What Bureaucracies Do

Megan McArdle writes,

Does Congress need to give agencies a freer hand in developing good systems? I’m all for it. Should Congressional Republicans commit to support the president in hardening our government against cyber-attacks and other disasters, rather than simply holding political show hearings? Heck yes. But these things won’t happen unless the president makes fixing government IT a bigger priority — and starts enforcing accountability for every disaster that happens on his watch.

Along similar lines, David Strom, an IT consultant, writes,

If a private industry CIO had this sort of security record, they would never work in IT ever again, unless to become a motivational speaker and tell people what not to do. Instead, because they are the Feds, we just shake our heads and wonder what is going on, and some how give them a free pass to mess something else up again. It really boils my blood.

In my view, bureaucracies are notable for two things.

1. They filter out new ideas.

2. They blur accountability. When you make a reasonable request and are turned down because of “policy,” you have encountered this blurred accountability.

I understand the constructive value of filtering out new ideas. A large organization can only focus on a few major initiatives. Those initiatives had better be good ones. Most new ideas are bad. Think of a Type I error as making a catastrophically bad bet and a Type II error as missing out on a profitable opportunity. Bureaucracies help to curb Type I errors but tend to make Type II errors. And every middle manager who has ever had an idea die in the bureaucracy is convinced, usually incorrectly, that the organization committed a Type II error.

Perhaps there is also a constructive value for blurred accountability. But I cannot think of one.

Non-marketable Outputs and Executive Compensation

I have suggested that one can think of firms as taking marketable inputs and producing non-marketable outputs. These non-marketable outputs ultimately contribute to marketable outputs. It is the non-marketable outputs that bind the firm together. If instead all outputs were marketable, then you could unbundle the firm and arrive at marketable output using market transactions among many firms.

I have also suggested that non-marketable outputs have an indeterminate value. This in turn makes the compensation paid to workers indeterminate.

Apply this to CEOs or other top executives. A CEO produces non-marketable output. The CEO’s “output” consists of key decisions with regard to strategy and personnel. It also includes intangible effects on employees, customers, and other firms.

Non-marketable output is, by definition, mostly valuable within the firm. The value of firm X’s CEO to firm X is likely to be quite a bit higher than the value of firm X’s CEO to firm Y. Thus, the CEO’s opportunity cost easily could be low relative to the value that the CEO provides. Whereas for low-level positions, it is plausible that competition serves to narrow the range of potential compensation, the same is not true at the level of CEO. It would seem that the range of indeterminacy in CEO pay ought to be especially high.

Observers on the left have argued that the rise in CEO pay in recent decades reflects changes in social norms rather than an increase in CEO productivity. Although there may be other explanations, I would think that the range of indeterminacy is sufficiently high that one should not dismiss the social-norms story out of hand.

Non-marketable Outputs

A non-marketable output is something that has relatively little value outside of one firm. One company’s tax return won’t help any other firm file its return. A half-finished Chevy is not of much use to Toyota.

1. I claim that a typical firm buys marketable outputs, produces non-marketable outputs, and turns at least some of these non-marketable outputs into marketable outputs.

2. I can imagine a firm that produces only non-marketable outputs because it works only for a single buyer. However, there is a sense in which the firm and its buyer can be treated as a single entity.

3. Non-marketable outputs are what determine the configuration of firms. Suppose that there are ten stages of production. If at each stage the output is marketable, then there might exist firms at each stage of production. On the other hand, if only the final stage is marketable, then there will be just one firm.

4. The value of a non-marketable output is indeterminate. It has to be worth at least as much as the cost of the inputs required to produce it, and it cannot be worth more than the entire marketable output of the firm. But that leaves a wide range. Consequently, workers engaged in the production of non-marketable output do not have a well-defined marginal revenue product.

5. I conjecture that the larger the firm, the higher the proportion of non-marketable output relative to total output. If all you are doing is buying marketable outputs and selling marketable outputs, then you can be a tiny firm, like somebody who sells on e-Bay. On the other hand, if you manufacture airplanes, then most of your effort goes into producing unfinished airplanes, so you need a large firm.

Compare the old-fashioned general store to Wal-Mart. Wal-Mart has important non-marketable output in its supply chain, consisting of logistical systems and contracts with sellers. That supply chain might be worth something to an old-fashioned general store, and you can imagine a different Wal-Mart acting solely as a wholesaler/distributor. However, the supply chain is worth even more when it is integrated with large, strategically-located retail outlets, namely Wal-Mart stores.

6. I conjecture that non-marketable output tends to become increasingly important as the economy becomes more complex. That in turn would suggest that the trend would be for firms to get larger.

7. Some important creative destruction takes place in the arena of non-marketable outputs. Uber and taxi companies both offer on-demand rides. But Uber replaces the taxi company’s non-marketable output, its dispatching system, with something different. Amazon and traditional sellers both offer books. But Amazon replaces the non-marketable outputs of the traditional sellers (inventory management, product display, and customer fulfillment) with something else.

Note that Amazon found that a lot of its infrastructure proved to be marketable. Other companies rent server space from Amazon or sell products using Amazon.

Capital Indivisibility as a Theory of the Firm

Cameron Murray writes,

If it was the division of labour that leads to increased productivity, labour could just as easily be divided between firms. The fact that pin factories, even with only ten men, still performed all 18 tasks, instead of specialising in just 10 tasks, is clear evidence that there is something special and coordinated about the tasks themselves that arise from the particular capital investments. The tools and machines are designed to be compatible with each other, and if part of the process is done outside the firm, each of the two firms would inevitably be tied to the same compatible capital equipment, and would therefore find gains by merging into a single firm.

Pointer from Mark Thoma.

