Chapter 6 reasons for incentives

CHAPTER 6 Reasons for Firm Incentives Amazing things happen when people take responsibility for everything themselves. The results are quite different, and at times people are unrecognizable. Work changes and attitudes to it, too. Mikhail Gorbachev n conventional economic discussions of how firms are managed, incentives are nowhere considered. This is the case because the “firm” is little more than a theoretical “black box” in which things happen somewhat mysteriously. Economists typically acknowledge that the “firm” is the basic production unit, but little or nothing is said of why the firm ever came into existence or, for that matter, what the firm is. As a consequence, we are told little about why firms do what they do (and don’t do). There is nothing in conventional discussions that tells us about the role of real people in a firm. How are firms to be distinguished from the markets they inhabit, especially in terms of the incentives people in firms and markets face? That question is seldom addressed (other than, perhaps, specifying that firms can be one of several legal forms, for example, proprietorships, partnerships, professional associations, or corporations). In conventional discussions of the “theory of the firm,” firms maximize their profits, which is their only noted raison d’être. But students of conventional theory are never told how firms do what they are supposed to do, or why they do what they do. The owners, presumably, devise ways to ensure that everyone in the organization follows instructions, all of which are intent on squeezing every ounce of profit from every opportunity. Students are never told what the instructions are or what is done to ensure that workers follow them. The structure of incentives inside the firm never comes up because their purpose is effectively assumed away: people do what they are supposed to do, naturally or by some unspecified mysterious process. For people in business, the economist’s approach to the “firm” must appear strange indeed, given that business people spend much of their working day trying to coax people to do what they are supposed to do. Nothing is less automatic in business than getting people to pay attention to their firms’ profits (as distinguished from the workers’ more personal concerns). In this chapter, before we delve into the structure of firm costs in following chapters, we address the issue of why firms exist not because it is an interesting philosophical question. Rather, we are concerned with that question because its answer can help us understand why the existence of firms and incentives go hand in hand. There is more than an ounce of truth to the refrain, “You cannot have one without the other.” In this chapter, we lay out the limited I Chapter 6. Reasons for Firm Incentives 2 economic propositions that will undergird the analysis of much of the book. These propositions are powerful as they are simple, are relatively easily to understand. How Firms Make Markets More Efficient Why is it that firms add to the efficiency of the markets? That’s an intriguing question, especially given how standard theories trumpet the superior efficiency of markets. Students of conventional theory might rightfully wonder: If markets are so efficient, why do entrepreneurs ever go to the trouble of organizing firms? Why not just have everything done by way of markets, with little or nothing actually done (in the sense that things are “made”) inside firms? All of the firm’s inputs could be bought by individuals, with each individual adding value to the inputs he or she purchases and then selling this result to another individual who adds more value, etc. until a final product is produced and a final market is reached at which point the completed product is sold to consumers. The various independent suppliers may be at the same general location, even in the same building, but everyone, at all times, could be up for contracting with all other suppliers or some centralized buyer of the inputs. By keeping everything on a market basis, the benefits of competition could be constantly reaped. Entrepreneurs could always look for competitive bids from alternative suppliers for everything used -- whether in the form of parts to be assembled, accounting and computer services to be used, or, for that matter, executive talent to be employed. Individuals, as producers relying exclusively on markets, could always take the least costly bid. They could also keep their options open, including retaining the option to switch to new suppliers that propose better deals. No one would be tied down to internal sources of supply for their production needs. They would not have to incur the considerable costs of organizing themselves into production teams and departments and various levels of management. They would not have to incur the costs of internal management. They could, so to speak, maintain a great deal of freedom! Then why do firms exist? What is the incentive – driving force – behind firms? For that matter, what is a firm in the first place? University of Chicago Law and Economics Professor Ronald Coase, on whose classic work “The Nature of the Firm” much of this chapter is based and many of the particular arguments drawn, proposed a substantially new but deceptively simple explanation. 