What Firms Should Do

An important message of this chapter is that because people can’t have everything they want, they will do what they can to get as much as they can. “Firms” are a means by which people can get “more” of what they want than otherwise. Firms are expensive operations, by their nature. Accordingly, people would not bother organizing themselves into “firms” if there were not gains to be had by doing so. But therein lies a fundamental dilemma for managers, how can managers ensure that the gains that could be had are actually realized and are shared in some mutually agreed upon way by all of the “stakeholders” in the firm? The problem is especially difficult when everyone associated with the firm – owners, managers, line workers, buyers, and suppliers -- probably want to take a greater share of the gains than they are getting and which he pointed out that no one person could make something even as simple as a lead pencil.31 It takes literally thousands of people specializing in such things as the production of paint, graphite, wood products, metal, machine tools, and transportation to manufacture a pencil and make it conveniently available to consumers. No one knows enough – or can know enough – to do everything required in pencil production. Prosperity depends on our ability to become very efficient in a specialized activity and then to exchange in the market place the value we produce for a wide range of products that have been efficiently produced by other specialists. Our ability to exchange in the market place not only allows us to produce more value through specialization, it also allows us to obtain the greatest return for our specialized effort by imposing the discipline of competition on those from whom we buy.
In this chapter, we extend our discussion of how transaction costs in markets can cause firms to extend the scope and scale of their operations. We are concerned with a special form of “opportunistic behavior” relating to the use of specialized plant and equipment that can cause firms to make things themselves even though outside suppliers could produce those things more efficiently.
Make or Buy Decisions
Much the same advantage from specialization and exchange applies to firms as well as individuals. But that comment begs an important question: Exactly what should firms make inside their organizations and what should they buy from some outside vendor? Business commentators have a habit of coming up with rules that don’t add very much to the answer. For example, one CEO deduced, “You should only do, in-house, what gives you a competitive advantage.”32 Okay, but why would anyone get a competitive advantage by doing anything inside, given that such a move reduces, to one degree or another contribute less in the way of work and investment than they are contributing. Managers have to find ways of overcoming the stakeholders’ inclination to “give little but take a lot.” One of the rolls of incentives is to overcome that inclination by tying how much people receive with what they give to the firm.
One of the more important lessons business people learn is that efficiencies can be realized from specialization and exchange. Anyone who attempted to produce even a small fraction of what he or she consumed would be a very poor person indeed.
specialization, and as a manager it is useful to understand the cause of these limits and what it implies about the advantages of producing in-house rather than buying in the market.
The problem with total reliance on the market should now be familiar: there are significant costs -- transaction costs -- associated with making market exchanges. You have to identify those who are able and willing to enter into a transaction, negotiate the specific terms of the transaction and how those terms might change under changing circumstances, draw up a contract that reflects as accurately as possible the agreed upon terms, arrange to monitor the performance of the other party to make sure the terms of the agreement are kept, and be prepared to resolve conflicts that arise between the agreement and the performance. Because of these transaction costs, it is often better for some individual or some group of individuals to directly manage the use of a variety of resources in a productive enterprise that we call a firm.
Transaction costs are lower, for example, when owners of labor become employees of the firm by entering into long-run agreements to perform tasks, that are not always spelled out clearly in advance, under the direction of managers in return for a fixed wage or salary. A market transaction is not needed every time it is desirable to alter what a worker does. Employment contracts typically allow managers wide discretionary authority to re-deploy workers as circumstances change without having to incur further transaction costs. Furthermore, with a uniform employment contract with a large number of workers, a manager can direct productive interactions between these workers that might otherwise require negotiated agreements between each pair of workers. As an example, ten workers could be hired with ten transactions, each negotiated through a relatively simple and uniform employment agreement. If those ten workers were independent contractors who had to interact with each other in ways that employees of a firm often do, they might well have to negotiate the terms of that interaction in 45 separate agreements.35
In general, the higher the cost of transacting through markets, the more a firm will make for itself with its own employees rather than buy from other firms. The reason restaurants don’t make their own toothpicks is that the cost of transactions is extremely low in the case of toothpicks. It is hard to imagine the transaction costs of acquiring toothpicks ever getting so high that restaurants would make their own. But one might have thought the same about beef until McDonalds opened an outlet in Moscow. Because of the primitive nature of markets in Russia when McDonalds opened its first Moscow outlet (before the collapse of the Soviet Union), relying on outside suppliers for beef of a specified quality was highly risky. Because of the high transaction costs, McDonalds raised it own cattle to supply much of its beef requirements for its Moscow restaurant. Negotiating an agreement between two parties can be costly, but the most costly part of a transaction often involves attempts to avoid opportunistic behavior by the parties after the agreement has been reached. Agreements commonly call for one or both parties to make investments in expensive plant and equipment that are highly specific to a particular productive activity. Once the investment is made, it has little, if any value in alternative activities. Investments in highly specific capital are often very risky, and therefore unattractive, even though the cost of the capital is less than it is worth. The problem is that once someone commits to an investment in specific capital to provide a service to another party, it is very tempting for that other party to take advantage of the investor’s inflexibility by paying less than the original agreement called for.36 There are so-called “quasi rents” that are appropriable, or that can be taken by another party through unscrupulous, opportunistic dealing.37 The desire to avoid this risk of opportunistic behavior can be a major factor in a firm’s decision to make rather than buy what it needs.
Any price between $125 and $150 million a year would be attractive to both investors in the pipeline and the electric generating plant that would use it. If, for example, the generating plant agrees to pay investors $137.5 million each year to build and operate the pipeline, both parties would realize annual profits of $12.5 million from the project. But the investors would be taking a serious risk because of the lack of flexibility after the pipeline is built. The main problem is that a pipeline is a dedicated investment, meaning there is a big difference in the return needed to make the pipeline worth building and the return needed to make it worth operating after it is built. While it takes at least $125 million per year to motivate building the pipeline, once it has been built it will pay to maintain and operate it for anything more than $25 million. Why? Because that is all it takes to operate the line. The pipeline investment itself is a sunk cost, literally and figuratively, not to be recaptured once it has been made. So after investors have made the commitment to construct the pipeline, the generating plant would be in a position to capture almost the entire value of initial pipeline investment by repudiating the original agreement and offering to pay only slightly more than $25 million per year.40
Of course, our example is much too extreme. The generating plant is not likely to risk its reputation by blatantly repudiating a contract. And even if it did, the pipeline investors would have legal recourse with a good chance of recovering much, if not all, of their loss. Furthermore, as the example is constructed, the generating plant has more to lose from opportunistic behavior by the pipeline owners than vice versa. If the pipeline refuses service to the plant, the cost of producing electricity increases by $150 million per year. So the pipeline owners could act opportunistically by threatening to cut off the supply of natural gas unless they receive an annual payment of almost $150 million per year.
