Just as the development of property rights in resources subject to congestion can be seen as an attempt to achieve efficiency gains, so the development of institutional structures such as firms can be viewed in the same light. In Chapter 2, the firm as a device to economise on transactions costs was considered in some detail. We did not emphasise at that stage, however, that the contractual relationships found within ‘the firm’ establish a structure of property rights in the use of resources. In a classic paper, Alchian and Demsetz (1972) elaborated on this theme and argued that the structure of property rights observed in the classical capitalist firm was a response to transactional problems, and in particular to the problem of ‘team production’.
The essence of the firm for Alchian and Demsetz is that it permits people to work as a team. Team production occurs when an output is produced by the simultaneous cooperation of several team members. Production is not a sequence of identifiable stages by which a series of intermediate products are gradually transformed into the final output. Rather, the final output is the joint result of the combined efforts of all the inputs working at the same time. It follows that the individual contribution of each member of the team to the final output cannot be isolated and observed. All that can be observed in terms of output is the combined result of the entire team’s efforts.
A further complication is that any one person’s activity may affect the productivity of the other members of the team. In these circumstances there will exist an incentive for people to get together and agree to take account of external effects in their behaviour. In the last section, we showed how people could gain by forming a ‘fisheries consortium’ if their fishing activities imposed external disbenefits on each other. Here, the same argument can be used to show that a collective agreement to modify behaviour may be useful in the presence of external benefits. Person A agrees to work a little harder on the understanding that person B will do likewise. The benefits in terms of higher output of their joint decision to work harder will be sufficient to compensate them both, although any individual commitment to greater effort in the absence of the other party would not have conferred net private benefits on the person undertaking the extra work.
The situation is analogous to the public goods problem discussed in Chapter 2. No individual person may have an incentive to provide a public good, although a joint decision to produce one may confer benefits on everyone. It will be recalled that a joint decision was difficult to arrange because each person had an incentive to understate his or her true valuation of the public good in the hope that other people would pay to provide it. People, in other words, would tend ‘to shirk’ and fail voluntarily to pay their contributions. In the same way, a joint agreement to work harder in order to increase team output will be difficult to implement unless each person’s behaviour can be monitored. Without monitoring, each person will ‘shirk’ and hope to ‘free ride’ on the effort of other people. Note that this problem would not arise if an identifiable output could be assigned costlessly to each person, for then a contract linking reward to performance would be possible. In the case of ‘team production’, however, there is a single output produced by the simultaneous cooperation of all members of the team, and the individual contribution of each member cannot be separately identified.
Problems of ‘moral hazard’ will therefore have to be overcome if the potential advantages of team production are to be achieved. The ‘solution’ suggested by Alchian and Demsetz is that the team requires a ‘monitor’ to observe the individual members and to check that their effort is satisfactory.
Clearly, this solution requires that effort is observable and this will obviously not always be the case. Where the team is concerned with the coordination of fairly simple ‘manual’ operations, the observation of the inputs to ensure that they perform the tasks they contract to perform may not be very costly. In other cases, observation of behaviour may be a very imperfect guide to the effective input of the team member involved. Further, as we saw in Chapter 2, a monitor may not have the information to judge whether the actions taken by a particular person are or are not in the interests of the team as a whole. The problem is equivalent to person A’s difficulty of contracting with his or her architect.
Assuming for the time being that a monitor is capable of observing the effort of team members, the problem remains of providing the monitor with some incentive to bother. If the monitor is simply another member of the team whose job is to check that all other team members are fulfilling their contractual commitments, the monitor would have as much incentive to shirk as anyone else. It is for this reason, argue Alchian and Demsetz, that the monitor becomes a residual claimant. Each team member receives a contractual reward in the form of a wage, and the monitor receives whatever remains after these payments have been made. The more effectively the team operates, the bigger the residual will be, and hence the monitor will have a definite interest in promoting the efficiency of the team. All the benefits from improved coordination will accrue to the monitor instead of being shared amongst the team members.
If the status of residual claimant is to provide the monitor with an incentive rather than merely an interest, he or she must be able to discipline team members. It would be pointless monitoring the behaviour of team members if they could then ignore the monitor’s criticisms. Thus, the monitor becomes the common party to all contracts with the power to alter these contractual arrangements and to add and subtract from the team (to hire and fire). Note the difference here from Coase’s view of the firm. Coase emphasised the costs of arranging detailed multilateral contracts as an explanation of the firm. Alchian and Demsetz emphasise the necessity of the monitor having control of contractual arrangements in the context of team production if shirking is to be reduced.
From the perspective of property rights theory, therefore, the traditional single proprietorship can be seen as a form of enterprise which concentrates property rights in the hands of a single person. The ‘private’ nature of these property rights gives the possessor the maximum incentive to consider the consequences of his or her actions for the market value of the rights. The more effectively the single contractual agent or proprietor monitors and organises the team, the greater is the residual claim and the more valuable will be his or her property rights on the market. Exchangeable private rights to determine the use of team resources, monitor operations and claim the residual, represent a response to the moral hazard problem posed by shirking in the context of team production.
Although Alchian and Demsetz in their original (1972) paper saw team production as the primary source of the moral hazard problem, it is evident from the arguments reviewed in Chapter 2 that, even in the absence of team production as we have conceived it, asymmetric information can lead to problems of moral hazard. Whenever it is difficult to assess the quality of an intermediate product, for example, the supplier may have an incentive to shirk and there will be an advantage in appointing a specialist monitor. In this way, a purely market transaction becomes a transaction conducted within a firm. We will consider this process in more detail in a later chapter on the subject of vertical integration. For the present, it is merely necessary to note that the single proprietorship can be considered as a response to the ‘shirking’ problem and that this does not require us to assume conditions of team production rather, as Williamson (1975, pp. 49-50) emphasises, this may be an appropriate view wherever information difficulties lead to opportunistic behaviour.
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.