1 He reasoned that the firm is any organization that supercedes the pricing system, in which hierarchy, and methods of command and control are substituted for exchanges. To use his exact words: “A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.” 2 1 Ronald H. Coase, “The Nature of the Firm,” Economica, vol. 4 (1937), pp. 386-405, reprinted in R. H. Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988), pp. 33-55. 2 Ibid., pp. 41-42. Chapter 6. Reasons for Firm Incentives 3 Good answers to the question of why firms exist is more complicated and longer in the making than might be thought, but space limitations of this book require us to be brief. Some economists have speculated that firms exist because of the economies of specialization of resources, a key one being labor. Clearly, Adam Smith and many of his followers were correct when they observed that when tasks are divided among a number of workers, the workers become more proficient at what they do. Smith began his economic classic The Wealth of Nations by writing about how specialization of labor increased “pin” (really nail) production. 3 By specializing, workers can become more proficient at what they do, which means they can produce more in their time at work. They also don’t have to waste time changing tasks, which means more time can be spent directly on production. While efficiency improvements can certainly be had from specialization of any resource, especially labor, Smith was wrong to conclude that firms were necessary to coordinate the workers’ separate tasks. This is because, as economists have long recognized, their separate tasks could be coordinated by the pricing system within markets. Markets could, conceivably, exist even within the stages of production that are held together by, say, assembly lines. Workers at the various stages could simply buy what is produced before them. The person who produces soles in a shoe factory could buy the leather and then sell the completed soles to the shoe assemblers. For example, the bookkeeping services provided a shoe factory by its accounting department could easily be bought on the market. Similarly, all of the intermediate goods involved in Smith’s pin production could be bought and sold until the completed pins are sold to those who want them. Why, then, do we observe firms as such, which organize activities by hierarchies and directions that are not based on changing prices (which distinguishes them from markets)? In terms of our examples, why are there shoe and pin companies? Admittedly, over the years economists have tendered various answers. 4 3 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), pp. 4-12. 4 The late University of Chicago economist Frank Knight speculated that firms arise because of uncertainty (Risk, Uncertainty, and Profit [Chicago: University of Chicago Press, 1971]). If business were conducted in a totally certain world, there would be no need for firms, according to Knight. Workers would know their pattern of rewards, and there would be no need for anyone to specialize in the acceptance of the costs of dealing with risks and uncertainties that abound in the real world of business. As it is, according to Knight, some workers are willing to work for firms because of the type of deal that is struck: The workers accept a reduction in their expected pay in order to reduce the variability and outright uncertainty of that pay. Entrepreneurs are willing to make such a bargain with their workers because they are effectively paid to do so by their workers (who accept a reduction in pay) and because the employers can reduce their exposure to risk and uncertainties faced by individual workers by making similar bargains with a host of workers. As Knight put it (see the bottom of the next page), This fact [the intelligence of one person can be used to direct others] is responsible for the most fundamental change of all in the form of organization, the system under which the confident and adventuresome assume the risk or insure the doubtful and timid by Chapter 6. Reasons for Firm Incentives 4 Again, how can the existence of firms, as constructs distinctly different from markets, be explained? There are probably many reasons people might think firms exist, several of which Coase dismisses for being wrongheaded or for not being important. 5 What Coase was interested in, however, was not a catalogue of “small” explanations for this or that firm, but an explanation for the existence of firms that, to one degree or another, is applicable to virtually all firms. He was seeking a unifying theme, a common basis. In his 1937 article, he struck upon an unbelievably simple answer to his puzzle, but it was also an explanation that earned him the Nobel Prize in Economics -- more than a half-century later! What did he say? How did he justify the firm’s existence? Simply put, he observed that there are costs of dealing in markets. He dubbed these costs marketing costs, but most economists now call them transaction costs. Whatever they are called, these costs include the time and resources that must be devoted to organizing economic activity through markets. Transaction costs include the particular real economic costs (whether measured in money or not) of discovering the best deals as evaluated in terms of prices and attributes of products, negotiating contracts, and ensuring that the resulting terms of the contract are followed. When we were going through our explanation of how work on an assembly line could be viewed as passing through various markets, most readers probably