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.

4 thoughts on “Specialization, Externality, and Firms

  1. I respectfully disagree. You start by saying the sub-process is unlikely to be coordinated by market processes. You then shift to a statement that only finished products are worth something.

    A service within a production team is marketable and can be bought by and sold to the production team. This occurs in countless examples on countless markets. End to end production with no outsourcing is not even the norm in my opinion.

    Granted, there are reasons not to outsource a routine component including bargaining issues. But this does not imply that the sub process skills or services are not marketable.

  2. This and the following post seem to be extensions of Oliver Williamson’s insights on the nature of firms and markets.

    I’m not sure that this is economics, or if it’s more business administration or organizational theory, but predefined processes actually play more of a role in coordinating these complicated intra-firm production systems than managers themselves. These processes work a lot like contracts between firms: Defining responsibilities, procedures for disparate people and groups interacting, timelines and deliverables, even sanctions for failure to deliver. Managers’ primary role in production isn’t so much coordinating different workers as ensuring processes are followed, then working through unanticipated gaps in the process. (Much like mediators or courts with regard to contracts.) These processes are also created through negotiation between the groups who use them.

    In fact, some of the worst managers, the micromanagers, are counter productive because they directly intervene in their employee’s work process instead of simply ensuring employees follow standard policies and procedures.

    Finally, like contracts, there are standardized forms for internal processes that get adopted (with tweaks) into firms: Six Sigma, Agile, ITIL, these all work like contracts by defining different parts of the work process and how different groups within a firm interact with each other.

    So, maybe intra- and inter- firm coordination isn’t so different after all? Which brings us back to the question: Why firms? In some cases, we’re seeing firms ask that by outsourcing various tasks traditionally done internally. But, I think there’s still a transaction cost answer: Internal procedures are vastly more complicated and deal with much smaller chunks of work than formal contracts. (And as some procedures get more formalized, they become the new frontier for the firm. For example, it’s easier to outsource _a part_ of your software development when you can specify that you’re using the Agile development method and all your bidders know what that is.) Also, internal processes are often living constructs, meaning that they are periodically or constantly reassessed and updated to reflect changes in the environment. This would be far more expensive to do with formal contracts between multiple firms.

  3. You say that each worker’s contribution is not marketable, but why should that be? What if you imagine each worker as a firm, disaggregated and strung together in a chain? Or imagine each step of improvement or value-addition as outsourced or outsourceable at market prices? Then the value of each worker or division is easier to assess.

    The obvious conclusion is that there must be plenty of benefits from ‘vertically integrating’ all these mini-firms together into a single organization.

  4. People are actively working on the problem of making individual worker contributions marketable. This problem is not terribly different from the one solved by assurance contracts. It can be solved using contracts with decentralized enforcement mechanisms, which is a technology implicit in the bitcoin blockchain. One place to look is https://www.vinumeris.com/lighthouse.

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