the effort exertion and skill level. Overcoming these asymmetries by providing incentives for workers to exert effort and self-select by skill level.

Predictions of standard ATEmployees work harder when their pay is based on performance.

Firms are more likely to use performance-based pay when they have less information about actual employee efforts.

Firms are more likely to use performance-based pay when they have less information about employee skill level, and/or as employee skill level is more heterogeneous.

Team-based compensationFirms are more likely to use team-based performance pay (vs individual pay) when coordination across workers is important, when free riding is less likely, or when monitoring costs are low (individual effort is not observable).

Basic predictions of ATWhen both effort and output are highly observable, firms prefer to use a set salary.

When individual skill is not observable, compensation both motivates employees but also attracts specific types of employees. Firms are more likely to use performance-based pay when employee skills are not observable compared to when they are.

INCORPORATING INSIGHTS FROM PSYCHOLOGY AND DECISION RESEARCH INTO ATIn this section the authors discuss how these psychological factors, overconfidence and social comparison processes, add costs to performance-based compensation systems.

Performance-based pay and social comparisonIndividuals generally seek and are affected by social comparison with others, gaining information about their own performance. Social comparison allows employees gain knowledge of the pay of others. Employees do not only respond to their own compensation, but also to the compensation of others. In individual pay-for-performance systems pay will inevitably vary between employees. When input and performance is unobservable or perceptions are biased this lead to an unequal feeling of the employee and therefore effort reduction and reduce morale.

Perceived inequity in pay can furthermore have a costly asymmetric effect: belowmedian earners might exit the firm and above median earners may not become more effective because of the superior pay.

SO: Perceived inequity through wage comparison reduces the effort benefits of individual pay-for-performance compensation systems and introduces additional

costs from sabotage. Furthermore, random shocks (the employee cannot do anything about the drop in performance, as it might be due to its environment) introduce also costs from reduction in effort and sabotage.

Overconfidence and performance-based payEmployees might be overconfident about their own abilities and too optimistic about their future. People tend to be overconfident about their ability on tasks they perform very frequently, find easy, or are familiar with. This implies implications with employees performing work, as they perform it frequently and are familiar with it. Therefore, performance-based pay may fail to efficiently sort workers by skill level. This might cause them to select into performance-based positions that are suboptimal for their skill set, causing the firm to hire lower ability workers than they think.

Overconfidence may lead to reduced effort when combined with social comparison. As they overestimate their ability they might feel superior when comparing to others and not understand why they earn less or the same.

REDUCING PSYCHOLOGICAL COSTS THROUGH TEAM-BASED AND SCALED COMPENSATIONAs social comparison and overconfidence may make individual pay-for-performance systems less attractive, firms might still favour such sort of system to increase the value created. This paper argues that there are 2 alternative systems:

1. Team-based wages: reduces costs of social comparison. This makes it a little more attractive than predicted by agency theory, which holds that team-based pay will be based only when there are benefits to coordination across employees that are greater than the costs of free riding.

2. Scale-based wages: employees are compensated based on seniority, which reduces thatcosts of social comparison and overconfidence and are therefore more attractive than standard AT would predict.

Reducing social comparison costs through intermediate forms of compensationFirms with team-based compensation systems keeps the performance-based incentives, but ties them to the team performance instead of the individual performance. Reduces wage comparison by equalizing everyones wages in the same team. However, some issues of social comparison remain, as they only perceive equality of the pay when they perceive everyones contribution to the team equal. So contribution in a team should not be highly heterogeneous.

However, there still my occur social comparison between teams. This can be reduced by scaled wages, employees may view this policy still as unfair but will not feel personally insulted.

Reducing overconfidence costs through flattening compensationWhen individuals in teams are overconfident and the team performs low, they willfeel that the rest of team isnt up to their standard and they might lower their efforts. So team-based compensation only resolves problems of overconfidence inindividual pay-for-performance when the performances of team members are observable.

Through flattening wages across the firm, workers are less likely to socially compare and therefore do not seek to transfer to another team.