imagined that the whole process could be terribly time consuming, especially if the suppliers and producers at the various stages were constantly subject to replacement by competitors. Reasons Firms Exist Once the costs of market activity are recognized, the reason for the emergence of the firm is transparent: Firms, which substitute internal direction for markets, arise because they reduce the need for making market transactions. Firms lower the costs that go with market transactions. If internal direction were not, at times and up to some point, more cost- guaranteeing to the latter a specified income in return for the assignment of the actual results . . . With human nature as we know it, it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter’s actions without being given power to direct his work. And on the other hand the second party would not place himself under the direction of the first without such a guarantee . . . The result of this manifold specialization of function is the enterprise and wage system of industry. Its existence in the world is the direct result of the fact of uncertainty (Ibid., pp. 269-270). 5 Ibid, pp. 41-42. For example, Coase concedes that some people might prefer to be directed in their work. As a consequence, they might accept lower pay just to be told what to do. However, Coase dismisses this explanation as unlikely to be important because “it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of ‘being one’s own master’” (Ibid., p. 38). Of course, it might be that some people like to control others, meaning they would give up a portion of their pay to have other people follow their direction. However, again Coase finds such an explanation lacking, mainly because it could not possibly be true “in the majority of the cases.” (Ibid.). People who direct the work of others are frequently paid a premium for their efforts. Chapter 6. Reasons for Firm Incentives 5 effective than markets, then firms would never exist – would have no reason for being, meaning that no one would have the required incentive to go to the trouble of creating them. However, while firms may never eliminate the need for markets and contracts, with all of their attendant costs, they must surely reduce them. Entrepreneurs and their hired workers essentially substitute one long-term contract for a series of short-term contracts: The workers agree to accept directions from the entrepreneurs (or their agents, or managers) within certain broad limits (with the exact limits subject to variation) in exchange for security and a level of welfare (including pay) that is higher than the workers would be able to receive in the market without firms. Similarly, the entrepreneurs (or their agents) agree to share with the workers some of the efficiency gains obtained from reducing transaction costs. 6 The firm is a viable economic institution because both sides to the contract – owners and workers -- gain. Firms can be expected to proliferate in markets simply because of the mutually beneficial deals that can be made. Those entrepreneurs who refuse to operate within firms and stick solely to market-based contracts, when in fact a firm’s hierarchical organization is more cost-effective than market-based organizations, will simply be out-competed for resources by the firms that do form and achieve the efficiency-improving deals with workers (and owners of other resources). If firms reduce transaction costs, does it follow that one giant firm should span the entire economy, as, say, Lenin and his followers thought possible for the Soviet Union? Our intuition says, “No!” But there are also good reasons for expecting firms to be limited in size. Cost Limits to Firm Size Clearly, by organizing activities under the umbrella of firms, entrepreneurs give up some of the benefits of markets, which provide competitively delivered goods and services. Managers suffer from their own limited organizational skills, and skilled managers are scarce, as evident by the relatively high salaries many of them command. Communication problems within firms expand as firms grow, encompassing more activities, more levels of production, and more diverse products. Because many people may not like to take directions, as the firm expands to include more people, the firm may have to pay progressively higher prices to workers and other resource owners in order to draw them into the firm and then direct them. 6 Coase recognizes that entrepreneurs could overcome some of the costs of repeatedly negotiating and enforcing short-term contracts by devising one long-term contract. However, as the time period over which a contract is in force is extended, more and more unknowns are covered, which implies that the contract must allow for progressively greater flexibility for the parties to the contract. The firm is, in essence, a substitute for such a long-term contract in that it covers an indefinite future and provides for flexibility. That is to say, the firm as a legal institution permits workers to exit more or less at will and it gives managers the authority, within bounds, to change the directives given to workers. Chapter 6. Reasons for Firm Incentives 6 There are, in short, limits to what can be done through organizations. These limits can’t always be overcome, except at greater costs, even with the application of the best organizational techniques, whether through the establishment of teams, through the empowerment