But our main point dare not be overlooked and should be taken seriously by cost minimizing and profit maximizing business people: Anytime a transaction requires a large investment in dedicated capital, there is the potential for costly problems in negotiating and enforcing agreements. True, opportunistic behavior (actions taken as a consequence of an investment that has been made and cannot be recaptured) will seldom be as blatant as in the above example where it is clear that a lower price is a violation of the contract. But in actual contracts involving long-term capital commitments, unforeseen changes in circumstances (higher costs, interrupted supplies, stricter government regulations, etc.) can justify changes in prices, or other terms of the contract. Typically contracts will attempt to anticipate some of these changes and incorporate them into the agreed upon terms, but it is impossible to anticipate and specify The early history of the automobile industry provides an example of a merger between two companies that can be explained by the advantages of producing rather than buying when dedicated capital investment is involved.41 In 1919, General Motors entered into a long-term contract with Fisher Body for the purchase of closed metal car bodies. This contract required that Fisher Body invest in expensive stamping machines and dies specifically designed to produce the bodies demanded by GM. This put Fisher Body in a vulnerable position, given that once the investment was made GM could have threatened to buy from someone else unless Fisher Body reduced prices substantially. This problem was anticipated, which explains why the contract required that GM buy all of the closed metal bodies from Fisher and specified the price as equal to Fisher’s variable cost plus 17.6 percent.
However, while these contractual terms protected Fisher against opportunistic behavior on the part of GM, they created an unanticipated opportunity for Fisher to take advantage of GM. The demand for closed metal bodies increased rapidly during the early 1920s (in part because of increased auto sales, but also from a dramatic shift from open wooden bodies to closed metal bodies). The increased production lowered Fisher’s production costs, and indeed made it possible for Fisher to lower its costs significantly more than it did. Evidence suggests that Fisher took advantage of the 17.6 percent “price add-on” by keeping its variable costs (particularly labor costs), and therefore the price charged GM, higher than necessary.
General Motors was aware of this “over charge” and requested that Fisher build a new auto body plant next to GM’s assembly plant. This would have eliminated the costs of transporting the auto bodies (a variable cost that came with the 17.6 percent add-on) and reduced GM’s price. Fisher refused to make the move, however, possibly because of concerns that such a dedicated investment to GM requirements would be exploited by GM. As a result of the potential haggling, threats and counter-threats, GM bought Fisher Body in 1926 and the two companies merged. GM could buy Fisher simply because their tenuous dealings, with accompanying transaction costs, were depressing both companies’ market value. GM could pay a premium for Fisher simply because of the anticipated transaction cost savings.

The construction of electric generating plants next to coalmines provides another example of the potential benefits to a firm for producing an input rather than buying it when highly specific capital is involved. There is an obvious advantage in “mine-mouth” arrangements from reducing the cost of transporting coal to the generating plant. But if the mine and the generating plant are separately owned, the potential for opportunistic behavior exists after the costly investments are made. The mine owner, for example, could take advantage of the fact that the generating plant is far removed from a rail line connecting it to other coal supplies by increasing the price of coal. To avoid such risks, common ownership of both the mine and the generating plant is much more likely in the case of “mine-mouth” generating plants than in the case of generating plants that can rely on alternative sources of coal. And, when ownership is separate in a “mine-mouth” arrangement, the terms of exchange between the generating plant and mine are typically spelled out in very detailed and long-term contracts that cover a wide range of future contingencies.42
There are other ways a firm can benefit from the advantages of buying an input rather than producing it while reducing the risks of being “held-up” by a supplier who uses specialized equipment to produce a crucial input. It can make sense for the firm to buy the specialized equipment and then rent it to the supplier. If the supplier attempts to take advantage of the crucial nature of the input, the firm can move the specialized equipment to another supplier rather than be forced to pay a higher than expected price for the input. This is exactly the arrangement that automobile companies have with some of their suppliers. Ford, for example, buys components from many small and specialized companies, but commonly owns the specialized equipment needed and rents it to the contracting firms.43
Firms are also aware that those who supply them with services are reluctant to commit themselves to costly capital investments that, once made, leave them vulnerable to hold-up (demands that the terms and conditions of the relationship be changed after an investment that cannot be recaptured has been made). In such case the firm that provides the capital equipment An arrangement that reduced the threat of opportunistic behavior on the part of firms against workers was the much-criticized “company town.” In the past it was common for companies (typically mining companies) to set up operations in, what were at the time, very remote locations. In the company towns, the company owned the stores where employees shopped and the houses where they lived. The popular view of these company stores and houses is that they allowed the companies to exploit their workers with outrageous prices and rents, often charging them more for basic necessities than they earned from backbreaking work in the mines. The late Tennessee Ernie Ford captured this popular view in his famous song “Sixteen Tons.”44
Without denying that the lives of nineteenth-century miners were tough, company stores and houses can be seen as a way for the companies to reduce (but not totally eliminate) their ability to exploit their workers by behaving opportunistically. Certainly workers would be reluctant to purchase a house in a remote location with only one employer. The worker who committed to such an investment would be far more vulnerable to opportunistic wage reductions by the employer than would the worker who rented company housing. Similarly, few merchants would be willing to establish a store in such a location, knowing that once the investment was made they would be vulnerable to opportunistic demands for price reductions that just covered their variable costs, leaving no return on their capital cost. Again, in an ideal world without transaction costs – and without opportunistic behavior -- mining companies would have specialized in extracting ore and would have let suppliers of labor buy their housing and other provisions through other specialists. But in the real world of transaction costs, it was better for mining companies to also provide basic services for their employees. This is not to say that there was no exploitation. But the exploitation was surely less under the company town arrangement than if, for example, workers had bought their own houses.45
The threat to one party of a transaction from opportunistic behavior on the part of the other party explains other business and social practices. Consider the fact that despite valiant efforts, the vast majority of farm workers have never been able to effectively unionize in the United States. No doubt many reasons explain this failure, but one reason is that a union of farm workers would be in a position to harm farmers through opportunistic behavior. A crop is a highly specialized and, before harvested, immobile investment, and one whose value is easy to The threat of opportunistic behavior is surely an important consideration in another important exchange relationship, that of marriage. Although there clearly are exceptions, rich people seldom marry poor people. The story of the wealthy prince marrying poor, but beautiful, Cinderella, is, after all, a fairy tale. Rich people generally marry other rich people. As with all activities, there are many explanations for marital sorting, including the obvious fact that the rich tend to hang around others who are rich. But an important explanation is that marriage is effectively a specialized investment that, once made, commits and creates value not easily shifted to another enterprise, or object of affection. The rich person who marries a poor person is making an investment that is subject to hold-up. This is a hold-up possibility that is not ignored, as evidenced by the fact that pre-nuptial agreements are common in the case of large wealth differences between the two parties to a marriage. But because of the difficulty of anticipating all possible contingencies relevant to distributing wealth upon the termination of a marriage, such agreements still leave lots of room for opportunistic behavior. Marriage between people of roughly equal wealth reduces, though hardly eliminates, the ability of one party to capture most of the value committed by the other party.
A good general rule for a manager is to buy the productive inputs the firm needs rather than make them. When inputs are produced in-house, some of the efficiency advantages of specialization provided through market exchange are lost. But as with most general rules, there are lots of exceptions to that of buying rather than making. In many cases the loss from making rather than buying will be more than offset by the savings in transaction costs. Typically, firms should favor making those things that require capital that will be used for specific purposes and, therefore, will not have a ready resale market.
