Idiosyncratic exchange, rent seeking, entrepreneurship and opportunism

1. IDIOSYNCRATIC EXCHANGE

The analysis of sections 3 to 6 helps us to rationalise some of the charac­teristics of hierarchical structures. Even in the context of identical employ­ees performing identical tasks it is possible to understand the development of recognisable hierarchies. We have seen that the provision of effort incen­tives where individual output cannot be identified or where employees are risk averse may involve the use of monitoring gambles and hence (i) the use of monitors to measure effort; (ii) wages rising faster than productivity over time (Lazear) with mandatory retirement after a certain point; or, (iii) the use of ‘tournament-like’ incentive schemes whereby the firm undertakes to pronounce a certain fraction of its employees as ‘winners’ by promoting them to higher-paid positions (Lazear and Rosen, 1981; Malcolmson, 1984).

These ideas depend simply on the existence of moral hazard and the assumed propensity of people to shirk if they are not being monitored. They thus relate most closely to the discussion of ‘team production’ in Chapter 4. The fact that certain hierarchical features are explicable on this basis alone is significant, since theorists usually prefer their work to depend upon the weakest assumptions possible. Yet, it has to be admitted that the

models discussed so far produce only the barest outlines of a hierarchy, stripped of the complexity associated with the organisation of large firms. For a less austere approach, richer in its implications for internal structure, we now return to the work of Williamson (1975).

It will be recalled from Chapter 2 that person A, in his attempts to extend his house, faced many transactional problems other than the simple inabil­ity to observe the effort of the workpeople involved. It was of the essence of person A’s problem that potential craftspeople were not of identical ability, that the different people in the team had different jobs to do, and that person A was not, and could not become, apprised of the best way of performing the different tasks involved. Certain information and certain types of skill were inevitably associated with the actual business of per­forming the job in question and would not be available on equal terms to person A. This type of knowledge was considered also in Chapter 3, where the scope for entrepreneurial reward from Hayek’s ‘knowledge of time and place’ was discussed. Further, A confronted the ‘bounded rationality’ problem; the plain incapacity to calculate all possible best responses to every conceivable set of contingencies. Williamson’s approach to hierar­chies is rooted in an appreciation of these more varied but very fundamen­tal transactional difficulties.

All people have their own special skills and attributes, and all tasks are idiosyncratic to some degree. As Doeringer and Piore (1971) put it: ‘almost every job involves some specific skills . . . The apparently routine opera­tion of standard machines can be importantly aided by familiarity with the particular piece of operating equipment . . . Moreover … a critical skill is the ability to operate effectively with the given members of the team’ (p. 15). At the risk of repetition, note again the difference between this observation as the starting point for analysis, and the models of sections 5 and 6 which assume away task idiosyncrasy and differential skills. If, as a matter of observation, people and jobs are all special to some degree, transactions cannot be regarded as ‘standard’. Each transaction has its own features which are unique, and the central agent or firm will find itself bargaining continually in a situation of bilateral monopoly and with asymmetrically distributed information. The possibilities available to the employee in these circumstances for ‘opportunistic behaviour’ were dis­cussed in detail in Chapter 2. As Williamson defines it (Williamson et al., 1975, pp.258-9): ‘opportunism is an effort to realise individual gains through a lack of candour or honesty in transactions. It is a somewhat deeper variety of self-interest seeking assumption than is ordinarily employed in economics; opportunism is self-interest seeking with guile.’ Employees enter the firm and gradually become skilled and adept at specific tasks. This specialised knowledge gives the incumbent employee ‘first-mover advantages’ over potential replacements from outside and thus places the employee in a bargaining position which he or she may try to exploit in negotiations with the firm. Essentially, Williamson sees most of the characteristics of employment hierarchies as a response to the transactional difficulties posed by ‘small-numbers bargaining’ and ‘oppor­tunistic behaviour’. Before proceeding to outline the mechanisms which are supposed to cope with ‘opportunism’, it will be useful to reflect in more detail on its nature and in particular on its relationship to the subject matter of Chapter 3 – ‘entrepreneurship’.