of employees, or through the creation of new business and departmental structures (for example, relying on top-down, bottom-up, or participatory decision making). Even the best industrial psychology theories and practices have their limits when applied to human relationships. The Agency Problem Firms might be restricted in their size because they are also likely to suffer from a major problem -- the so-called agency problem (or, alternately, the principal/agent problem) that will be considered and reconsidered often in this book. This problem is easily understood as a conflict of interests between identifiable groups within firms. The entrepreneurs or owners of firms (the principals) organize firms to pursue their own interests, which are often (but, admittedly, not always) greater profits. To pursue profits, however, the entrepreneurs must hire managers who then hire workers (all of whom are agents). However, the goals of the worker/agents are not always compatible with the goals of the owner/principals. Indeed, they are often in direct conflict. Both groups want to get as much as they can from the resources assembled in the firms. The problem the principals face is getting the agents to work diligently at their behest and with their (the principals’) interests in mind, a core problem facing business organizations that even the venerable Adam Smith recognized more than two centuries ago. 7 Needless to say, agents often resist doing the principals’ bidding, a fact that makes it difficult -- i.e., costly -- for the principals to achieve their goals. It might be thought that most, if not all, of these conflicts can be resolved through contracts, which many can. However, like all business arrangements, contracts have serious limitations, not the least of which is that they can’t be all-inclusive, covering all aspects of even “simple” business relationships (which all are more or less complex). Contracts simply cannot anticipate and cover all possible ways the parties to the contract, if they are so inclined, can get around specific provisions. The cost of enforcing the contracts can also be a problem, and an added cost, even when both parties know that provisions have been violated. Each party will recognize the costs and may be tempted to exploit them, and will figure that the other may be 7 In his classic The Wealth of Nations, Adam Smith wrote, “The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot be well expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company” [The Wealth of Nations (New York, Modern Library, 1937), p. 700]. Chapter 6. Reasons for Firm Incentives 7 equally tempted. Each will seek some means by which the contract will be self-enforcing, or will encourage each party to live up to the letter and spirit of the contract because it is in the interest of each party to do so. This is where incentives will come in, to help make contracts self-enforcing. Incentives can encourage the parties to more closely follow the intent and letter of contracts. Competition will be a powerful force toward minimizing agency costs. Firms in competitive markets that are not able to control agency costs are firms that are not likely to survive for long, mainly because of what has been dubbed the “market for corporate control.” 8 Firms that allow agency costs to get out of hand will risk either failure or takeover (by way of proxy fights, tender offers, or mergers). In later chapters, we will discuss at length how managers can solve their own agency problems including controlling their own behavior as agents for shareholders. At the same time, we would be remiss if we didn’t repeatedly point out the market pressures on managers to solve such problems, even if they are not naturally inclined to do so. If corporations are not able to adequately solve their agency problems, we can imagine that the corporate form of doing business will be (according to one esteemed financial analyst 9 ) “eclipsed” as new forms of business emerge. Of course, this means that obstruction in the market for corporate control (for example, legal impediments to takeovers) can translate into greater agency costs, and less efficient corporate governance. Why are firms the sizes they are? When economists in or out of business usually address that question, the answer most often given relates in one way or another to economies of scale. By economies of scale, we mean something very specific, the cost savings that emerge when all resource inputs -- labor, land, and capital -- are increased together. In some industries, it is indeed true that as more and more of all resources are added to production within a given firm, output expands by more than the use of resources. That is to say, if resource use expands by 10 percent and output expands by 15 percent, then the firm experiences economies of scale. Its (long-run) average cost of production declines. Why does that happen? The answer is almost always “technology,” which is another way of saying that it “just happens,” given what is known about combining inputs and getting output. This is not the most satisfying explanation, but it is nonetheless true that economies of scale are available in some industries (automobile) but not in others (crafts). We agree that the standard approach toward explaining firm size is instructive. We have spent long hours at our classroom boards with chalk in hand developing and describing scale economies in the typical fashion of professors, using (long-run) average cost curves and pointing out when firms in the expansion process contemplate starting a new plant. We think the 8 One of the more important contemporary articles on the “market for corporate control” is by Henry G. Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy, vol. 73 (April 1963), pp. 110-120. 9 See Michael C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review (September-October 1989), pp. 64-65. Chapter 6. Reasons for Firm Incentives 8 standard approach is useful, but we also believe it leaves out a lot of interesting forces at work on managers within firms. This is understandable, given that standard economic theory totally assumes away the roles of managers, which we intend to discuss at length. Coase and his followers have taken a dramatically different tack in explaining why firms are the sizes they are in terms of scale of operations and scope of products delivered to market. The new breed of theorists pays special attention to the difficulties managers face as they seek to expand the scale and scope of the firm. They posit that as a firm expands, agency costs mount. This is primarily because workers have more and more opportunities to engage in what can only be tagged opportunistic behavior – or taking advantage of their position by misusing and abusing firm resources. Shirking, or not working with due diligence, is one form of opportunistic behavior that is known to all employees. Theft of firm resources is another form. As the firm grows, the contributions of the individual worker become less detectable, which means workers have progressively fewer incentives to work diligently on behalf of firm objectives, or to do what they are told by their superiors. They can more easily hide. The tendency for larger size to undercut the incentives of participants in any group is not just theoretical speculation. It has been observed in closely monitored experiments. In an experiment conducted more than a half century ago, a German scientist asked workers to pull on a rope connected to a meter that would measure the effort expended. Total effort for all workers combined increased as workers were added to the group doing the pulling at the same time that the individual efforts of the workers declined. When three workers pulled on the rope, the individual effort averaged 84 percent of the effort expended by one worker. With eight workers pulling, the average individual effort was one-half the effort of the one worker. 10 Hence, group size and individual effort were inversely related – as they are in most group circumstances -- inversely related. The problem evident in the experiment is not that the workers become any more corrupt or inclined to take advantage of their situation as their number increases. The problem is that their incentive to expend effort deteriorates as the group expands. Each person’s effort counts for less in the context of the larger group, a point which University of Maryland economist Mancur Olson elaborated upon decades ago (and we considered in detail in the last chapter). 11 The “common objectives” of the group become less and less compelling in directing individual 10 As reported by A. Furnham, “Wasting Time in the Board Room,” Financial Times, March 10, 1993, p. xx. 11 See Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1965). Olson argues that common goals have less force in “large” groups than “small” groups, which explains why cartels don’t form in open competitive markets. All competitors might understand that it is in their group interest to cut production and increase their market price, if all curb production. However, each competitor can reason that its individual curb in output will have no effect on total output and thus cannot be detected. Hence, the “logic of collective action” is for everyone to “cheat” on the cartel, or not curb production, which means that nothing will happen to the market price. Chapter 6. Reasons for Firm Incentives 9 efforts. Such a finding means that if each worker added to the group must be paid the same as all others, the cost of additional production obviously rises with the size of the working group. The finding also implies that to get a constant increase in effort with the additional workers, all workers must be given greater incentive to hold to their previous level of effort. 12 Optimum Size Firms How large should a firm be? Contrary to what might be thought, the answer depends on more than “economies of scale” technically specified. Technology determines what might be possible, but it doesn’t determine what will happen. And what happens depends on policies that minimize shirking and maximize the use of the technology by workers. This means that scale economies depend as much or more on what happens within any given firm as they do on what is technologically possible. The size of the firm obviously depends on the extent to which owners must incur greater monitoring costs as they lose control with increases in the size of the firm and additional layers of hierarchy (a point well developed by Oliver Williamson in his classic article written more than thirty years ago 13 ). However, the size of the firm also depends on the cost of using the market. Management information Professors Vijay Gurbaxani and Seungjin Whang have devised a graphical means of illustrating the “optimal firm size” as the consequence of two forces: “internal coordinating costs” and “external coordinating costs.” 