Visible and invisible hands governing the firm

1. The Boundary of the Firm

From sections 1 and 2 of this chapter we have seen that the ‘visible hand’ can guide the process of resource allocation and integrate vertical, lateral, conglomerate or international transactions using a variety of corporate structures. As has been remarked in earlier chapters, however, the distinc­tion between visible and invisible hands is less clear than the terminology suggests. As Klein, Crawford and Alchian (1978) put it ‘the conventional sharp distinction between markets and firms may have little general analyt­ical importance’ (p. 326). When thinking about the firm, it is natural to envis­age the factory and office buildings, the machines and equipment, the signs proclaiming the company name, and perhaps even the wrought-iron gates confidently symbolising the idea that there is a clear boundary to be drawn between what goes on inside and what goes on outside. Begin to think in terms of the transactions involved, however, and the buildings and offices look increasingly ‘open plan’, the gate is perpetually ajar, and the evanes­cent firm appears to have all the substance of the residual grin on Alice’s Cheshire cat. It would, however, be prudent to avoid the fate of the unfor­tunate sheepdog in Hardy’s novel⁵, which, concluding that it was employed to run after sheep, drove them over a precipice and was shot for its pains, a result ‘which so often attends dogs and other philosophers who follow out a train of reasoning to its logical conclusion’. Our aim is to pursue the firm in an attempt to learn more about it; not to hound it to existinction.

Nevertheless, a transactions cost approach to economics does make a clear definition of ‘the firm’ difficult, and theorists have avoided the problem by concentrating instead on the question of why contractual arrangements differ as circumstances differ. In some cases, ‘market-like’ contracts are adopted; in other cases, contracts are more ‘firm-like’. ‘Firm­like’ contracts, it will be recalled, govern the transactions between the parties involved over a long period of time. They are also, because of bounded rationality, incompletely specified and leave many obligations implicit. ‘Market-like’ contracts, by contrast, are (in the purest case) com­pletely specified, with obligations perfectly understood and explicit. Because of bounded rationality, such contracts can involve only the sim­plest transactions and relatively short periods of time. So clearly is the con­tract specified and so easily is it policed that the identity of the buyer or seller is of no consequence and transactions can be almost ‘anonymous’, as when someone purchases a raw material such as copper of verifiable quality on a specialised market.

The first stage in the substitution of ‘firm-like’ for pure market relation­ships occurs, therefore, when the specific identity of buyers and sellers begins to matter. In a very stable, unchanging environment, information asymmetries and adverse selection might inhibit trade, but the development of specialised dealers in the various goods and services with a valuable ‘rep­utation’ to protect (as described by Alchian, see Chapter 2) will enable exchange to proceed. Any ‘reputable dealer’ will suffice for the purposes of buying or selling, and there will be no particular reason for always using the same one. Static conditions therefore greatly favour the use of markets and correspondingly restrict the scope of the firm. Where contractual require­ments are complex and uncertain, bounded rationality leads both to implicit contracts and a much increased scope for moral hazard and the exercise of opportunism. It then becomes advantageous to develop a continuing trading relationship with particular suppliers. These suppliers (like the labour force in Chapter 6) gain in the experience of perceiving what the cus­tomer wants, satisfying a particular customer’s changing requirements and coping with the idiosyncrasies of the tasks in hand. A continuing relation­ship is also central to the problem of policing the behaviour of suppliers. Thus, as Spence (1975) remarks, ‘many of the structural features of resource allocation problems appear similar in markets and in organisations’ (p. 171).

The requirements of a continuing association able to respond flexibly to new circumstances, and capable of providing incentives leading to cooper­ation instead of opportunism, gives rise to the ‘firm’. As we saw at the end of Chapter 6, Williamson (1979) refers to the firm as a governance struc­ture. However, the boundaries of such a structure, and the boundaries of the firm as defined by the law, will not necessarily coincide. Continuing rela­tionships, embodying procedures for adjudicating in the event of disputes and including monitoring and incentive devices, can evolve between legally quite separate firms. The governance structure idea has something in common with Edwards and Townsend’s definition of the firm as ‘an area of unified business planning’ (p. 64) although it is important not to inter­pret this as implying that each firm is a miniature ‘command economy’. Some firms may adopt procedures which are quite decentralised, as was seen in section 2.

