Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Class 2 Notes: Alchian and Demsetz on Production,

Information Costs, and Economic Organization
Recall from the previous class that organization begins with people specializing; first
functionally and occupationally, later by organizing cooperatively around elements of
work (e.g. pin making steps) and adopting more complex production functions. Trade
emerges to coordinate specialists and leads to a price system or market. Transactions
can be performed through the market, e.g. the putting out system, or through hierarchy
within firms. There are costs to using the market or price system. Coase argued that firms
emerge when hierarchy is more efficient than market transactions. In Coase’s model firm
scale and scope limits on firms are determined by diminishing returns to management,
the costs of organizing, the incidence of mistakes, and the nature of the markets for
factors of production.

Objectives: To build on Coase’s notion of the firm through Alchian and Demsetz’
perspective and to take a closer look at the incentives to form firms. We will set the stage
for discussing incentives by defining types of firms in light of the intensity of managers’
stakes in their firm’s results. We will touch, all too briefly, on Demsetz’ extension of the
ideas contained in the earlier article he co-authored with Alchian. Then we’ll move on to
examine George Stigler’s extension of Adam Smith’s theorem about the division of labor
depending upon the size of the market to explain the division of labor within and across
firms in terms of the shapes of production functions and their relationship to the size of
the market. This provides a basis to explore the relationship(s) between the degree of
sustainable vertical integration, the practice of outsourcing, and the emergence of new
firms in decreasing cost industries. We will extend these principles to explain in part the
emergence of clusters.

Increased efficiency
Greater potential rewards

Cooperative, team-based production

Monitoring and metering Difficult to determine individual

Familiarity with workers output
Incentive system design Asymmetric information
Contract design Agency costs
Potential for shirking

Free rider problem

1
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Alchian and Demsetz and the Importance of Cooperation as an

Explanation of Firms

Adam Smith emphasized the productivity enhancing power of specialization and the
importance of exchange or trade to realizing its benefits. Dennis Robertson had observed
that we find “islands of conscious power in the ocean of unconscious cooperation like
lumps of butter coagulating in a pail of buttermilk.” Coase attributed the emergence and
dominance of the firm to lower transactions costs within firms due the application of
authority and hierarchy. In fact, the great majority of transactions in a market economy
occur within firms rather than across firms or individual producers using the price
system. Coase pulled economists away from the “black box” or production function
conception of the firm and prompted them, eventually, to think more deeply about what
firms were and how they functioned.

In 1972, Armen Alchian and Harold Demsetz published a very important paper,
“Production, Information Costs and Economic Organization,” that extended both our
understanding of how firms emerge and connected that understanding to how firms
manage their internal transactions and relationships.1 Alchian and Demsetz expanded
upon Coase’s narrow transactions cost explanation and focused on the firm’s role in
managing cooperative teams in light of information costs and the consequent need for a
central contracting authority.

“…Resource owners increase productivity through cooperative

specialization and this leads to the demand for economic organizations
which facilitate cooperation…”2

Where Coase implicitly assumed that market or firm production differed only with
respect to transactions costs, Alchian and Demsetz noted that firms made a different sort
of production possible. Cooperative, team-based production could be much more efficient
than separable, additive market-based production. The firm still has transactions costs,
especially for gathering and using information, but the key ones are directed to
monitoring and measuring the performance of cooperating resources. On that foundation
Alchian and Demsetz developed a systematic picture of the firm’s internal workings; how
the role of managers emerged from the need to meter teams, how managers’ incentives to
be productive are driven by sharing the residual created by the teams under their
direction, and how the intensity of the connection between residual sharing and
managerial effort helps to define types of firms.

