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.

4 thoughts on “Specialization, Bilateral Monopoly, and Firms

  1. I agree with the contents of your post. Very insightful, and I’m not saying that to make you feel good. It is my opinion that traits such as “loyalty” and “teamwork” are not always explicitly rewarded in some corporate cultures, but in my experience these are valuable traits, at least when possessed by otherwise competent employees. I’ve seen the other side of this coin as well when I worked in Wall Street, a hypercompetitive environment where employers and employees tend to view the employment relationship through more of a transactional lens. This has upsides, but many downsides as well. Chief among the downsides is poor internal communication, which can result in some nasty risks being swept under the rug.

  2. Once again, I’d say I agree with the gist, but with a couple of small quibbles:

    1. Regarding hiring people from outside the firm: I don’t think this necessarily has a big negative impact on morale. In my experience, if folks hired from outside can come in and show themselves to be talented and effective as managers and hiring them looks like the “right move” to their peers and subordinates, then the people who were passed over may well take a hit to their self-esteem, but they’ll respect the decision and their performance/morale won’t suffer too badly, although they may still choose to leave. In other words, if you’re hiring outsiders, it should be because they possess some kind of human capital that your current employees don’t. If that is the case, your employees will, I think, in general, not react too negatively.

    2. Mergers and acquisitions can raise morale, also. Working for a larger, combined firm with a more plausible claim on “industry leader” status gives a boost in social status to employees and will improve their morale. Personal example: a few years ago, the CPA firm I worked at merged with a large competitor and the combined firm was now national in scope and one of the ten largest firms in the country, by total revenue. Much was made of this Top Ten status inside the firm and out, particularly when it came to recruiting. I do not think that was misguided; everyone seemed to like mentioning that we were now the eighth largest firm in the country (yes, including me) or whatever it was. To take a more general example, I’d say that even if you’re just an assistant branch manager, telling people you work at Wells Fargo or PNC just sounds a little more desirable than telling people you work at Podunk Community Bank, even if the job and pay are identical.

    Also, acquiring a competitor can in many increase opportunities for promotion, which can also boost morale. Firm A wants to expand from City 1 to City 2, and to facilitate this quickly, it acquires Firm B, which has an established presence in City 2. As part of that merger, it may move people from City 1 to City 2 to help manage and grow the new operations. The folks being asked to move are presumably getting some kind of promotion or at least increased compensation for their troubles, and their departure opens up positions back in City 1.

    Of course, the downside is that Firm B employees in City 2 might take an offsetting hit in morale if they do not like having to answer to their new bosses from City 1.

  3. I have long direct experience with the firms cited as an example – I spent 2 decades working in the Microsoft OS division, a substantial part of that in a complicated venture with IBM. The history of DOS, OS/2, Windows 9x, and Windows NT (what everybody today thinks of as “windows”) is more complicated that is generally supposed.

    One thing MSFT used to retain staff was a kind of “golden handcuff” – stock options that vested over time. Over the period of my tenure there this worked out to huge compensation. But that depended on everything going well in both the user market (DOS and Windows and Windows NT in the end all sold really well, as of course did Office) and the stock market (MSFT rising to have the highest market cap in the world at various points.)
    If the market hadn’t been rapidly growing, or the equity values for the company not rapidly growing, that particular mechanism for maintaining a pattern of loyalty (a pattern of trade…) wouldn’t have worked nearly so well.

    It was also the case that one could have high prestige (at least within the company) and very high compensation, without being “promoted” up the management hierarchy (there was a ranking hierarchy, separate from management level.) Some of that may have changed in the 10 years since I left.

    I think this suggests that the patterns (be they trade, specialization, rents, sunk costs, regulatory demands, whatever) that lead to a bilateral monopoly will be peculiar to each case.

    The thing that really ended the example bilateral arrangement was that IBM had a crushing need to control markets, and customers pretty quickly reached a point of demanding “commodity” products. IBM announced they “would not sell commodity hardware” at about the same time as the largest buyers announced they would “ONLY buy commodity hardware” – the rest is history.

    Finally, whether IBM “allowed” the clones, or failed to stop them, or the legal arrangments of the time were such that it would have been impossible to stop them, is unclear to me.

    The huge mass commoditization of the PC and with it commoditization of computing power has to have been one of the largest technology shocks in history, and compressed into a rather short time.

  4. I will also say that contracts enforcing anything, among large players like MSFT, IBM, Intel, Google, etc. are very subtle things.

    I suspect that a contract to “enforce” any sort of bilateral monopoly will be very hard to write in a way which (a) is legal w.r.t. anti-trust, (b) is legal w.r.t. contract law, (c) is practical to enforce, (d) doesn’t let some golden goose escape or get eaten.

Comments are closed.