2. Arm’s Length and Obligational Transactional Relations

The contrast between ‘firm-like’ and ‘market-like’ transactional arrange­ments is sometimes linked to the idea of ‘obligation’. It is often argued, for example, that contracts in the United Kingdom and the United States are arm’s length whereas in Japan they are obligational. These concepts are not simply related to ‘internal’ and ‘external’ transactions, however. It does not follow, for example, that Japanese firms are more highly vertically inte­grated than are those in the United States. Indeed, the contrary seems to be the case. The greater continuity and trust associated with obligational transacting in Japan results in a generally lower level of vertical integration. ‘Outside’ contracts can achieve levels of coordination in Japan that require integration and ‘inside’ contracts in the United States.

It would be a gross oversimplification, however, to think that arm’s length contracting does not occur in Japan or that obligational relation­ships are never to be found in the United States or the United Kingdom. There is a spectrum of contractual relationships. Sako (1990), in a study of buyer-supplier relations in Japan and the United Kingdom, contrasted various characteristics of the contracts which she found in the electronics industry. Suppliers in the UK tended to have larger numbers of customers, with a lower level of dependency on any particular one. British suppliers could not count on repeat orders to the same extent as companies in Japan. Transactions tended to be more ‘legalistic’, with written documents playing a greater role in the United Kingdom. Trust, as measured by the willing­ness of suppliers to manufacture in advance of receipt of an order or by the willingness of buyers to forgo quality inspection, was generally lower in the United Kingdom. In other words the conventional contrast in transac­tional styles was supported by the evidence, but it was also true that varia­tions occurred within each sector and that relationships between some buyers and suppliers could have pronounced obligational features even in the United Kingdom.

More recent work by Helper and Sako (1995) and Sako et al. (1998) has investigated supplier relations in the automotive industry. They find that supplier-customer relations in this industry are becoming more ‘relational’ and less ‘arm’s length’ in the United States and the UK, although survey responses provided little evidence that suppliers felt their customers were becoming more trustworthy. The average length of contract offered to sup­pliers in the UK rose from one year in 1990 to three years in 1994. Similarly the median length rose from one year to one and a half years in the US (Sako et al., 1998, p. 183). This might be interpreted as a sign of greater ‘commitment’ between suppliers and customers. In Japan, there was a slight move towards ‘exit’ rather than ‘voice’ relationships but it was not clear whether this represented the beginning of a long-run trend or a response to a cyclical contraction.⁶ Empirical studies of buyer-supplier relations are playing an important role in the discussion of different theories of eco­nomic organisation. In particular, these studies have cast doubt on both property rights and transactions cost theory. Japanese subcontracting seems to indicate that the existence of transactional hazards can be handled using methods short of the common ownership of the assets (as in the Grossman-Hart framework) or the establishment of ‘unified governance’ within a single firm (as in the Williamson framework). Instead, the impor­tance of repeat dealing and the evolution of trust between legally separate firms in a durable relationship is emphasised.⁷

3. The Franchise Chain

A set of ‘outside’ contracts which produce a form of economic organisa­tion similar to a single ‘firm’ is the franchise chain. In a typical franchise contract, the franchisee pays a fee to the franchisor for the right to market a particular ‘branded’ product or service. The franchisee agrees to run the business in the manner stipulated so that product, price, hours of opera­tion, personnel policies and so on may be standard throughout the chain. The franchisor may provide assistance in the form of managerial training or site selection, and the franchisee will usually pay a royalty in the form of a percentage of sales. Rubin (1978) notes that a common explanation for these arrangements is that outside capital is attracted, and that franchising is a method of tapping the capital provided by the franchisee. However, the explanation is clearly suspect since, if the franchisee is risk averse, s/he would prefer a ‘share’ in the profits of the entire franchise chain rather than the right to the return from a single outlet in the chain. Risk-spreading con­siderations would therefore work against the franchise as an efficient form of economic organisation unless franchisees are all risk neutral. Yet the success of franchising in particular areas suggests that it has its advantages. The explanation favoured by Rubin is in terms of monitoring and control within the firm. Usually, the franchisee is physically removed from the fran­chisor (as, for example, in a fast-food chain) and detailed monitoring would be extremely costly. Incentives can be provided instead by paying a fran­chise fee for the right to run the business for some period of time.