By introducing scale-based wages the overconfident workers will observe higher wages in other firms and therefore leave the company, re-establishing equality. So getting rid of the overconfident workers.

Scale-based and team performance-based wages will drive out the most overconfident workers.

IMPLICATIONS FOR FIRM STRATEGYSo, the compensation system might not only be positive as the AT tells us. Social comparison limits a firm not being able to apply powered incentives or a wide variance of compensation levels across employees.

Furthermore, high powered performance-based incentives attract overconfident individuals that bare high risk actions that may lead the firm to bankrupt.

However, overconfident CEOs often lead the firm to more innovation in competitive industries.

Alvesson, M. and Krreman, D. 2004. Interfaces of control. Technocratic and socio-ideological control in a global management consultancy firm.

-This paper investigates a variety of forms of management control in a large managementconsultancy company-Although the literature on organizational and management control suggests a wide array offorms of control, it is common to emphasize a main form of control, either in the form of aparticular organizational structure or in the form of a specific mode of control dominating-different control forms may be linked to, and supporting and sustaining each other, ratherthan subdued and marginalized by a dominant form

Forms of management control-the exercise of control is a big part of a managers job-managerial activity that attempts to control behavior typically includes designing andsupervising work processes-2 types of control:

Socio-ideological: attempts to control worker mind-seto Social relations and ideology are basic ingredientso Efforts to persuade people to adapt to certain values, norms and ideas of what

is good for the organization Technocratic: attempts to control worker behavior

o Management works primarily with plans, arrangements and systems focusing behavior and/or measurable outputs

-we attempt to demonstrate how control forms interact, occasionally merge and, sometimes,contradict each other

Ouchi came up with his three approaches to control in an organization's management: Market control Bureaucratic control Clan control

Study questions:

1. Explain what agency theory is with your own words (including the theorys assumptions and key propositions/relationships).

2. Based on all the papers, what are the strengths and weaknesses of agencytheory?

3. Under which conditions will designing a compensation system according toagency theory lead to high value creation for the organization?

Week 3

Alchian, A. A. and Demsetz, H. 1972. Production, Information Costs, and Economic Organization

Two important problems face a theory of economic organization: - to explain the conditions that determine whether the gains from specialization and cooperative production can be better obtained within a firm or across markets. - Explain the structure of the organization.

Alchian and Demsetz first try to explain what kind of power firms has (at first sight, a firm= input owners cooperate) . A delusion is that the firm is characterized by the power to settle issues by authority. In fact, the only power a firm has is that it can withhold future business or by seeking compensation in the courts for any failure to honor an exchange agreement.

The questions that drive this paper are: Exactly what is a team process and why does it inducethe contractual form,called the firm?

The metering problem

The economic organization facilitates the payment of rewards in accord with productivity. (positively correlated). Consequently, two key demands are placed on economic organizations: metering input productivity and metering rewards. In the classical analyses of the economic organization, the analyses of production and distribution tends to assume sufficiently economicor zero costs--. In other words, it assumes that productivity automatically created its rewards. However, the assumption of zero costs is in reality not correct due to metering problems. All in all, if the economic organization meters poorly, then productivity will me smaller, but ifit meters well than productivity will be greater.

But what makes metering difficult and hence induces means of economizing on metering costs?

Team production

In general, with team production it is difficult, solely by observing the total output, to either define or determine each individuals contribution to this output of the cooperating inputs.

Team production is defined as a production in which 1) several types of resources are used and 2) the product is not a sum of separable outputs of each cooperating resource; 3) not all resources used in team production belong to one person (which is team organization problem).

It is possible to increase production through team effort. Think of two men loading bulky cargo onto a truck. By working together, they can load the cargo in far less time than if they worked separately; the product of their efforts exceeds the sum of their individual

contributions. When there is a team effort like this, you have information problems: it is hard to tell who is shirking. Furthermore, It is possible to meter each input's (laborer's) marginal contribution, either by observation or specification of the inputs.

