The process of exchange and the fim

All exchange transactions encounter problems of information and enforce­ment. Consider, for example, the process of building houses. Suppose that a person, A, who, for the sake of convenience, we shall call a ‘he’, wishes to build an extension to his home. One possibility is that he will draw up some plans, submit them to the relevant public authorities, dig the foundations, order the bricks, mix the cement, build the walls, plaster the interior, put in the doors and windows and undertake to install any electrical fitments and plumbing. Elementary economic principles, however, suggest this is unlikely. Recognising the advantages to be gained from specialisation and exchange, person A might instead decide to spend his time in a suitably remunerative occupation and then to purchase the services of specialist help. He could, for example, pay an architect to draw plans, another agent to obtain the necessary planning consent, a bricklayer to build walls and an electrician, carpenter, plumber and so forth to fulfil their respective tasks.

By forming agreements with specialists, person A will gain the classic advantages from exchange. But he has also given himself some problems.

  1. Like a cook consulting Hannah Glasse’s Art of Cookery who is there advised ‘first catch your hare’, A has to find the people who are going to help him. As may be subtly suggested in this celebrated misquote, obtaining the constituent ingredients is not necessarily the easiest part in any process of coordination.
  2. Having located his bricklayer, architect and electrician, A has to form some assessment of their professional competence.  If the bricklayer is more productive  at laying bricks than is person A there should be some advantage in using his or her services, but how does A acquire such information? The existence of some other examples of the brick- layer’s handiwork which A can inspect,  or the recommendation of other satisfied clients, are obvious possibilities. Inspecting  other ser- vices and goods, however, may present greater  difficulties. Person A may never be quite sure that he is not risking life and limb each time he switches on his electric kettle!
  1. With each of his contacts, A will draw up a separate  agreement,  but this will not necessarily be as straightforward as it sounds. Person A knows what he wants to do in a very general sense: he wants to extend his house. The technical details of how this can be accomplished and the options available may, however, be quite beyond him. When he approaches his architect with a request to produce some plans, he therefore confronts a significant problem. He cannot ask the architect to undertake a highly specific and carefully delineated  task, since at this level of  detail  A quite  literally  does not  know  what  he wants. Instead he must ask the architect to act on his behalf. The architect is A’s agent and is asked to make specific recommendations which are likely to satisfy the general requirements  laid down by person A. Proceeding in this way enables A to gain the advantages of specialised advice, but  as an intelligent  and  shrewd individual  he is sure to be beset by a few nagging doubts.

If, for example, A does not like the architect’s suggested plans and does not wish to proceed with the project, will he have to pay a fee to the architect? Clearly the architect is unlikely to agree to waive his or her fee simply because the client is dissatisfied. Such an arrangement would provide an enormous  incentive to person A to dissemble. He would  claim to  see no  merit  in the  plans  whatever  whilst  secretly taking careful note of their contents. The alternative arrangement, however, by which the architect is paid a fee irrespective of the quality of his or her work, is likewise fraught with difficulties, this time from the perspective of person A. Person A may wonder whether the archi- tect has given his problem  more  than  a moment’s  thought, or has perhaps  delegated the case to some assistant  of little talent and even less experience.

Similar considerations will play a part in person A’s dealings with each of the other tradespeople involved in his project. The plumber, for example, cannot  be told in detail how to proceed,  since only the broad  objectives are defined by A. Technicalities  such as the gauge and type of piping to be used, the potential  heat output required  of the boiler, the positioning of thermostats, the siting of the pumps, are all matters upon which A will have to accept the advice of the expert.

The plumber  will be asked to solve these detailed problems  in ways which serve the interests of A. He or she should not install a boiler with the wrong characteristics  simply because he/she stands  to gain from an agreement with the suppliers, but the client will be in a weak position from which to detect such behaviour.

  1. Overcoming the  difficulties of  formulating enforceable  agreements with each individual is an important prerequisite to the success of A’s plans. Of equal significance, however, is A’s ability to coordinate the activities of each of his helpers. To build an extension to a house using specialist help involves many people cooperating together. Only in the simplest cases will the provisions of one person’s contract  be entirely independent  of the provisions  in another’s.  A decision, for example, to lay a concrete floor rather than a wooden suspended floor will influence the way in which the heating  system is installed. Likewise, the  electrician  and  plumber  may  have  to  work  closely together  at various  stages. Thus, A will find it difficult to finalise his agreement with any one person in the absence of agreements with all the others. Stolidly, he contacts first one and then another, asking advice, modi- fying his original proposals  and renegotiating terms until eventually he calculates  that  construction can  begin.  Inevitably  there  will be some  residual  uncertainty about  his plans,  some  unforeseen difficulties  which  will arise  and  which  will result  in  a  continuing process of bargaining. Within rather vaguely defined limits, his crafts- men accept the obligation to be flexible. Outside these limits, they will claim that the job they are doing was not part of their original agree- ment and will therefore wish to renegotiate  terms.

As building starts, A becomes painfully aware that delays and problems in one area have implications for his plans in others. Bricklayers turn up but cannot build because the inspector has yet to see the foundations. Person A nevertheless pays them for their time. The nagging doubts  which afflicted A at the beginning now turn  to serious concern. Indeed, he begins to have nightmares.  In his sleep he sees the extension to his house. Were those gaps in the roof really the latest thing in ventilation?  Is it usual for walls to sway so far in the breeze? In the nearby hotel, his architect and lawyer share a joke over a glass of whisky. It seems they are using his wallet to pay for their drinks. His gaze returns to his extension, only to see the whole struc- ture collapse in a cloud of dust. Across the rubble a shadowy figure advances towards  him coughing and dusting his pin-stripe  suit. The planner  from the local authority serves him with a demolition  order as a result of failure to comply with all necessary regulations.  Person A wakes up sweating. He, at least, has discovered the primary message of this chapter. Whatever may be the potential  advantages of special- isation and exchange, they certainly do not come free.

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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