Like Smith, Coase, and Stigler before them, Alchian and Demsetz recognized the
importance of specialization in increasing wealth but they defined the problems facing a
theory of economic organization a little differently. In their view the theory had two
charges:

1
Armen Alchian, Harold Demsetz, “Production, Information Costs, and Economic Organization,”
American Economic Review, 1972, Vol. 66, pp 777-95
2
Ibid, page 777
23
Ibid, page 777
4
Alchian and Demsetz, op cit, p778
5
See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76.
Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it 2
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

… to explain the conditions that determine whether the gains from

specialization and cooperative behavior can better be obtained within an
organization like the firm, or across markets, and to explain the structure of
the organization.3

Alchian and Demsetz offer a bit of a riposte to Coase’s emphasis on the relative power of
hierarchy over markets by arguing that the firm really has no more authority or capacity
to discipline resources than does the market. The firm does not own all of its inputs and
has access to no disciplinary action more powerful than that between contracting parties
in the market. Where Coase suggested that firms arose to perform those transactions that,
due to the costs of using the market, could be conducted more efficiently within a firm;
Alchian and Demsetz asserted that the fundamental rationale for firms was their superior
capacity to foster cooperation among specialists. In their model the firm is the
“centralized contractual agent in a team productive process.” 4

I. The Metering Problem

Economic efficiency requires paying resources on the basis of their productivity (e.g.
payments equal to value marginal product). This is relatively easy in competitive market
transactions because the supply of the last unit will be priced at its marginal cost. This
condition is harder to achieve within firms, especially when joint, team, or cooperative
production methods are used and thus requires internal metering and information. The
degree of productivity is directly related to the efficacy of metering. The roots of what
Nicholas Kaldor (1908-1986) called “supervisory” management and the identification of
its contribution are in the metering problem.5

II. Team Production

Alchian and Demsetz identified the jointness of team or cooperative work that was
inherently suited to being performed within a firm as the critical characteristic of a firm.

3
Ibid, page 777
4
Alchian and Demsetz, op cit, p778
5
See Nicholas Kaldor, “The Equilibrium of the Firm,” The Economic Journal, March 1934, pp. 60-76.
Kaldor distinguished between the “supervisory” and “co-ordination” management roles. He argued that it
was the latter which was fixed for the individual firm and hence the basis for ultimately diminishing returns
to other resources. Kaldor built on Austin Robinson’s The Structure of Competitive Industry, and, like
Coase, rejected Frank H. Knight’s notion of control resting with those who bear the ultimate risks (perhaps
uncertainty would be the more accurate term here). Kaldor defined and explained the firm in terms that
seem to anticipate the central contracting agent of Alchian and Demsetz and their emphasis on the residual
value as a basis of management compensation, “…for theoretical purposes the most satisfactory definition
of a firm is that of a ‘productive combination possessing a given unit of co-ordinating ability” which marks
it off from ‘productive combinations’ (such as an industry) not possessing this distinguishing peculiarity. It
is the one factor which in the long run is ‘rigidly attached to the firm’ which, so to speak, lives and dies
with it; whose remuneration, therefore is always price-determined.” When he wrote this article, Kaldor
was still in his neoclassical phase and had not moved on to his later emphasis on macroeconomic issues and
the development of Keynesian models. Kaldor was very dismissive of monetarism and is famous for
criticizing Milton Friedman’s analogy of increasing the money supply by dropping money from a
helicopter (a theme later picked up by Ben Bernanke) and went so far as to discuss the different
consequences should the helicopters release their manna over poor or rich parts of London.

3
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

In other words, the firm with its central contractor makes possible a more efficient type
of production, a type that would be very difficult, if not impossible, to achieve working
through the price system or market. Their notion of the firm as a vehicle for promoting
cooperation through centralized contracting is significantly different than the classical
view of the firm as a set of production functions but is perhaps not really so far from
Coase’s notion of firms serving to economize on transactions costs. Today, transactions
costs are often defined broadly to include information, search, contracting, and other
similar costs associated with exchanges but not directly embodied in the product or
service being exchanged.