The Decision to Franchise
The decision a firm faces over whether to expand through additional outlets that are owned by the firm or that are franchised to outside investors has many of the features of decisions to make or buy inputs. Franchising is simply a type of firm expansion – with special contractual features and with all the attendant problems.

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Reasons for Firm Incentives

Amazing things happen when people take responsibility for everything themselves. The results are quite different, and at times people are unrecognizable. Work changes and attitudes to it, too.
Mikhail Gorbachev
n conventional economic discussions of how firms are managed, incentives are nowhere
considered. This is the case because the “firm” is little more than a theoretical “black box”
in which things happen somewhat mysteriously. Economists typically acknowledge that the “firm” is the basic production unit, but little or nothing is said of why the firm ever came into existence or, for that matter, what the firm is. As a consequence, we are told little about why firms do what they do (and don’t do). There is nothing in conventional discussions that tells us about the role of real people in a firm.
How are firms to be distinguished from the markets they inhabit, especially in terms of the incentives people in firms and markets face? That question is seldom addressed (other than, perhaps, specifying that firms can be one of several legal forms, for example, proprietorships, partnerships, professional associations, or corporations). In conventional discussions of the “theory of the firm,” firms maximize their profits, which is their only noted raison d’être. But students of conventional theory are never told how firms do what they are supposed to do, or why they do what they do. The owners, presumably, devise ways to ensure that everyone in the organization follows instructions, all of which are intent on squeezing every ounce of profit from every opportunity. Students are never told what the instructions are or what is done to ensure that workers follow them. The structure of incentives inside the firm never comes up because their purpose is effectively assumed away: people do what they are supposed to do, naturally or by some unspecified mysterious process. For people in business, the economist’s approach to the “firm” must appear strange indeed, given that business people spend much of their working day trying to coax people to do what they are supposed to do. Nothing is less automatic in business than getting people to pay attention to their firms’ profits (as distinguished from the workers’ more personal concerns).
In this chapter, before we delve into the structure of firm costs in following chapters, we address the issue of why firms exist not because it is an interesting philosophical question. Rather, we are concerned with that question because its answer can help us understand why the existence of firms and incentives go hand in hand. There is more than an ounce of truth to the refrain, “You cannot have one without the other.” In this chapter, we lay out the limited
Chapter 6. Reasons for Firm Incentives
economic propositions that will undergird the analysis of much of the book. These propositions are powerful as they are simple, are relatively easily to understand.
How Firms Make Markets More Efficient
Why is it that firms add to the efficiency of the markets? That’s an intriguing question, especially given how standard theories trumpet the superior efficiency of markets. Students of conventional theory might rightfully wonder: If markets are so efficient, why do entrepreneurs ever go to the trouble of organizing firms? Why not just have everything done by way of markets, with little or nothing actually done (in the sense that things are “made”) inside firms? All of the firm’s inputs could be bought by individuals, with each individual adding value to the inputs he or she purchases and then selling this result to another individual who adds more value, etc. until a final product is produced and a final market is reached at which point the completed product is sold to consumers. The various independent suppliers may be at the same general location, even in the same building, but everyone, at all times, could be up for contracting with all other suppliers or some centralized buyer of the inputs. By keeping everything on a market basis, the benefits of competition could be constantly reaped. Entrepreneurs could always look for competitive bids from alternative suppliers for everything used -- whether in the form of parts to be assembled, accounting and computer services to be used, or, for that matter, executive talent to be employed.
Individuals, as producers relying exclusively on markets, could always take the least costly bid. They could also keep their options open, including retaining the option to switch to new suppliers that propose better deals. No one would be tied down to internal sources of supply for their production needs. They would not have to incur the considerable costs of organizing themselves into production teams and departments and various levels of management. They would not have to incur the costs of internal management. They could, so to speak, maintain a great deal of freedom!
Then why do firms exist? What is the incentive – driving force – behind firms? For that matter, what is a firm in the first place? University of Chicago Law and Economics Professor Ronald Coase, on whose classic work “The Nature of the Firm” much of this chapter is based and many of the particular arguments drawn, proposed a substantially new but deceptively simple explanation.1 He reasoned that the firm is any organization that supercedes the pricing system, in which hierarchy, and methods of command and control are substituted for exchanges. To use his exact words: “A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.”
While efficiency improvements can certainly be had from specialization of any resource, especially labor, Smith was wrong to conclude that firms were necessary to coordinate the workers’ separate tasks. This is because, as economists have long recognized, their separate tasks could be coordinated by the pricing system within markets.
Markets could, conceivably, exist even within the stages of production that are held together by, say, assembly lines. Workers at the various stages could simply buy what is produced before them. The person who produces soles in a shoe factory could buy the leather and then sell the completed soles to the shoe assemblers. For example, the bookkeeping services provided a shoe factory by its accounting department could easily be bought on the market. Similarly, all of the intermediate goods involved in Smith’s pin production could be bought and sold until the completed pins are sold to those who want them.
Why, then, do we observe firms as such, which organize activities by hierarchies and directions that are not based on changing prices (which distinguishes them from markets)? In terms of our examples, why are there shoe and pin companies? Admittedly, over the years economists have tendered various answers.4
3 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), pp. 4-12. 4 The late University of Chicago economist Frank Knight speculated that firms arise because of uncertainty (Risk, Uncertainty, and Profit [Chicago: University of Chicago Press, 1971]). If business were conducted in a totally certain world, there would be no need for firms, according to Knight. Workers would know their pattern of rewards, and there would be no need for anyone to specialize in the acceptance of the costs of dealing with risks and uncertainties that abound in the real world of business.
As it is, according to Knight, some workers are willing to work for firms because of the type of deal that is struck: The workers accept a reduction in their expected pay in order to reduce the variability and outright uncertainty of that pay. Entrepreneurs are willing to make such a bargain with their workers because they are effectively paid to do so by their workers (who accept a reduction in pay) and because the employers can reduce their exposure to risk and uncertainties faced by individual workers by making similar bargains with a host of workers. As Knight put it (see the bottom of the next page),
This fact [the intelligence of one person can be used to direct others] is responsible for the most fundamental change of all in the form of organization, the system under which the confident and adventuresome assume the risk or insure the doubtful and timid by
Chapter 6. Reasons for Firm Incentives
Again, how can the existence of firms, as constructs distinctly different from markets, be explained? There are probably many reasons people might think firms exist, several of which Coase dismisses for being wrongheaded or for not being important.5 What Coase was interested in, however, was not a catalogue of “small” explanations for this or that firm, but an explanation for the existence of firms that, to one degree or another, is applicable to virtually all firms. He was seeking a unifying theme, a common basis. In his 1937 article, he struck upon an unbelievably simple answer to his puzzle, but it was also an explanation that earned him the Nobel Prize in Economics -- more than a half-century later!