If the franchise chain is an institutional response to the incentives problem, why do not franchisees keep all the profits attributable to their business? Why does the franchisor typically receive a royalty? Rubin argues that the franchisor also requires incentives. The profitability of a given outlet does not depend exclusively on how that particular outlet is managed. It also depends on the image of the product generally with poten­tial customers, and this ‘goodwill’ is the primary responsibility of the fran­chisor. The franchisor is responsible for policing quality, and ensuring that each franchisee maintains the correct standards. Through advertising, the franchisor also attempts to keep the distinctive features of the product

known to the consuming public. Without the royalty, the franchisor would have a smaller incentive to pay attention to these activities. Thus, Rubin concludes (p. 230) that,

in those businesses where there is much managerial discretion, we would expect a higher percentage of the revenue of the franchisor to come from the initial fee and a relatively lower percentage to come from royalties . . . Second, where the trademark is more valuable we would expect more of the franchisor’s revenue to come from royalties, for this would create an incentive for him to be efficient in policing and maintaining value.

Martin (1988) takes the analysis further by investigating industries with differing proportions of managed and franchised operations in the United States. He argues that young firms may grow by franchising, not because of capital constraints but because franchising economises on management resources which would otherwise be very stretched. As firms mature, fran­chise contracts expire and direct monitoring may replace them. The pro­portion of company-owned outlets, in other words, should increase with the age of the chain. This ‘life-cycle hypothesis’ does not imply, however, that franchising is always simply a transitory form of organisation. In some circumstances, it will be a stable organisational form. High costs of moni­toring will obviously militate against the managed outlet, and very ‘noisy’ (in a statistical sense) or uncertain environments will therefore favour fran­chising. Urban environments make monitoring more reliable because results are more predictable. Rural locations are more variable, which rein­forces the franchising solution. The greater incidence of repeat buying in rural areas also favours franchising because the franchisee will have a smaller incentive to free ride on the brand-name capital of the chain.⁸

4. Quasi-vertical Integration

A further case of interest, which will be considered again in section 5, is a transaction which involves the buyer of an input providing the supplier with raw materials or important items of equipment necessary for its pro­duction. This has been termed quasi-vertical integration. Quasi-vertical integration has been defined by Monteverde and Teece (1982b) as ‘the own­ership by a downstream firm of the specialised tools, dies, jigs and patterns used in the fabrication of components for larger systems’ (p. 321). The buyer contracts ‘in the market’ for the supply of the desired input but has property rights in the equipment necessary for production to take place.

Another form of quasi-vertical integration, undertaken for rather different reasons, occurs when a company trains specialist staff necessary to sell its goods effectively, but then uses the premises and other inputs of an independent retail store. In this case, the company is attempting to gain greater control over the ‘human’ rather than the ‘physical’ capital. Examples would include the use of a particular area in a department store for the sale of glass, chinaware or cosmetics, supplied by specialist compa­nies and staffed by their trainees. A further option is the use of a franchise contract which gives the holder of the franchise an incentive to market a product with enthusiasm, if not always with the greatest care. The ‘firm­like’ features of this contract have already been discussed in subsection 3.3.

Integration, whether horizontal, vertical or geographical, may therefore be effected using a range of contractual mechanisms. The choice of con­tract will reflect the attempt to cope with the information problem. Earlier in this book it was found convenient to distinguish three facets to this problem and these will form the subject matter of the next three sections, but, first, a brief summary of each.

1. Coping with a changing environment There is first the problem of bounded rationality; the impossibility of predicting and specifying the appropriate response to every conceivable contingency. This leads to the firm as a device for handling change, for increasing flexibility and adaptability in the face of new circumstances. Here, the firm is closely connected to the entrepreneurial function identified by Casson and Knight; the exercise of judgement in the face of environmental uncer­tainty.
2. Policing transactions in the presence of opportunism A second facet to the problem is that of establishing and enforcing property rights. Property rights are insecure and, in the extreme case, worthless, if they cannot be enforced and protected. Enforcement requires, however, that infringements are detected, and detection requires information. This leads to the firm as a monitoring device to cope with moral hazard and adverse selection. The focus of attention is on information concerning the behaviour and performance of the various parties to a contract. It was this conception of the firm which underlay much of the analysis of Chapters 5 and 6.
3. Generating new knowledge The third facet is the problem of perceiv­ing (Kirzner), creating (Shackle) or forcing through (Schumpeter) new opportunities and new information. This leads to the firm as the insti­gator of change and is most closely associated with the view of entre­preneurship espoused by Schumpeter.

In sections 4, 5 and 6, each of these facets will be examined in turn to see how they are reflected in the structure of firms. We will attempt to show how modern theorists have linked the information problem to the organisational form adopted and especially to the extent of vertical, horizontal, conglom­erate and geographical (especially multinational) integration.

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.