Contracting (explicit or implicit) is the primary means of organizing sustained

cooperative effort among people, either inside of outside of a firm. Take a moment and
think about the “contract” as a device for cooperation and its relationship to property and
property rights. There can be no free or voluntary contracting between people without
property rights. Exercising our property rights to our own labor or other resources usually
involves transactions costs. The person or firm contracting for our services also incurs
transactions costs. These notions are central to the notion advanced by Jensen and
Meckling that a firm is a “nexus of contracts.”6

The concepts of a team and team-based production are central to the Alchian and
Demsetz model. Teams are a form of cooperative effort that may yield substantial
economic gains but involve significant contracting and monitoring efforts. The value of
contributions from individual resources in team-based production functions cannot be
measured readily because the activity involves joint efforts of team members. Such joint
effort may involve the simultaneous effort by team members (e.g.. cooperatively lifting a
heavy box) or the use of a shared resource (e.g. shared access to a power supply or an
assembly line) by team members. A team-based activity as a whole may be separated
from others conducted by the firm in the same way as those discussed by Stigler (whose
explanation of firm specialization and integration are discussed below).7

Jointness is a frequently encountered phenomenon in economics. Most students (at least

those who took the prerequisite) are familiar with the
problem of pricing joint outputs such as beef and hides
that result from raising cattle. You may recall that despite
the most ingenious, if logically strained, efforts of
accountants to allocate joint inputs and their costs to the
two outputs: it is impossible to determine separable
production or cost functions for the two outputs: one cow,
one carcass, and one hide.

6
Jensen, Michael C and William Meckling, 1976, “Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure,” Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360.
7
The concepts of production functions and production cost functions are essential to understanding how
business firms allocate their resources and make choices about how to produce output given different
technologies and factor prices. An accessible review of the production and cost functions by S.K. Mishra,
“A Brief History of Production Functions” Working Paper for the Social Science Research Network is
available free at http://www.scribd.com/doc/417083/A-Brief-History-of-Production-
Functions#fullscreen:on

4
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Jointness arises also with inputs in production functions involving cooperative labor and
resources. As Frank Knight observed, “In reality, of course, production is joint, almost
without exception.”8 To illustrate joint production Alchian and Demsetz use the example
of two men carrying a heavy box that neither alone could lift. We can measure how much
the team lifts, but we really can’t say easily how much each team member lifts. This
problem of non-separability of joint inputs has bedeviled economists for over a century
but as Knight stated, “… it is inappropriate for economists to argue as to whether the
separation of contributions to a joint product can or cannot be made; it is made; it is our
business to explain the mechanism by which it is accomplished.”9 Alchian and Demsetz
offer a solution to Knight’s problem.

The team-based box-carrying production function is a very different function than the
separable one-man box-carrying models with which it competes. One-man models would,
for example, likely require a redesign of the box packaging to make it smaller and lighter
or involve breaking the contents into smaller quantities, increasing packaging costs,
tracking costs, assembly costs, etc. The two-man box carrying production function will
be chosen when its increase in efficiency over the one-man methods is sufficient to
compensate the common resource and metering costs. In this simple case common or
shared resource is the management activity that can direct the cooperative behavior. In
other words there are three resources involved: two labor resources, and one management
resource. The latter is justified by its contribution to the efficiency of the former two.10,11

The shared application of physical capital is probably the most important example of
cooperative or joint output. When once relatively independently operating textile workers
came together to work within mills and to share power sources, it quickly became evident
that they could be managed more efficiently as a firm, i.e. through a central contracting
agent. More efficient investments in capital assets were possible when a central
contracting entity could plan for the full resource base and optimize inputs. This led to
changes in the size and capacity of equipment and increased specialization among the
workers. In almost all cases, the central contracting entity was the owner of the capital
assets used jointly by the workers and other resources.