The classical firm

One method to reduce shirking is for someone to specialize as a monitor to check the input performance of team members. But who monitor the monitor? Solution: give the monitor the residual value. (this can been seen in the current organizations. Stakeholders/shareholder monitor the firm and receive residual value (e.g. dividends. ). The monitor earns his residual through the reduction in shrinking that he brings about.

To discipline team members and reduce shirking, the residual claimant must have power to revice the contract terms and incentives of individual members without having to terminate oralter every other inputs contract. It is this entire bundle of rights that resolves the shrinking-information problem of team production better than does the noncentralized contractual arrangement. The bundle consist out of:

1. To be a residual claimant 2. To observe input behavior3. To be the central party common to all contract with inputs4. To alter the membership of the team5. To sell these rights, that defines the ownership of the classical firm (capitalist, free-enterprise).

In summary, two condition exist for the emergence of the firm: 1. It is possible to increase productivity through team-oriented production. 2. It is economical to estimate marginal productivity by observing or specifying input behavior.

Compared to other theories of the firm

This theory builds further upon the insights provided by Ronal Coase & Frank Knight. (e.g. markers do not operate costless and sometimes firms can work cheaper). To move further from this, it is necessary to know what is meant by a firm and explain the circumstances underwhich the cost of managing resources is low relative to the cost of allocating resources through market transaction. Also, this paper also suggests a definition of the classical firm (which was absent before).

Shortest summary, the main message:

The Alchian-Demsetz Approach

Measurement or metering problems are a reason that firms exist , according to Alchian & Demsetz (1972). Members have an incentive to cooperate because jointly they can produce more than solely. Shirking among team members increases (shirking = behavior that range

from cheating to merely giving less than ones best effort). When it is not possible to monitor the individuals contribution, each on the members will be rewarded equally. This will increaseshrinking.

The firm exist so it can monitor the efforts. A hierarchy emerges. But who monitors the monitor? Solution: give the monitor the residual value. (this can been seen in the current organizations. Stakeholders/shareholder monitor the firm and receive residual value (e.g. dividends. )

Cabrera, A. and Cabrera, E. F. 2002. Knowledge-sharing dilemmas.

This paper looks at previous research to see why people are hesitant to participate in knowledge sharing within firms and what management can do to solve these problems.

Research shows that the problem with an knowledge sharing culture do not lie with technical problems but with the willingness of employees to share information.

First the article shows that knowledge are resource which can lead to competitive advantage because they meet the VRIN requirements. It is valuable, rare (and unique because it is path dependent) hard to appropriate by third parties (because of its supra-individual character) and difficult to imitate because it is causally ambiguous.

We look at organizational knowledge at two dimension. The degree of articulation, tacit/explicit and degree of aggregation, individual and collective forms of knowledge (so whit who does it resides). This gives us four classes of knowledge: 1) individual-tacit (embodied knowledge), 2) individual-explicit (embrained knowledge), 3) collective-explicit (encoded knowledge) 4) collective-tacit (encultured and embedded knowledge).

Collective knowledge emerges from interaction and dialogue among the members of a community or an organization. So knowledge creation is the result of a double process of combination and exchange of knowledge. (Exchanging knowledge will have feedback, which enhances the knowledge)

There are different dilemmas, which the sharing of knowledge faces. Social dilemmas describe paradoxical situation in which individual rationality leads to collective irrationality .For instance individual attempts to maximize pay-off can result in collective damage.

The public-good dilemma is that everyone has access to the public knowledge of a firm but noone knows who is and who is not contributing, which tempts individuals to free ride.

The resource dilemma is that when everyone uses a certain resource (knowledge) this will deplete the resource for future use.

