Why Business Organizations?

A striking aspect of contemporary market economies is the importance of large, organized groups working together as business firms. The self-employed individual who works alone is the exception in our economy--only a small fraction of those working fit into this category. There is a puzzle here, because in the large firm the role of the market as a coordinator of decisions is replaced by commands of a hierarchical authority. From a worker's point of view, for example, factory life in the market economy of the United States is very similar to factory life in a command economy such as that of the former Soviet Union. In both systems, the number of people working at various tasks in a factory as well as the schedule they must work is determined not by a market, but by orders coming from above.

The division of labor provides one possible reason for the existence of organized firms. If a complex task is divided into a series of parts, and a specialist does each part, much more can be produced than if everyone tries to do the whole task alone. Adam Smith wrote a famous passage emphasizing this point:

"To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently and without any of them haveing been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day...."

However, the division of labor need not cause business organizations; it could instead result in a series of different professions. One could imagine the profession of the wire drawer, who would sell his output to the wire straighteners, who would sell their output to wire cutters, etc. The market could coordinate their activities instead of a manager. It would raise price for any good that was in short supply and lower price for any good in surplus, thereby encouraging people to produce each step in the proper proportion. In fact in the earliest stages of the industrial revolution, the textile industry was made up of the separate professions of carder, spinner, weaver, etc. and they worked separately in their own homes. Early in the industrial revolution these trades were brought together under the factory roof, and a system of hired workers working under supervision replaced the individual craftsmen.

One can also imagine a system in which one person owned the pin-making equipment and contracts with people each day to operate the equipment. With this method, which has been used since antiquity in agriculture, the usual employer-employee relationship does not exist. The hired worker can agree to do a specific task, and pay for each task can vary from day to day. A modern firm uses this relationship when it hires the services of outside consultants, lawyers, or accountants. The person hired is not considered a normal employee because the power of the employer to give orders--to direct his efforts to where the employer sees fit--is very limited. The tasks that the outside person does are agreed to in a market transaction.

A second possible reason for business organizations is that man is a social animal and that he would rather work in groups than alone. A problem with this hypothesis is that people do not just work together in groups, but they work under the supervision and orders of a "boss." Few people profess to enjoy obeying orders.

An interesting solution to this problem was suggested in 1937 by Ronald Coase. Coase argued that "...the main reason why it is profitable to establish a firm is that there is a cost of using the price mechanism." This cost may come from the difficulty of discovering what the prices are, but a more important source is in the problems of negotiating a separate contract for each exchange transaction. A simple contract, often for a fairly long term, is agreed to instead. The exact tasks that the employee is to do are nebulous, but the employee agrees to obey the employer's orders to do a wide variety of tasks.

Coase said that the firm will expand whenever the cost of organizing a transaction within the firm is less than carrying out the same transaction by an exchange in the market. Development of the giant corporation can be explained by the improvement in management technique. This theme has been developed by Alfred Chandler, who examines the growth of the managerial corporation in America in a book entitled The Visible Hand (Belknap Press, 1977). The title refers to the "invisible hand" of Adam Smith, who discussed the capability of the market to coordinate the actions of many individuals producing different products. The visible hand refers to the role of managers in coordinating the actions of many individuals, each doing a specialized task.

The development of the assembly line is an example of a discovery that made coordination by command cheaper. Most people understand that an assembly line breaks a complex task into a series of simple tasks and thus captures benefits from the division of labor. But it also makes monitoring workers easier. The manager can better see how well each worker performs. Because the production process flows from one task to the next, a worker who does a poor job or a slow job will quickly become obvious. Poor performance at one task will cause problems further down the line. Further, there is a whole group of managers on the floor--the foremen--who monitor, try to solve any problems that do occur, and make decisions about where particular people should be used.

Coordination in the firm is by command, although persuasion and various sorts of exchanges may also be important. A manager determines the exact task a person performs. The manager's challenge is to decide how best to use the available resources. Coordination in the market is based on voluntary transactions. The ability of command to coordinate is obvious, whereas the ability of the market to coordinate is not so obvious. This difference is apparent whenever the economy experiences a problem; there is always a demand that the government "do something." In the 1930s, it responded with massive public works. In the early 1970s, when the public realized that inflation was a problem, the clamor for action led to wage and price controls. The rapid rise in oil prices in the late 1970s led to a mass of regulations. In each of these cases and in a huge number of others that could be cited, restrictions are placed on the market. Instead of relying solely on coordination through the market, the government decides to rely at least partly on command. What is remarkable, however, is that in few of the cases of government intervention is there convincing evidence that the government action had its intended effect. In a many of them, there is some evidence, although often not conclusive, that the government action had harmful side effects. The difficulty of achieving results through government action may be largely due to the costs of using command--the visible hand--as a means of coordination.

If there were no costs to using command, one would expect the vision (or nightmare) of Karl Marx to be reality today--monopoly capital. In Marx's vision, one capitalist would gobble up another until in the end only a few giant capitalists would own and run everything. Then, the revolution would come. But this vision of the giant capitalists ignores the costs of giving incentives to workers, monitoring their behavior, and deciding how best to use their skills. It is ironic that the closest approximations to the monopoly capitalists that Marx predicted were the centrally-planned states of Eastern Europe and the Soviet Union. In their attempt to eliminate the market, they organized their economies as a giant state-run enterprise. The poor performances in satisfying consumer wants that these economies experienced were largely due to their use of command in places where the market was a much cheaper way to organize.

Industries that have the ability to easily monitor quality and speed will find coordination by command cheap. Such industries will generally have increasing returns to scale and thus large firms. Industries in which it is not easy to monitor quality and speed will tend to have many small firms. Agriculture is an example of this second sort of industry. Attempts to farm on a large scale have not been notably successful in the United States. In the former Soviet Union and in other socialist countries, the structuring of agriculture in large organized farms was disastrous in terms of food production. Agriculture cannot be made into an assembly-line process, and the many factors that determine the success of the crop make it difficult to determine responsibility if someone does shirk. As a result, very large land owners in the United States more often rent their land to independent farmers than hire farmers to cultivate it.

In the abstract theory of exchange economics, the internal world of the firm does not exist. All coordination is through the price mechanism. However, the existence of large organizations, established on a voluntary basis, points out that coordination through the invisible hand requires resources, and that those who find ways to coordinate more cheaply can profit from their discoveries. In a way, the existence of large firms is an irony in a market economy. They indicate that a way to succeed in a market economy is to find a better way to coordinate people than market coordination, to replace the market by command.

Perhaps a reason that team sports are so popular in a country that so honors the individual is that they reflect a paradox of the modern world: those groups that cooperate best internally are best able to compete externally. Team sports encourage both cooperation and competition; the two are not incompatible. The often-heard criticism of capitalism, that it encourages competition and thus discourages cooperation, ignores the very existence of the large coordinated enterprises that are most visible in the economy.

Next we discuss screening and signaling.