Team or cooperative production is characterized by three factors:

1. Several types of resources are used

8
Frank H. Knight, 1921, Risk Uncertainty and Profit, originally published by University of Chicago Press,
quotes here are from the Kindle edition by Cosimo Classics, 2005 location 1175 of 4511.
9
Ibid, location 1270 of 4511
10
The workers do not have to be employees to work cooperatively or share a resource. For example, some
independent cab drivers jointly operate or support a central dispatcher to provide efficient routing.
11
A team production function e.g. z = f (x,y) is described mathematically by the second cross partial
derivatives of the function with respect to the variables: ∂f2/∂x∂y ≠ 0. For example If the production
function is z = f(x,y) = x3 + x2y3 -2y2 then fx = 3x2 + 2xy3,
and fxfy =∂/∂y (3x2 + 2xy3) = 6xy2. But, if the production function is z = f(x,y) = x3 – 2y2
Then fx = 3x2 and fxfy = ∂/∂y (3x2) = 0. In general at least one term of the production function’s has to
contain a product of the variables – an indication of “jointness” and hence a team function.

5
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

2. The product is not the sum of separable outputs of each resource12

3. Not all of the resources belong to one person

Jensen and Meckling point out that the Alchian and Demsetz over-emphasize the role of
technical jointness and that their argument holds where agency costs and multiple
contracts are involved.

“Alchian and Demsetz (1972) object to the notion that activities within the
firm are governed by authority, and correctly emphasize the role of
contracts as a vehicle for voluntary exchange. They emphasize the role of
monitoring in situations in which there is joint input or team production.
We are sympathetic with the importance they attach to monitoring, but we
believe the emphasis that Alchian and Demsetz place on joint input
production is too narrow and therefore misleading. Contractual relations
are the essence of the firm, not only with employees but with suppliers,
customers, creditors, and so on. The problem of agency costs and
monitoring exists for all of these contracts, independent of whether there is
joint production in their sense; i.e., joint production can explain only a
small fraction of the behavior of individuals associated with a firm.”

Jensen and Meckling’s insight is a valuable qualification to the original Alchian and
Demsetz argument and was largely adopted by Demsetz in his follow-up article discussed
below. Technical jointness is not necessary for a divergence between principal and agent
objectives and for asymmetric information to emerge. Nothing is lost by thinking of team
production in lieu of technically joint production.

The Insidious Temptation to Shirk

Alas, team members are human and some are inclined to exploit the difficulty of
determining individual contributions in a joint or team production setting. The incentive
to shirk (shirking is a form of moral hazard and similar to the free rider problem) is
inversely related to the costs of detection and directly related to the value that the shirker
places on his relief from effort. Recall that we emphasized that people seek to maximize
their self-interest as reflected in their utility function. People will shirk and gain leisure
when the value they place on it is less than the costs they expect to pay.

Economists note that each team member possesses asymmetric information; each knows
how much he is shirking but it is difficult for others to be sure.13 The shirker gains all of
the benefit arising from his indolence but pays only a share of the lost value. Team

12
Michael C. Jensen and William H. Meckling, Journal of Financial Economics, October, 1976, V. 3, No.
4, pp. 305-360. Reprinted in Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims and
Organizational Forms, Harvard University Press, December 2000 available at
http://hupress.harvard.edu/catalog/JENTHF.html Also published in Foundations of Organizational
Strategy, Michael C. Jensen, Harvard University Press, 1998.
13
Even in the two-man box carry, one worker may suspect the other is shirking but unless they have
worked together for some time, cannot really distinguish shirking from less strength or capability.

6
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

production makes it more difficult to detect shirking. A team member has therefore more
incentive to shirk than the same person working in a non-cooperative or independent
fashion where shirking is much easier to detect and the entire costs are more likely to fall
on the shirker. Note that where (literal) teams are involved in producing an outcome as in
sports, there are tremendous, almost obsessive, attempts to quantify contributions.14 A
slightly lesser urge holds for business and is often the basis of incentive schemes. We will
discuss the process of aligning effort, measuring and rewarding contribution when we
cover compensation system design.