2. RENT SEEKING, ENTREPRENEURSHIP AND OPPORTUNISM

The entrepreneur is nothing if not an opportunist. Without the ability to perceive opportunities and to make use of them while they last, resource reallocation and the efficiency gains which accompany them could not occur. From the hero of Chapter 3, however, the opportunist has unac­countably become the villain of Chapter 6, whose fiendish unreliability the whole paraphernalia of hierarchical organisations are designed to coun­teract. How are we to explain this unexpected change of view? The answer is basically simple in outline although often extraordinarily complex in detail. It revolves around the distinction between rent seeking and entre­preneurship. Entrepreneurship, as we saw at length in Chapter 3, produces efficiency gains. It extends our knowledge of the available possibilities for division of labour and exchange. The entrepreneur trades in property rights and, if successful, receives an entrepreneurial profit from the efficiency gains he or she has created. Rent seeking is behaviour aimed at acquiring or asserting property rights other than by voluntary exchange. Resources are expended in efforts merely to redistribute income.

Tullock (1980a) defines rent seeking as follows: ‘an individual who invests in something that will not actually improve productivity or will actually lower it, but that does raise his income because it gives him some special position or monopoly power, is ‘rent seeking’ and the ‘rent’ is the ‘income derived’ (p. 17). The idea grew initially out of dissatisfaction with the conventional approach to measuring social losses due to monopoly. Monopoly profits in received theory are not part of the social costs of monopoly. They merely represent transfers from consumers who are worse off to monopoly producers who are better off. Tullock argued, however, that if it were possible to receive profits by creating monopolies, people would invest resources in ‘monopoly-creating activities’. Further, the resources ‘invested’ in total could equal or even on occasions far exceed (Tullock, 1980b) the monopoly profits obtained by the eventual holder of the monopoly. Thus, the profits of monopolists attract attempts to gain monopoly privileges, and the resources expended in these attempts are part of the ‘efficiency loss’ associated with monopoly. A similar argument applies in cases where tariff protection is sought. Consumers lose and pro­tected producers gain from measures to restrict foreign trade, but if these producer ‘gains’ are available, producers will expend effort and resources in lobbying and pressuring politicians to grant them protection. These politi­cal efforts are ‘rent seeking’ and represent social losses.

The archetypal form of rent seeking is theft. Theft involves a simple redistribution of resources and diverts activity from production and exchange to either thieving itself or protection from thieving. Burglar alarms, locks and other security devices use up scarce resources and are a response to a purely redistributional activity. To quote Tullock again: ‘as a successful theft will stimulate other thieves to greater industry and require greater investment in protective measures, so each successful establishment of a monopoly or creation of a tariff will stimulate greater diversion of resources to attempts to organise further transfers of income’ (1980c, pp. 48-9). The contrast between gaining from theft and gaining from the encouragement of fully voluntary exchange is the essential contrast between rent seeking and entrepreneurship. Readers should be aware that this use of the terms ‘rent seeking’ and ‘entrepreneurship’ is not fully agreed upon. Rent seeking is sometimes broken down into different types and an entrepreneur is often simply viewed as any rent seeker. Entrepreneurs do seek, and if successful receive, a form of rent (the efficiency gains created) and thus it is understandable that they should be seen as rent seekers. But the term ‘rent seeking’ is now so closely associated with the pursuit of income transfers, and the theory of entrepreneurship so intimately associ­ated with the pursuit of efficiency gains, that the suggested distinction between rent seeking and entrepreneurship seems both useful and tenable.

When presented as the difference between theft and voluntary exchange, nothing might seem more clear-cut than the difference between rent seeking and entrepreneurship.27 Yet detailed cases can give rise to conceptual prob­lems. These problems will ultimately derive from ambiguities about prop­erty rights. If rent seeking involves a form of theft, it must, as Sisk (1985) emphasises, imply the infringement of someone’s property rights: ‘Rent­seeking emerges when rights are challengeable’ (p. 96). In the case of monopoly, considered above, the right of people to use resources in the monopolised trade was restricted by government decree. Thus, people’s rights to use their resources (their property rights, see Chapter 4) have been restricted by the activities of the rent seeker, and the result is an uncom­pensated transfer. Similarly, if person A pays another to do some shopping and the shopper (an opportunist) lies about the price of the items pur­chased, a theft has taken place. The fact that person A may not know with certainty that he has been robbed does not affect the issue. His property rights have been infringed by the rent seeker and the knowledge that he is vulnerable to this type of rent seeking will presumably reduce his use of the shopper, or restrict it to items for which receipts (somehow made tamper proof) can be obtained.