What did he say? How did he justify the firm’s existence? Simply put, he observed that there are costs of dealing in markets. He dubbed these costs marketing costs, but most economists now call them transaction costs. Whatever they are called, these costs include the time and resources that must be devoted to organizing economic activity through markets. Transaction costs include the particular real economic costs (whether measured in money or not) of discovering the best deals as evaluated in terms of prices and attributes of products, negotiating contracts, and ensuring that the resulting terms of the contract are followed. When we were going through our explanation of how work on an assembly line could be viewed as passing through various markets, most readers probably imagined that the whole process could be terribly time consuming, especially if the suppliers and producers at the various stages were constantly subject to replacement by competitors.
Reasons Firms Exist
Once the costs of market activity are recognized, the reason for the emergence of the firm is transparent: Firms, which substitute internal direction for markets, arise because they reduce the need for making market transactions. Firms lower the costs that go with market transactions. If internal direction were not, at times and up to some point, more cost-
guaranteeing to the latter a specified income in return for the assignment of the actual results . . . With human nature as we know it, it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter’s actions without being given power to direct his work. And on the other hand the second party would not place himself under the direction of the first without such a guarantee . . . The result of this manifold specialization of function is the enterprise and wage system of industry. Its existence in the world is the direct result of the fact of uncertainty (Ibid., pp. 269-270).
5 Ibid, pp. 41-42. For example, Coase concedes that some people might prefer to be directed in their work. As a consequence, they might accept lower pay just to be told what to do. However, Coase dismisses this explanation as unlikely to be important because “it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of ‘being one’s own master’” (Ibid.,
p. 38). Of course, it might be that some people like to control others, meaning they would give up a portion of their pay to have other people follow their direction. However, again Coase finds such an explanation lacking, mainly because it could not possibly be true “in the majority of the cases.” (Ibid.). People who direct the work of others are frequently paid a premium for their efforts.
Chapter 6. Reasons for Firm Incentives
effective than markets, then firms would never exist – would have no reason for being, meaning that no one would have the required incentive to go to the trouble of creating them. However, while firms may never eliminate the need for markets and contracts, with all of their attendant costs, they must surely reduce them.
Entrepreneurs and their hired workers essentially substitute one long-term contract for a series of short-term contracts: The workers agree to accept directions from the entrepreneurs (or their agents, or managers) within certain broad limits (with the exact limits subject to variation) in exchange for security and a level of welfare (including pay) that is higher than the workers would be able to receive in the market without firms. Similarly, the entrepreneurs (or their agents) agree to share with the workers some of the efficiency gains obtained from reducing transaction costs.6
The firm is a viable economic institution because both sides to the contract – owners and workers -- gain. Firms can be expected to proliferate in markets simply because of the mutually beneficial deals that can be made. Those entrepreneurs who refuse to operate within firms and stick solely to market-based contracts, when in fact a firm’s hierarchical organization is more cost-effective than market-based organizations, will simply be out-competed for resources by the firms that do form and achieve the efficiency-improving deals with workers (and owners of other resources).
If firms reduce transaction costs, does it follow that one giant firm should span the entire economy, as, say, Lenin and his followers thought possible for the Soviet Union? Our intuition says, “No!” But there are also good reasons for expecting firms to be limited in size.
Cost Limits to Firm Size
Clearly, by organizing activities under the umbrella of firms, entrepreneurs give up some of the benefits of markets, which provide competitively delivered goods and services. Managers suffer from their own limited organizational skills, and skilled managers are scarce, as evident by the relatively high salaries many of them command. Communication problems within firms expand as firms grow, encompassing more activities, more levels of production, and more diverse products. Because many people may not like to take directions, as the firm expands to include more people, the firm may have to pay progressively higher prices to workers and other resource owners in order to draw them into the firm and then direct them.
6Coase recognizes that entrepreneurs could overcome some of the costs of repeatedly negotiating and enforcing short-term contracts by devising one long-term contract. However, as the time period over which a contract is in force is extended, more and more unknowns are covered, which implies that the contract must allow for progressively greater flexibility for the parties to the contract. The firm is, in essence, a substitute for such a long-term contract in that it covers an indefinite future and provides for flexibility. That is to say, the firm as a legal institution permits workers to exit more or less at will and it gives managers the authority, within bounds, to change the directives given to workers.
Chapter 6. Reasons for Firm Incentives
There are, in short, limits to what can be done through organizations. These limits can’t always be overcome, except at greater costs, even with the application of the best organizational techniques, whether through the establishment of teams, through the empowerment of employees, or through the creation of new business and departmental structures (for example, relying on top-down, bottom-up, or participatory decision making). Even the best industrial psychology theories and practices have their limits when applied to human relationships.
The Agency Problem
Firms might be restricted in their size because they are also likely to suffer from a major problem -- the so-called agency problem (or, alternately, the principal/agent problem) that will be considered and reconsidered often in this book. This problem is easily understood as a conflict of interests between identifiable groups within firms. The entrepreneurs or owners of firms (the principals) organize firms to pursue their own interests, which are often (but, admittedly, not always) greater profits. To pursue profits, however, the entrepreneurs must hire managers who then hire workers (all of whom are agents). However, the goals of the worker/agents are not always compatible with the goals of the owner/principals. Indeed, they are often in direct conflict. Both groups want to get as much as they can from the resources assembled in the firms.
The problem the principals face is getting the agents to work diligently at their behest and with their (the principals’) interests in mind, a core problem facing business organizations that even the venerable Adam Smith recognized more than two centuries ago.7 Needless to say, agents often resist doing the principals’ bidding, a fact that makes it difficult -- i.e., costly -¬for the principals to achieve their goals.
It might be thought that most, if not all, of these conflicts can be resolved through contracts, which many can. However, like all business arrangements, contracts have serious limitations, not the least of which is that they can’t be all-inclusive, covering all aspects of even “simple” business relationships (which all are more or less complex). Contracts simply cannot anticipate and cover all possible ways the parties to the contract, if they are so inclined, can get around specific provisions. The cost of enforcing the contracts can also be a problem, and an added cost, even when both parties know that provisions have been violated. Each party will recognize the costs and may be tempted to exploit them, and will figure that the other may be
7 In his classic The Wealth of Nations, Adam Smith wrote, “The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot be well expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company” [The Wealth of Nations (New York, Modern Library, 1937), p. 700].
Chapter 6. Reasons for Firm Incentives
equally tempted. Each will seek some means by which the contract will be self-enforcing, or will encourage each party to live up to the letter and spirit of the contract because it is in the interest of each party to do so. This is where incentives will come in, to help make contracts self-enforcing. Incentives can encourage the parties to more closely follow the intent and letter of contracts.
Competition will be a powerful force toward minimizing agency costs. Firms in competitive markets that are not able to control agency costs are firms that are not likely to survive for long, mainly because of what has been dubbed the “market for corporate control.”8 Firms that allow agency costs to get out of hand will risk either failure or takeover (by way of proxy fights, tender offers, or mergers). In later chapters, we will discuss at length how managers can solve their own agency problems including controlling their own behavior as agents for shareholders. At the same time, we would be remiss if we didn’t repeatedly point out the market pressures on managers to solve such problems, even if they are not naturally inclined to do so. If corporations are not able to adequately solve their agency problems, we can imagine that the corporate form of doing business will be (according to one esteemed financial analyst9) “eclipsed” as new forms of business emerge. Of course, this means that obstruction in the market for corporate control (for example, legal impediments to takeovers) can translate into greater agency costs, and less efficient corporate governance.