Managing teams (or any complex cooperative activity) calls for specialized monitoring
skills and techniques. Since a team joint production function is not separable into the
marginal value products of individual resources, it is impossible to measure the precise
marginal value product of each member individually. Because of its jointness, we can’t
divine exactly the individual contribution of each man lifting the box and there is thus an
incentive for team members to shirk. Shirkers diminish the overall productivity of the
team and hence its rewards but they incur only a share of the lost income. So, the shirk-
inclined (aka lazy !#$%^&*) will relax up to the point where they perceive that the
incremental expected utility they gain from additional leisure is equal to their share of the
forgone team compensation.

14
Bill James, an economics major at the University of Kansas, was largely responsible for the founding of
sabermetrics, the statistical analysis of baseball player performance and potential that has transformed
baseball team management. His concepts have since spread to other major sports. James’ early adopter,
Billy Beane, GM of the Oakland Athletics, was the subject of Michael Lewis’ book Moneyball which can
be read profitably as a guide to information-based management in general.

7
 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

III. The Classical Firm

The principal (often but not always the owner) is the centralized contractual agent that
makes team production possible and efficient. He is a common party to the contracts of
!
all of the agents and thus able to coordinate their efforts. He is
Residual!
rewarded in the form of residual (net) returns available after the
agents (usually but not always employees) have been
$!!!Price!and!

compensated. His role and objective is to manage the actions of

Cost!

the agents in a way that produces enough income net of other

costs (the residual) to compensate the agents, pay for shared
!
Team!!!Output! resources, and leave enough to compensate the principal.

Quid custodiet ipsos custodes?15 His stake in the residual is what keeps the principal or
manager stimulated to perform and to resist shirking. Of course, as we’ll discuss more
deeply later, the manager is human and will engage in shirking or the pursuit of other
values up to point where the costs that he incurs will be just offset by the satisfaction or
utility that he gains.

Centralized contracting is a distinguishing characteristic of firms and makes internal

resource redeployment and utilization easier.16 Suppose our two box-carriers did not work
for the firm. A principal could contract in the spot labor market with A (the man on the
right) and then either the principal or A could in turn contract with B (the guy on the left).
This form of spot labor market operates in the casual labor exchanges that are found in
every city at locations where groups of men looking for work congregate and are
informally hired by employers for daily or hourly tasks.17 This !

arrangement could work well for the instant problem of moving

the box. But, if there is a lull in the need for box moving, it might
involve another round of contracting to redeploy A and B to, say,
replacing evil, planet-destroying, soon-to-be-illegal incandescent
light bulbs with energy-efficient LEDs.

15
Who shall watch the watchers? The phrase is attributed to the Roman poet Juvenal and the object
variously translated as watchers, guards, or watchmen. It is the perennial problem of any hierarchical
system and a major problem in corporate governance when, for example, directors are appointed by crony
executives with whom they empathize more than they do with the shareholders.
16
Centralized here means that all contracts are with the firm. Such contracts may be made at different
points within the firm.
17
Not all spot casual labor markets operate out of centralized locations; in some cases the spot market
moves to the work site. Trucks are often loaded in the wee hours by casual laborers who line up outside the
loading docks in the early morning to get a place. Since demand varies, the earlier the arrival the higher the
chance of being selected for that morning’s shift. This leads to a certain amount of gaming and strategizing
over the best arrival time. Unfortunately, the first few spots are not particularly desirable because the more
thuggish members of the casual labor community like to arrive late and beat up or intimidate the first
several workers into relinquishing their places. During my brief career in the causal labor sector I found
that spots eight through fifteen were usually a good hedge against injury while preserving a high
probability of selection.

8
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Another advantage of centralized contracting is the accumulation of knowledge by the

principal. Over time, the principal acquires knowledge by observing A and B that he can
apply to improve process design, hiring, or other aspects of the business. Experience is
an important management and entrepreneurial characteristic. The broader the experience
and knowledge about aspects of the business that a manager or entrepreneur has the more
likely he or she is to be effective.18

Team production will be used when it yields a level of output sufficiently greater than the
best alternative separable production function to cover the extra costs of monitoring and
disciplining team members. Alchian and Demsetz summarize their model as:

“The essence of the classical firm is identified here as a contractual

structure with: 1) joint input production; 2) several input owners; 3) one
party who is common to all the contracts of the joint in- puts; 4) who has
rights to renegotiate any input's contract independently of contracts with
other input owners; 5) who holds the residual claim; and 6) who has the
right to sell his central contractual residual status. The central agent is called
the firm's owner and the employer.”19

The scale of the firm is limited in the Alchian and Demsetz model in a manner consistent
with Coase but more richly drawn than simple internal transaction cost overload or
diminishing returns to management.