Consider now the case of the artistically inclined entrepreneur of Chapter 3 who notices a valuable picture hanging in the house of an unsus­pecting old lady. He offers her a sum sufficient to acquire the picture and makes a fortune. Has the old lady been robbed? Most of us would be inclined initially to say that she had, and that this action was rent seeking. Yet, in principle, this is clearly not the case. No uncompensated transfer took place and no property rights were infringed. Our trader with knowl­edge of the art market was an entrepreneur. There is no economic princi­ple which says that entrepreneurs, even as we have defined them, will be generous to old ladies (which is not to say, of course, that they ought not to be). Suppose, however, that we change the story so that the old lady shrewdly suspects that her picture is valuable and approaches an expert with an offer to pay for his or her professional advice. The professional adviser lies to her, purchases the item, and again makes a fortune by reselling at a huge profit. This is rent seeking because it involves the adviser implicitly challenging the old lady’s right to the information for which she had paid. Trade in information gives rise to many problems, but the most fundamental is that of establishing clear and policeable property rights. It would, no doubt, be difficult to prove that the adviser had abridged the lady’s property rights: ‘I really had no idea at the time that the picture would prove to be so valuable.’ This, though, is simply to reiterate the basic point that the lower the cost of challenging a person’s property rights, the more likely such rights are to be challenged, and hence the greater will be the amount of rent seeking. Property rights in information are eminently chal­lengeable.

The use of the word ‘theft’ in the context of rent seeking requires care. It is clearly a useful analogy, but the more neutral ‘uncompensated transfer’ is a less value-laden term. If a group of businessmen lobby politicians and receive a subsidy for their industry, they are rent seeking. The tax mecha­nism is used to transfer resources from one group of people to another. An uncompensated transfer occurs and, with it, the attenuation of taxpayers’ property rights, but although some of us are apt to declaim on occasions that ‘all taxation is theft’, from a legal point of view this is obviously not so, and to avoid confusion it is better that theft be considered the archetypal case rather than the defining characteristic of rent seeking.

A case closer to the problem of employer and employee is that of the plumber and person A in Chapter 2. A plumber who installs a system of unnecessary technical sophistication to heat a customer’s house is a rent seeker. The resources expended are pure waste and the customer’s rights to the information possessed by the plumber have been implicitly challenged. Contrast this with a plumber who, after finalising an agreement with person A, perceives new opportunities which will enable the same objec­tives to be achieved at much lower cost. The plumber returns to person A and renegotiates the agreement. In the process he or she deliberately under­states the cost-reducing characteristics of his/her discovery and succeeds in making a large profit. Is he/she a rent seeker or an entrepreneur? Everything depends upon our understanding of the contractual relationship between the plumber and person A. If the plumber had signed a contract saying ‘I undertake to serve person A in the capacity of plumber over the following period and faithfully promise to use all the information at my disposal during this period in the interests of person A’, the activities of the plumber in attempting to mislead person A could be construed as rent seeking. The plumber is renouncing the provisions of a contract. This is, of course, pre­cisely what happens when a person paid by time-rate shirks. If, though, the plumber’s contract merely states ‘I undertake to install a heating system which meets the following specifications’, the use of new information to achieve this end at lower cost is pure entrepreneurship. If the contract actu­ally specifies the exact equipment to be installed so that renegotiation is necessary before the new information can be used, the plumber may be less than candid about the cost advantages of the new system and vastly under­estimate them, but no one has ever claimed that entrepreneurs must be frank. They merely fulfil their contractual obligations. A person paid by piece-rate who discovers methods of improving his or her output is an entrepreneur, and may not be required contractually to inform his/her employer of these developments.28

Our discussion of principal and agent in Chapter 5 can thus be recast in terms of rent seeking and entrepreneurship. The contractual problem was to find mechanisms which would reduce rent seeking and channel attention away from attempts to challenge property rights towards attempts to achieve more effective coordination of resources. For Williamson, this is also the function of hierarchical organisations. Both rent seekers and entre­preneurs are opportunists, but institutional structures determine the returns available from opportunist contract-breaking and opportunist con­tract-making and contract fulfilment. The baby of entrepreneurship sits, if we can adapt a popular metaphor, in the bathwater of rent seeking, and the function of hierarchies is to jettison the latter whilst somehow retaining the former. This manoeuvre is beset with difficulty and not infrequently ends with the baby ousted and the performer drenched with the bathwater. In the next section, however, we consider Williamson’s observations on the procedures which make this result less likely.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.

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