These dilemmas make it that people do not want to share their knowledge because they feel that the social fence is to high (the effort spend does not outweigh the benefits)

Three main areas are given in which these dilemmas reside and how to overcome them:

Restructuring the pay-off function

This is making the rewards higher of the cost of contributing lower so that it is easier for people to share knowledge or that the gains of doing so far outweigh the costs. This can be done by:

Assure employees have the time to make knowledge available to others (make it a standard task of them)

Increase individual pay-off through a cooperation-contingent transformation or a public-good transformation. 1) Cooperation-contingent is when an incentive reward is offered. However this may result in people giving a lot of low quality knowledge. 2) Public-good transformationis a incentive when the public knowledge makes money for the team. This stimulates high

quality knowledge since else the incentive is not given. This is thus a gain sharing or profit sharing plan.

Also the incentives do not have to be money but can also be status rewards, put them in the newsletter for instance. The most effective way is to align its human resource policies with this new role demanded from employees.

Increasing efficacy

When groups are getting to big people tend to feel that they cannot make a difference by sharing their knowledge. Therefore increasing efficacy is very important. There are two distinct types of efficacy: 1) information self-efficacy, the believe that the information is helpful to co-workers were they to receive it. This expectancy will be higher if individuals believe the information truly increases the value of the shared good. 2) Connective efficacy is the belief that others will actually receive the information if it is contributed.

Feedback mechanisms are thus important, for instance by having rating systems or let the contributors know how much their knowledge is used.

In addition employees need to be assured that there will be a minimum critical mass of contributions to the knowledge repository. They dont want to think they are the only one doing anything. Thus groups can not be to small, but when groups are getting bigger it is important to let everyone know they are part of the team which leads to them feeling more involved. Training programs help let employees feel part of the team, it also shows them that people are thus going to use their information which motivates them to produce more of it.

Promoting group identity and personal responsibility

This is the sense of being part of the group as mentioned earlier. The probability of cooperating increase when 1) interaction among participants are frequent and durable, 2) participants are easily identifiable, 3) there is sufficient information available about each individuals actions (people are not anonymous but have a face).

Communication between members is thus an impotent tool for establishing group identity. A possible solution to the knowledge-sharing dilemma may be to create knowledge-sharing groups and make it clear to employees that they belong to a specific group.

Ostrom, E. 2000. Collective action and the evolution of social norms. (2000)

Zero contribution thesis: Rational self-interested individuals will not act to achieve their common or group interests.

The idea that rational agents are not likely to cooperate, even when that would be to their mutual benefit, is also shown in the prisoners dilemma. this dilemma, along with other dilemmas are viewed as collective action problems.

The zero contribution thesis underpins the assumption that individuals cannot overcome collective action problems and need to have externally enforced rules to achieve their own long-term self-interest.

! However, this thesis contradicts observations of everyday life. Individuals in all parts of the world voluntary organize themselves to get the benefits of trade, provide mutual protection against risks and create and enforce rules to protect natural resources. On the other hand, research confirms that the temptation to fee-ride is a universal problem and people invest resources in monitoring and sanctioning the actions of each other.

A substantial gap exist between the theoretical prediction that self-interested individuals will have extreme difficulty in coordinating collective action and the reality that such cooperative behavior is widespread. This study will first focus on experimental evidence and potential theoretical explanations and secondly on real-world evidence.

Laboratory evidence on rational choice in collective action Models on rational individual action rational egoists have found that this assumption workswell in predicting the outcomes of auctions and competitive market situations. Subjects do notarrive at the predicted equilibrium in the first round, but behavior closely approximates the predicted equilibrium by the end of 5 rounds of the experiment. After a huge number of those experiments 7 general findings can be considered as the core facts;

1) Subjects contribute between 40 and 60 percent of their endowments to thepublic good in a one-shot game as well as in the first round of finitely repeatedgames.

2) After the first round, contribution levels tend to decay downward, butremain well above zero. A repeated finding is that over 70 percent of subjectscontribute nothing in the announced last round of a finitely repeated sequence.

3) Those who believe others will cooperate in social dilemmas are more likelyto cooperate themselves. A rational egoist in a public good game, however, shouldnot in any way be affected by a belief regarding the contribution levels of others.The dominant strategy is a zero contribution no matter what others do.