Why are firms the sizes they are? When economists in or out of business usually address that question, the answer most often given relates in one way or another to economies of scale. By economies of scale, we mean something very specific, the cost savings that emerge when all resource inputs -- labor, land, and capital -- are increased together. In some industries, it is indeed true that as more and more of all resources are added to production within a given firm, output expands by more than the use of resources. That is to say, if resource use expands by 10 percent and output expands by 15 percent, then the firm experiences economies of scale. Its (long-run) average cost of production declines. Why does that happen? The answer is almost always “technology,” which is another way of saying that it “just happens,” given what is known about combining inputs and getting output. This is not the most satisfying explanation, but it is nonetheless true that economies of scale are available in some industries (automobile) but not in others (crafts).
We agree that the standard approach toward explaining firm size is instructive. We have spent long hours at our classroom boards with chalk in hand developing and describing scale economies in the typical fashion of professors, using (long-run) average cost curves and pointing out when firms in the expansion process contemplate starting a new plant. We think the
8 One of the more important contemporary articles on the “market for corporate control” is by Henry G. Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy , vol. 73 (April 1963), pp. 110-120. 9 See Michael C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review (September-October 1989), pp. 64-65.
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standard approach is useful, but we also believe it leaves out a lot of interesting forces at work on managers within firms. This is understandable, given that standard economic theory totally assumes away the roles of managers, which we intend to discuss at length.
Coase and his followers have taken a dramatically different tack in explaining why firms are the sizes they are in terms of scale of operations and scope of products delivered to market. The new breed of theorists pays special attention to the difficulties managers face as they seek to expand the scale and scope of the firm. They posit that as a firm expands, agency costs mount. This is primarily because workers have more and more opportunities to engage in what can only be tagged opportunistic behavior – or taking advantage of their position by misusing and abusing firm resources. Shirking, or not working with due diligence, is one form of opportunistic behavior that is known to all employees. Theft of firm resources is another form. As the firm grows, the contributions of the individual worker become less detectable, which means workers have progressively fewer incentives to work diligently on behalf of firm objectives, or to do what they are told by their superiors. They can more easily hide.
The tendency for larger size to undercut the incentives of participants in any group is not just theoretical speculation. It has been observed in closely monitored experiments. In an experiment conducted more than a half century ago, a German scientist asked workers to pull on a rope connected to a meter that would measure the effort expended. Total effort for all workers combined increased as workers were added to the group doing the pulling at the same time that the individual efforts of the workers declined. When three workers pulled on the rope, the individual effort averaged 84 percent of the effort expended by one worker. With eight workers pulling, the average individual effort was one-half the effort of the one worker.10 Hence, group size and individual effort were inversely related – as they are in most group circumstances -- inversely related.
The problem evident in the experiment is not that the workers become any more corrupt or inclined to take advantage of their situation as their number increases. The problem is that their incentive to expend effort deteriorates as the group expands. Each person’s effort counts for less in the context of the larger group, a point which University of Maryland economist Mancur Olson elaborated upon decades ago (and we considered in detail in the last chapter).11 The “common objectives” of the group become less and less compelling in directing individual
10 As reported by A. Furnham, “Wasting Time in the Board Room,” Financial Times, March 10, 1993, p. xx. 11 See Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1965). Olson argues that common goals have less force in “large” groups than “small” groups, which explains why cartels don’t form in open competitive markets. All competitors might understand that it is in their group interest to cut production and increase their market price, if all curb production. However, each competitor can reason that its individual curb in output will have no effect on total output and thus cannot be detected. Hence, the “logic of collective action” is for everyone to “cheat” on the cartel, or not curb production, which means that nothing will happen to the market price.
Chapter 6. Reasons for Firm Incentives
efforts. Such a finding means that if each worker added to the group must be paid the same as all others, the cost of additional production obviously rises with the size of the working group. The finding also implies that to get a constant increase in effort with the additional workers, all workers must be given greater incentive to hold to their previous level of effort.12
Optimum Size Firms
How large should a firm be? Contrary to what might be thought, the answer depends on more than “economies of scale” technically specified. Technology determines what might be possible, but it doesn’t determine what will happen. And what happens depends on policies that minimize shirking and maximize the use of the technology by workers. This means that scale economies depend as much or more on what happens within any given firm as they do on what is technologically possible. The size of the firm obviously depends on the extent to which owners must incur greater monitoring costs as they lose control with increases in the size of the firm and additional layers of hierarchy (a point well developed by Oliver Williamson in his classic article written more than thirty years ago13). However, the size of the firm also depends on the cost of using the market.
Management information Professors Vijay Gurbaxani and Seungjin Whang have devised a graphical means of illustrating the “optimal firm size” as the consequence of two forces: “internal coordinating costs” and “external coordinating costs.”14 As a firm expands, its internal coordinating costs are likely to increase. This is because the firm’s hierarchical pyramid will likely become larger with more and more decisions made at the top by managers who are further and further removed from the local information available to workers at the bottom of the pyramid. There is a need to process information up and down the pyramid. When the information goes up, there are unavoidable problems and costs: costs of communication, costs of miscommunication, and opportunity costs associated with delays in communication, all of which can lead to suboptimal decisions. These “decision information costs” become progressively greater as the decision rights are moved up the pyramid.
Attempts to rectify the decision costs by delegating decision making to the lower ranks may help, but this can – and will -- also introduce another form of costs -- which, you will recall, we previously have called agency costs. These include the cost of monitoring (managers
12 Workers can also reason that if the residual from their added effort goes to the firm owners, they can possibly garner some of the residual by collusively (by explicit or tacit means) restricting their effort and hiking their rate of pay, which means that the incentive system must seek to undermine such collusive agreement. For a discussion of these points see, Felix R. FitzRoy and Kornelius Kraft, “Cooperation, Productivity, and Profit Sharing,” Quarterly Journal of Economics (February 1987), pp. 23-35. 13 Oliver E. Williamson, “Hierarchical Control and Optimum Size Firms,” Journal of Political Economy , vol. 75 (no. 2, 1967), pp. 123-138. 14Vijay Gurbaxani and Seungjin Whang, “The Impact of Information Systems on Organizations and Markets,” Communication of the ACM, January 1991, pp. 59-73.
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actually watching employees as they work or checking their production) and bonding (workers providing assurance that the tasks or services will be done as the agreement requires), and the loss of the residual gains (or profits) through worker shirking, which we covered earlier.
The basic problem managers face is one of balancing the decision information costs with agency costs and finding that location for decision rights that minimizes the two forms of costs. From this perspective, where the decision rights are located will depend heavily on the amount of information flow per unit of time. When upward flow of information is high, the decision rights will tend to be located toward the floor of the firm, mainly because the costs of suboptimal decisions by having the decision making done high up the hierarchy will be high. The firm, in other words, can afford to tolerate agency costs because the costs of avoiding the them, via centralized decisions, can be higher.