14 As a firm expands, its internal coordinating costs are likely to increase. This is because the firm’s hierarchical pyramid will likely become larger with more and more decisions made at the top by managers who are further and further removed from the local information available to workers at the bottom of the pyramid. There is a need to process information up and down the pyramid. When the information goes up, there are unavoidable problems and costs: costs of communication, costs of miscommunication, and opportunity costs associated with delays in communication, all of which can lead to suboptimal decisions. These “decision information costs” become progressively greater as the decision rights are moved up the pyramid. Attempts to rectify the decision costs by delegating decision making to the lower ranks may help, but this can – and will -- also introduce another form of costs -- which, you will recall, we previously have called agency costs. These include the cost of monitoring (managers 12 Workers can also reason that if the residual from their added effort goes to the firm owners, they can possibly garner some of the residual by collusively (by explicit or tacit means) restricting their effort and hiking their rate of pay, which means that the incentive system must seek to undermine such collusive agreement. For a discussion of these points see, Felix R. FitzRoy and Kornelius Kraft, “Cooperation, Productivity, and Profit Sharing,” Quarterly Journal of Economics (February 1987), pp. 23-35. 13 Oliver E. Williamson, “Hierarchical Control and Optimum Size Firms,” Journal of Political Economy, vol. 75 (no. 2, 1967), pp. 123-138. 14 Vijay Gurbaxani and Seungjin Whang, “The Impact of Information Systems on Organizations and Markets,” Communication of the ACM, January 1991, pp. 59-73. Chapter 6. Reasons for Firm Incentives 10 actually watching employees as they work or checking their production) and bonding (workers providing assurance that the tasks or services will be done as the agreement requires), and the loss of the residual gains (or profits) through worker shirking, which we covered earlier. The basic problem managers face is one of balancing the decision information costs with agency costs and finding that location for decision rights that minimizes the two forms of costs. From this perspective, where the decision rights are located will depend heavily on the amount of information flow per unit of time. When upward flow of information is high, the decision rights will tend to be located toward the floor of the firm, mainly because the costs of suboptimal decisions by having the decision making done high up the hierarchy will be high. The firm, in other words, can afford to tolerate agency costs because the costs of avoiding the them, via centralized decisions, can be higher. Nevertheless, as the firm expands, we should expect that the internal coordinating costs along with the cost of operations will increase. The upward sloping line in Figure 6.1 depicts this relationship. But internal costs are not all that matter to a firm contemplating an expansion. It must also consider the cost of the market, or what Gurbaxani and Whang call “external coordination costs.” If the firm remains “small” and buys many of its parts, supplies, and services (such as accounting, legal, and advertising services) from outside venders, then it must cover a number of what we have called “transaction costs.” These include the costs of transportation, inventory holding, communication, contract writing, and contract enforcing. However, as the firm expands in size, then these transaction costs should be expected to diminish. After all, a larger firm seeks to supplant market transactions. The downward sloping line in Figure 6.1A depicts this inverse relationship between firm size and transaction costs. Again, how large should a firm be? If a firm vertically integrates, it will engage in fewer market transactions, lowering its transaction costs. It can also benefit from economies of scale, the technical kind mentioned earlier. However, in the process of expanding, it will confront growing internal coordination costs, or all of the problems of trying to move information up the decision making chain, getting the “right” decisions, and then preventing people from exploiting their decision making authority to their own advantage. The firm should stop expanding in scale and scope when the total of the two types of costs -- external and internal coordinating costs -- are minimized. This minimum can be shown graphically by summing the two curves in Figure 6.1A to obtain the U-shaped curve in Figure 6.1B. The optimal (or most efficient/cost-effective) firm size is at the bottom of the U. This way of thinking about firm size would have only limited interest if it did not lend itself to a couple of additional observations, which permit thinking about the location, shape, and changes in the curve. First, the exact location of the bottom will, of course, vary for different firms in different industries. Different firms have different capacities to coordinate activities . premium for their efforts. Chapter 6. Reasons for Firm Incentives 5 effective than markets, then firms would never exist – would have no reason for being,. 1989), pp. 64 -65 . Chapter 6. Reasons for Firm Incentives 8 standard approach is useful, but we also believe it leaves out a lot of interesting forces at