4) In general, learning the game better tends to lead to more cooperation, not less. 5) Face-to-face communication in a public good gameas well as in other

types of social dilemmasproduces substantial increases in cooperation that aresustained across all periods including the last period. Subjects use the time to discuss the optimal joint strategy, to extract promises from one another, and to give verbal tongue-lashings when aggregate contributions fall below promised levels.

6) subjects will expend personal resources to punish those who make below-average contributions to a collective benefit, including the last period of a finitely repeated

game. No rational egoist is predicted to spend anything to punish others, since the positive impact of such an action is shared equally with others whether or not they alsospend resources on punishing.

7) The rate of contribution to a public good is affected by various contextual factors including the framing of the situation and the rules used for assigning participants, increasing competition among them, allowing communication, authorizing sanctioningsystems or allocating benefits.

These facts are hard to explain using the standard theory that all individuals who face the same game evaluate decisions in the same way!

Building a theory of collective action with multiple types of players From the experimental findings one can formulate the key assumptions that need to be included in a revised theory of collective action.

Assumption of two types of norm-using players:1. Conditional cooperators: individuals who are willing to initiate cooperative action

when they estimate others will reciprocate and repeat these actions as long as a sufficient proportion of the others involved reciprocate. They will tend to be trustworthy in collective dilemmas as long as the proportion of others who return trustis relatively high. They tend to vary in their tolerance to for free riding. When they aredisappointed they will reduce their contributions. If they do so they discourage other conditional cooperators from further contributions.

2. Willing punishers: these are players that are willing to punish free riders throughverbal rebukes or to use costly material payoffs when available. They might also reward those who have contributed more than the minimal level. Some conditionalcooperators may also be willing punishers.

Together, conditional cooperators and willing punishers create an opening for collective action and a mechanism for making it grow.

Evolutionary processEvolutionary process explains the emerge and survival of multiple types of players. Accordingto this approach, those carrying the most successful strategies for an environment reproduce ata higher rate. Eventually the more successful strategies come to prominence in the population.During the Pleistocene survival was dependent on aggressively seeking individual returns and solving many day-to-day collective problems. Those who learned how to recognize who was deceitful and who was a trustworthy reciprocator had advantage over others.

Indirect evolutionary model: players receive objective payoffs, but make decisions based onthe transformation of these material rewards into intrinsic preferences. Those who value reciprocity, fairness and trustworthiness add a subjective change parameter to actions that are consistent or not consistent with their norms.

Prisoners dilemma games: if two players trust each other and cooperate, they can both receivea moderately high payoff. However, if one player cooperates and the other does not, then the one who did not cooperate receives an even higher payoff, while the other receives little or nothing. For a rational egoist playing this game, the choice is not to trust, because the expectation is that the other player will not trust, either. As a result, both players will end up with lower payoffs than if they had been able to trust and cooperate.

Social norms may lead to individuals behave different than others. Depending on how strongly they value conformance with (or deviance from) a norm. Rational egoists can be thought of as having intrinsic payoffs that are the same as objective payoffs, since they do not value the social norm of reciprocity. Conditional cooperators are trustworthy types and would have an additional parameter that adds value to the objective payoffs when reciprocating trust with trustworthiness. Therefore different types of players are likely to gain different objective returns.

Only trustworthy types would survive in a world with complete information: as new entrants of the population would adopt the preferences of those who obtained the higher material payoffs in the past.

Only rational egoist would survive in a world where there is no information about player types: first players will trust second players as long as the expected return of meeting trustworthy players exceeds the payoff obtained when neither player trusts each other.

Norms seem to have a certain staying power in encouraging a growth of the desire to cooperate. While cooperation enforced by externally imposed rules can disappear veryquickly. Therefore external rules and monitoring can crowd out cooperative behavior.

Worst of all worlds: when external authorities impose rules but are only able to achieve weak monitoring and sanctioning. The mild degree of monitoring discourages the formation of social norms, while also making it attractive to deceive and defect because there is a low risk o