Nevertheless, as the firm expands, we should expect that the internal coordinating costs along with the cost of operations will increase. The upward sloping line in Figure 6.1 depicts this relationship.
But internal costs are not all that matter to a firm contemplating an expansion. It must also consider the cost of the market, or what Gurbaxani and Whang call “external coordination costs.” If the firm remains “small” and buys many of its parts, supplies, and services (such as accounting, legal, and advertising services) from outside venders, then it must cover a number of what we have called “transaction costs.” These include the costs of transportation, inventory holding, communication, contract writing, and contract enforcing. However, as the firm expands in size, then these transaction costs should be expected to diminish. After all, a larger firm seeks to supplant market transactions. The downward sloping line in Figure 6.1A depicts this inverse relationship between firm size and transaction costs.
Again, how large should a firm be? If a firm vertically integrates, it will engage in fewer market transactions, lowering its transaction costs. It can also benefit from economies of scale, the technical kind mentioned earlier. However, in the process of expanding, it will confront growing internal coordination costs, or all of the problems of trying to move information up the decision making chain, getting the “right” decisions, and then preventing people from exploiting their decision making authority to their own advantage.
The firm should stop expanding in scale and scope when the total of the two types of costs -- external and internal coordinating costs -- are minimized. This minimum can be shown graphically by summing the two curves in Figure 6.1A to obtain the U-shaped curve in Figure 6.1B. The optimal (or most efficient/cost-effective) firm size is at the bottom of the U.
This way of thinking about firm size would have only limited interest if it did not lend itself to a couple of additional observations, which permit thinking about the location, shape, and changes in the curve. First, the exact location of the bottom will, of course, vary for different firms in different industries. Different firms have different capacities to coordinate activities
Chapter 6. Reasons for Firm Incentives
through markets and hierarchies. Second, firm size will also vary according to the changing abilities of firms to coordinate activities internally and externally.
Figure 6.1A and 6.1B External and Internal Coordinating Costs As the firm expands, the internal coordinating costs increase as the external coordinating costs fall.
Clearly, Adam Smith and many of his followers were correct when they observed that when tasks are divided among a number of workers, the workers become more proficient at what they do. Smith began his economic classic The Wealth of Nations by writing about how specialization of labor increased “pin” (really nail) production.3 By specializing, workers can become more proficient at what they do, which means they can produce more in their time at work. They also don’t have to waste time changing tasks, which means more time can be spent directly on production.
A firm that is efficient at processing information will be larger, everything else equal, than one that isn’t so able. If a firm is able to improve the efficiency of its upward information flow and reduce the number of wrong decisions, then the upward sloping curve in Figure 6.1A will move down and to the right, causing the sum of the two curves in the bottom panel of the figure to move to the right, for a greater optimal size firm. If the costs of using markets go down, the firm size can be expected to decline, not because the firm has become less efficient internally (it may have become more efficient), but because markets are now relatively more cost effective. Again, from this perspective, the size of the firm changes for reasons other than those related to the technology of actual production. It depends on the ability of managers to squeeze out the scale economies that are possible from their workers.
Of course, knowing that the owners will always worry that their manager-agents will exploit their positions for their own benefit at the expense of the owners, managers will want to “bond” themselves against exploitation of their positions. (And we don’t use the term “bond” in the modern pop-psychology sense of developing warm and fuzzy relationships; rather, we use it in the same sense that is common when accused criminals post a bond, or give some assurance that they will appear in court if released from jail.) That is to say, managers have an interest in letting the owners know that they, the managers, will suffer some loss when exploitation occurs.
Chapter 6. Reasons for Firm Incentives
Devices such as audits of the company are clearly in the interest of stockholders. But they are also in the interest of managers by reducing the scope for managerial misdeeds, thus increasing the market value of the company – and the value of its managers. By buying their companies’ stock, manager-agents can also bond themselves, assuring stockholders that they will incur at least some losses from agency costs. To the extent manager-agents can bond themselves convincingly, the firm can grow from expanded sources of external investment funds. By bonding themselves, manager-agents can demand higher compensation. Firms can be expected to expand and contract with reductions and increases in the costs of developing effective managerial bonds.15
Changes in Organizational Costs
Finally, we can observe that the size of the firm can be expected to change with changes in the relative costs of organizing a given set of activities by way of markets and hierarchies. For example, suppose that the costs of engaging in market transactions are lowered, meaning markets become relatively more economical vis a vis firms. Entrepreneurs should be expected to organize more of their activities through markets, fewer through firms. Then, those firms that more fully exploit markets, and rely less on internal directions, should be able to increase the payments provided workers and other resources that they buy through markets, collectively leaving fewer resources to expand their market share relative to those firms that make less use of markets. Accordingly, firms should be expected to downsize, to use a popular expression.
An old, well-worn, and widely appreciated explanation for downsizing is that modern technology has enabled firms to produce more with less. Personal computers, with their ever-escalating power, have enabled firms to lay off workers (or hire fewer workers). Banks no longer need as many tellers, given the advent of the ATMs.
One not-so-widely-appreciated explanation is that markets have become cheaper, which means that firms have less incentive to use hierarchical structures and more incentive to use markets. And one good reason firms have found markets relatively more attractive is the rapidly developing computer and communication technology, which has reduced the costs of entrepreneurs operating in markets. The new technology has lowered the costs of locating suitable trading partners and suppliers, as well as negotiating, consummating, and monitoring market-based deals (and the contracts that go with them). In terms of Figure 6.1, the downward sloping transaction costs curve has dropped down and to the left, causing the bottom of the U to move leftward.
“Outsourcing” became a management buzzword in the 1980s because the growing efficiency of markets, through technology, made it economical. Outsourcing continued apace in the 1990s. Of 26 major companies surveyed, 86 percent said they outsourced some activity industry generating $100 billion in annual revenues by 1996.16 For all practical purposes, airlines now outsource the acquisition of their reservations through independent contractors called travel agents, given that more than 70 percent of all airline reservations are now taken by such agents, working through computerized markets, not through the hierarchical structures within the airlines.
Frito-Lay has issued its sales people hand scanners in part to increase the reliability of the flow of information back to company distribution centers, but also to track the work of the sales people. The company can obtain reports on when each employee starts and stops work, the time spent on trips between stores, and the number of returns. The sales people can be asked to account for more of their time and activities while they are on the job.
Obviously, we have not covered the full spectrum of explanations for the rich variety of sizes of firms that exists in the “real world” of business. We have also left the net impact of technology somewhat up in the air, given that it is pressing some firms to expand and others to downsize. The reason is simple: technology is having a multitude of impacts that can be exploited in different ways by firms in different situations.
Prisoners’ Dilemma Problems, Again
The discussion to this point reduces to a relatively simple message: Firms exist to bring about cost savings, and they generate the cost savings through cooperation. However, cooperation is not always and everywhere “natural”; people have an incentive to “cheat,” or not do what they are supposed to do or have agreed to do. This may be the case because of powerful incentives to toward noncooperation built-in to many business environments.