According to Alchian and Demsetz, Murray’s first sentence is false. If the value of labor is in their combined product, rather than in each individual task, someone must manage the production process and allocate payments to individual workers. Remember, in an Alchian-Demsetz firm, marginal product is not defined.

I agree with Murray that if two firms have complementary capital then there is an incentive to merge, at least if one or both firms does not have a lot of other choices for partners in production. But what Murray sees as the gains from merging firms that use compatible capital equipment also would arise from merging firms whose workers who undertake complementary tasks in a production process.

When Marginal Product is Undefined

In an Alchian-Demsetz firm, marginal product is not defined.

Think of a business that has exactly one full-time tax accountant (TA). In a sense, the marginal product of the TA is zero, since the TA contributes zero output. On the other hand, the tasks performed by the TA have tremendous value, allowing the firm to remain in business and keeping the owner out of prison.

What determines the compensation paid to the TA? It cannot be less than the TA’s best alternative, or opportunity cost. It cannot be more than the firm’s best alternative, which could be to hire a different TA, outsource to an accounting firm, or try to automate the process using software. If there is lots of competition on both sides of the market, then compensation will be driven to some unique level. Otherwise, there may be a range of plausible outcomes.

Remember that most of us are Garett Jones workers. We do not produce output. We produce organizational capital. So most of us have undefined marginal product.

Alchian and Demsetz on Specialization and Firms

A reader pointed me to their classic paper, which is exactly on point.

there is a source of gain from cooperative activity involving working as a team, wherein individual cooperating inputs do not yield identifiable, separate products which can be summed to measure the total output. For this cooperative productive activity, here called “team” production, measuring marginal productivity and making payments in accord therewith is more expensive by an order of magnitude than for separable production functions.

In their summary,

While ordinary contracts facilitate efficient specialization according to comparative advantage, a special class of contracts among a group of joint inputs to a team production process is commonly used for team production. Instead of multilateral contracts among all the joint inputs’ owners, a central common party to a set of bilateral contracts facilitates efficient organization of the joint inputs in team production. The terms of the contracts form the basis of the entity called the firm-especially appropriate for organizing team production processes.

Chris Dillow asks a Question

In an interesting post on self-delusion and leadership, he writes,

if leaders are so often self-deluded, how come so many organizations succeed, or at least don’t collapse?

Pointer from Jason Collins. Some thoughts:

1. Perhaps we are looking at survivorship bias. There may have been hundreds of CEO’s, each with “reality distortion fields,” playing the tournament that Steve Jobs wound up winning.

2. Bureaucracy may provide a check against self-deluded leaders. Bureaucracy tends to err on the opposite side of overconfidence. Anyone who has ever tried to sell something to a big company has found that one “no” vote can cancel out many “yes” votes. Every CEO faces what Lewis Gerstner of IBM called a “culture of ‘no’.”

Specialization, Bilateral Monopoly, and Firms

A bilateral monopoly is when there is one buyer and one seller.

When the first IBM PC was introduced, there was one buyer for Microsoft’s operating system (DOS) and one seller. However, IBM allowed other companies to make “clones,” with the result that the hardware became a commodity and the software became worth a fortune.

We rarely observe bilateral monopolies between two firms, because each firm has such a strong incentive to try to create competition on the other side of the bilateral monopoly. Thus, I would argue that bilateral monopoly is more likely to wind up within a firm than across two firms.

Specific human capital, meaning skills that are valuable only in the context of a particular industry or a particular organization, gives rise to bilateral monopoly. An employee who is familiar with the procedures, culture, and systems that are peculiar to one firm is more valuable to the firm than another employee. For the employee, the firm is now a better fit than some other firm.

In the economy as a whole, specialization tends to produce a lot of specific human capital. Thus, many economic relationships have to take bilateral monopoly into account. You can think of these sorts of bilateral monopolies as repeated games, in which cooperating means sharing the rents from specific human capital, and defecting means either trying to appropriate all of the rents or ending the relationship.

Typical contract features that try to deal with these repeated games include increases in pay and benefits tied to length of service, including pension vesting or additional weeks of vacation. Some firms offer training or tuition reimbursement with a requirement that the worker continue with the firm for a period of time afterward.

I think that most of these sorts of contractual features could be reproduced across the boundaries of firms. That is, if I want you to invest in human capital specific to my firm, I can design a contract that induces you to remain in a long-term relationship.

However, there is another type of inducement that is almost inherently within the firm. That is the inducement provided by promotion from within. If you know that internal candidates have an advantage when a high-level position opens up, that gives you an incentive to invest in specific human capital within that firm.

In fact, I believe it is the case that organizations that promote almost entirely from within have very loyal middle managers. The cost is that such organizations can be culturally rigid and stagnant. Conversely, firms that frequently fill high-level positions from outside and/or engage in mergers and acquisitions can be more flexible and dynamic, but at a cost of low morale and high turnover at lower levels of management.

Specialization, Externality, and Firms

Suppose that a production process is divided into tasks. Think of Adam Smith’s example of a pin factory, or think of a software application developed by many people.

It is unlikely that this process will be coordinated by decentralized market prices. Separately, each worker’s contribution to the process is not marketable. It is the final product that can be sold. In a sense, there is a “production externality,” in that the finished product is worth something, even though the individual worker’s output is worth nothing by itself. The task of Coasian bargaining among the workers to come up with a way to allocate this externality is onerous, so it is handled by a manager in the context of a firm.

The New Matchmaking

A reader suggests, probably correctly, that this story belongs under Four Forces Watch.

The company has come up with a secret algorithm that invites select users to access the app based primarily on LinkedIn résumés and friend networks. Ambition, Bradford says, is the biggest trait The League looks for within its community.

It is a dating application with a very limited, exclusive clientele.

I remember when some discos/nightclubs used a similar sort of business model.