16 As reported by John A. Byrne, “Has Outsourcing Gone Too Far?” Business Week, April 1, 1996, p. 27.
Chapter 6. Reasons for Firm Incentives
An illustration of the tendency toward noncooperative behavior, despite the general advantage from cooperation, is a classic so-called “conditional-sum game” known as the prisoners’ dilemma (which we have already introduced without formally calling them by their proper name).17 This is a dilemma, commonly found in business, that takes its name from a particular situation involving the decision two prisoners have to make on whether or not to confess to a crime they committed. But the dilemma can also be applied whenever two or more people find themselves in a situation where the best decision from the perspective of each leads to the worst outcome from the perspective of all.
Consider a situation in which the police have two people in custody who are known to be guilty of a serious crime, but who, in the absence of a confession by one of them, can be convicted only of a relatively minor crime. How can the police (humanely) encourage the needed confession? One effective approach is to separate the two prisoners and present each with the same set of choices and consequences. Each is told that if one confesses to the serious crime and the other does not, then the one who confesses receives a light sentence of one year, while the one who does not confess receives the maximum sentence of fifteen years. If they both confess, then both receive the standard sentence of ten years. And if both refuse to confess, then each is sentenced to two years for the minor crime.
Overcoming a large-number prisoners’ dilemma by motivating cooperative behavior is obviously difficult, but not impossible. The best hope for those who are in a prisoners’ dilemma situation is to agree ahead of time to certain rules, restrictions, or arrangements that will punish those who choose the noncooperative option. For example, those who are jointly engaging in criminal activity will see advantages in forming gangs whose members are committed to punishing noncooperative behavior. The gang members who are confronted with the above prisoners’ dilemma will seriously consider the possibility that the shorter sentence received for confessing will hasten the time when a far more harsh punishment for “squealing” on a fellow gang member is imposed by the gang.
The problem illustrated by the prisoners’ dilemma is a very general one that is encountered in many different guises, most of which have nothing to do with prisoners. Excessive pollution, for example, can be described as a prisoners’ dilemma in which citizens – meaning, typically, a very large number of people -- would be better off collectively if everyone polluted less, yet, from the perspective of each individual the greatest payoff comes from continuing to engage in polluting activities no matter what others are expected to do. As another example, while there may be wide agreement that we would be better off with less government spending, each interest group is better off lobbying for more government spending on its favorite program. People are tempted by the noncooperative solution in polluting and lobbying because they benefit individually and only have limited and costly ways of ensuring that others resist the noncooperative solution.
Chapter 6. Reasons for Firm Incentives
Many areas of business are fertile grounds for the conditional-sum game situations represented by the prisoners’ dilemma. A number of examples of business-related prisoners’ dilemmas will be discussed in some detail in subsequent chapters, and an important task of managers is to identify and resolve these dilemmas as they arise both within the firm and with suppliers and customers of the firm. Indeed, we see “management” as concerned with finding resolutions of prisoners’ dilemmas. Good managers constantly seek to remind members of the firm of the benefits of cooperation and of the costs that can be imposed on people who insist on taking the noncooperative course.
Consider, for example, the issue of corporate travel, which is a major business expense -- estimated at over $130 billion in 1994 (the latest available data at this writing).18 If a business were able to economize on travel costs, it would realize significant gains. And much of this gain would be captured by the firms’ traveling employees who, if they were able to travel at less cost, would earn higher incomes as their net value to the firm increased. So all the traveling employees in a firm could be better off if they all cut back on unnecessary travel expenses. But the employees are in a prisoners’ dilemma with respect to reducing travel costs because each recognizes that he or she is personally better off by flying first class, staying at hotels with multiple stars, and dining at elegant restaurants (behaving noncooperatively), than making the least expensive travel plans (behaving cooperatively) regardless of what the other employees do. Each individual employee would be best off if all other employees economized, which would allow her salary to be higher as she continued to take luxury trips. But if the others also make the more expensive travel arrangements, she would be foolish not to do so herself since her sacrifice would not noticeably increase her salary.
Airlines have recognized the “games” people play with their bosses and other workers, and have played along by making the travel game more rewarding to business travelers, more costly to the travelers’ firms, and more profitable to the airlines – all through their “frequent-flier” programs. Of course, you can bet managers are more than incidentally concerned about the use of frequent-flier programs by employees. When American Airlines initiated its AAdvantage frequent-flier program in 1981, the company was intent on staving off the fierce price competition that had broken out among established and new airlines after fares and routes were deregulated in 1978. As other writers have noted, American was seeking to enhance “customer loyalty” by offering their best, most regular customers free or reduced-price flights after they built up their mileage accounts. Greater customer loyalty can mean that customers are less responsive to price increases, which could translate into actual higher prices. 19
At the same time, there is more to the issue than “customer loyalty.” American figured that it could benefit from the obvious prisoners’ dilemma their customers, especially business
18 As reported in Jonathan Dahl, “Many Bypass the New Rules of the Road,” The Wall Street Journal, September 29, 1994, p. B1. 19For a discussion of frequent-flier programs as a means of enhancing customer loyalty, see Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Currency/Doubleday, 1996), pp. 132-158.
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travelers, are in. By setting up the frequent-flier program, American (and all other airlines that followed suit) increased the individual payoff to business travelers for noncooperative behavior. American did this under its frequent-flier program by allowing travelers to benefit from more free flights and first-class upgrades by choosing more expensive, and often less direct, flights. They encouraged business people to act opportunistically, to use their discretion for their own benefit at the expense of everyone else in their firms.
For example, a business traveler who is on the verge of having enough miles in his American account to qualify for elite status (additional upgrades of travel perks) might choose a more expensive American flight over a comparable Southwest Airline flight just to get additional AAdvantage miles. The company would in effect, pick up the cost of the traveler’s vacation flight. Business travelers are also encouraged to book their flights later than they could, which requires paying full fare, so they can use their frequent-flier upgrades to first class (these upgrades are typically not allowed with discount tickets). Or business people will take circuitous routes to their destinations to qualify for more frequent-flier miles than could be gotten from a direct trip. The prisoners’ dilemma problem for workers and their companies has, of course, prompted as a host of other non-airline firms -- rental car companies, hotels, and restaurants – to begin granting frequent-flier miles with selected airlines for travel services people buy with them, encouraging once again higher-than-necessary travel costs. The company incurs the cost of the added miles plus the lost time.
Now, use of frequent-flier miles might actually lower worker wages (because of the added cost to their firms, which can reduce the demand for workers, and the benefit of the miles to workers, which can increase worker supply and lower wages, topics to be covered later), but, still, workers have an incentive to exploit the program. Again, they are in prisoners’ dilemma under which the cooperative strategy might be best for all, but the noncooperative strategy dominates the choice each individual faces.
These problems created by frequent-flier programs are not trivial for many businesses, and we would expect the bigger the firm, the greater the problem (given the greater opportunity for opportunistic behavior in large firms). Thirty percent of business travelers working for Mitsubishi Electronics America wait until the last few days before booking their flights, according to corporate travel manager John Fazio. Fazio adds, “We have people who need to travel at the last minute, but it’s not 30 percent.”20 Corporate travel managers complain that the frequent-flier programs have resulted in excessive air fares (a problem for 87 percent of the firms surveyed), wasted employee time (a problem for 68 percent of the surveyed firms), use of more expensive hotels (a problems for 67 percent of the surveyed firms), and unnecessary travel (a problem for 59 percent of the surveyed firms).21 The corporate travel managers
20 See Dahl, Ibid., p. B1. 21 As reported by Frederick J. Stephenson and Richard J. Fox, “Corporate Strategies for Frequent-Flier Programs,” Transportation Journal, vol. 32, no. 1, (Fall 1992), pp. 38-50. The 1991 survey included 506 corporate members of the National Business Travel Association who did not work for airlines.
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interviewed felt that the frequent-flier programs resulted in an average “waste” of about 8 percent of all of their travel expenditures.22
Frequent-flier programs put business travelers in a game situation that benefits the airlines at the expense of business travelers and their firms by encouraging noncooperative behavior. Recognizing this game, and the noncooperative incentives built into it, is important for managers who are trying to cut travel costs. And in the effort to cut these costs, managers are also in a game with the airlines, which respond to cost cutting measures with new wrinkles designed to intensify the prisoners’ dilemma faced by business travelers. For example, USAir announced plans to provide a Business Select class (featuring roomier seats and better meals) for those business travelers who pay full fare for their coach tickets.23 Of course, when all airlines have frequent-flier programs, the problems for firms may be compounded by the fact that all airlines have more “loyal” customer bases and all are less likely to cut prices (another topic to be addressed later in greater detail).
The Moral Sense
Much our analysis in the “Manager’s Corner” sections of the chapters to this book will be grounded, as it has already, in the principal/agent problem, or the tendency of underlings to pursue their own private goals at the expense of the goals of the firm and its owners. We do that for a simple reason: We want to understand how employees might behave in order that managers can draw up policies and incentives that can protect the firm and its owners from agency costs.
We do not by any means wish to suggest that people are not, in the slightest degree, driven by an innate sense of duty or obligation to do that which they are supposed to do as a employee in a team or firm. On the contrary, people do seem to have a built-in tendency to cooperate -- to a degree. UCLA business professor James Q. Wilson has shown, with reference to casual observation and to a host of psychological experiments, that most people do have a “moral sense,” which can show up in their willingness to forgo individual advantage (or opportunities to shirk) for the good of the group, which can be a firm.24
Moreover a variety of factors -- including considerations of equity and fairness -¬influence people’s willingness to cooperate. As organizational behaviorists have shown, “culture” has an impact on the extent of cooperation. People from “collectivistic” societies, like China, may be more inclined to cooperate than people from “individualistic” societies, like the United States.25 Training in “group values” can affect the extent of cooperation. What do people do? What should they do? Better yet, what do we expect them to do -- eventually? We suspect that different twosomes caught in the woods by sabretooth tigers over the millenniums have tried a number of strategies. However, running is, over the long run, a strategy for possible extinction, given that the tiger can pick off the runners one by one. We should not be surprised that human society has come to be dominated by people who have a “natural” tendency to cooperate or who have found ways to inculcate cooperation in their members. Moreover, parents spend a lot of family resources trying to ensure that children see the benefits of cooperation, and school teachers and coaches reinforce those values with an emphasis on the benefits of sharing and doing what one is supposed to do or has agreed to do vis a vis people beyond the reach of the family. Managers do much the same.
Those societies that have found ways of cooperating have prospered and survived. Those that haven’t have languished or retrogressed into economic oblivion, leaving the current generation with a disproportionate representation from groups that have been cooperative. Those who didn’t cooperate long ago when confronted with attacks by sabretooth tigers were eaten; those who did cooperate with greater frequency lived to propagate future generations.
What we are saying here is that human society is complex, driven by a variety of forces -- based in both psychology and economics -- that vary in intensity with respect to one another and that are at times conflicting. However, there are evolutionary reasons, if nothing else, to expect that people who cooperate will be disproportionately represented in societies that survive. Organizations can exploit -- and, given the forces of competition, must exploit --people’s limited but inherent desire or tendency to work together, to be a part of something that
Chapter 6. Reasons for Firm Incentives
is bigger and better than they are. Organizations should be expected to try to reap the synergetic consequences of their individual and collective efforts.
However, if that were the whole story -- if all that mattered were people’s tendencies to cooperate -- then management would hardly be a discipline worthy of much professional reflection. There would be little or no need or role for managers, other than that of cheerleader. The problem is that firms are also beset with the very incentive problems that we have stressed. The evolutionary process is far from perfect. Moreover, as evolutionary biologist Richard Hawkins has argued, we are all beset with “selfish genes” intent on using “survival machines” (living organisms such as human beings) to increase our chances (the genes’ individual chances, not so much the species’ chances) of survival.26 “Selfish genes” are willing to cooperate, if that’s what is needed (or, rather, is what works); but the fundamental goal is survival. To the extent that Hawkins is right, what he might be saying is, in essence, that we have to work very hard to override basic, self-centered drives at the core of our being.
It may well be that two people can work together “naturally,” fully capturing their synergetic potential. The same may be said of groups of three and four people, maybe ten or even thirty. The point that emerges from the “logic of collective action” is that as the group size -- team or firm -- gets progressively larger, the consequences of impaired incentives mount, giving rise to the growing prospects that people will shirk or in other ways take advantage of the fact that they and others cannot properly assess what they contribute to firm output.
As we have already studied, economists concerned with the economics of politics have long recognized how the “logic of choice” within groups applies to politics. The infamous “special interest” groups, which are relatively small and have long been the whipping boys of commentators, tend to have political clout that is disproportionate to their numbers. Indeed, special interest groups often get benefits from governments, with the high costs of their programs diffused over a much larger number of a more politically latent group, the general population of voters. Mancur Olson cites farmers for being the classic case of an interest group that constitutes a minor fraction (less than three percent) of the population but that has persuaded Congress to pass a variety of programs over the years that benefit farmers and their families and impose higher prices on consumers and higher taxes on taxpayers.27
Political economist James Buchanan points out that honor codes, which, when they work, can be valuable to all students, tend to break down as universities grow in size. For that matter, crime, which is a violation of the cooperative tendency of a community, if not a nation, tends to rise disproportionately to the population. Buchanan’s explanation is that the probability reports that when people think that their contribution to group goals, for example, pulling on a rope, cannot be measured, then individuals will reduce their effort.30 When members of a team pulling on a rope were blind folded and then told that others were pulling with them, the individual members exerted 90 percent of their best individual effort when one other person was supposed to be pulling. The effort fell to 85 percent when two to six other players were pulling. The shirking that occurs in large groups is now so well documented that it has a name -- “social loafing.”
A central point of this discussion is not that managers can never expect workers to cooperate. We have conceded that they will – but only to a degree, given normal circumstances. However, there are countervailing incentive forces, which, unless attention is given to the details of firm organization, can undercut the power of people’s natural tendencies to cooperate and achieve their synergetic potential.


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