• The greater the interdependencies among functions of the firm, and the needs for
specialized knowledge to manage those interdependencies, the more important is
centralized contracting.

• The larger a firm and the more different bodies of knowledge it must master to
manage interdependencies, the more difficult and expensive it becomes to
perform efficiently.20

Based in part on the thoughts of Alchian and Demsetz, economists have studied closely
the nature and behavior of teams. For example, Jacob Marschak and Roy Radner took the
concept of teams as introduced by Alchian and Demsetz to a much deeper level and
addressed the questions of optimal decision-making rules for teams under various states
of the world, range of actions, quality of information and other factors.21 There is also a

18
See Edward P. Lazear, 2005, “Entrepreneurship,” Journal of Labor Economics, October 2005, pp. 249-
280 for an explanation of the entrepreneurial value of broad know-how and experience and the
characteristics shared with senior managers.
19
Op. cit. p 794
20
Harold Demsetz, The Economics of the Business Firm: Seven Critical Commentaries, 2d commentary,
“Agency and Nonagency Explanations of the Firm’s Organization,” p 34. Demsetz builds on and clarifies
some of the points made in the original article with Alchian
21
Jacob Marschak and Roy Radner, Economic Theory of Teams, Cowles Foundation for Research in
Economics at Yale University, Yale University Press, 1972 (out of print but available from UMI Out-of-
Print Books on Demand). This book is comprehensive and rigorous but nearly inaccessible to a non-
specialist.

9
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

popular management literature that celebrates the benefits of collaboration including the
magnification of individual intellects and efforts through teams without unduly burdening
the reader with either economic theory or evidence.22 The popular team literature usually
ignores or minimizes the shirking problem and often paints an unrealistic picture of
enthusiastic collaborators. Those happy cases exist of course but many internal teams
impose additional costs and strains on participants many of whom perceive that their
individual expected rewards are meager but the costs significant.

Shirking is everwhere. The graduate project teams assembled for this course experience
serious shirking problems in 10-20 percent of the cases. In some, thankfully few, cases
student shirking takes the form of plagiarism. At a higher level of scholarship, a
disturbing number of published journal articles are retracted due to falsification of data. A
recent study that attempted to replicate published data found that about 75 percent of
psychology studies (64 percent in the top journals) could not be replicated. Not all of
these cases involve shirking or dishonest reporting but a strong case can be made that the
journals’ incentive to publish striking new findings has reduced their metering efforts.23

IV Types of Firms

As noted above, Alchian and Demsetz find that managers’ compensation is linked to their
contribution to the firm’s overall residual value or the residual value that the managers
create. The intensity of that linkage can be used to characterize different sorts of firms.

Profit sharing firms are generally found in small team size settings where self-policing
may be less costly than investing in specialized metering resources. Profit sharing (like
partnership) is frequently effective with small teams of difficult-to-monitor specialists
such as artists, lawyers, consultants, architects, etc. Larger firms often find that profit
sharing dilutes the central manager’s disincentives to shirk and may in fact cause overall
productivity to decline. The optimal size of the team under equal profit sharing schemes
is directly related to the incentives to shirk. The less precisely individual reward is
aligned with contribution, the less the incentive to perform efficiently.

Socialist firms are often marked by broad sharing of residual value (if any), which of
course reduces its value as an incentive to efficient management or as a deterrent to
shirking. For this reason, other disciplinary means such as workers committees must be
used to keep the managers engaged. Some of these may involve quantitative output
objectives while others may involve worker or agent evaluations. Agent evaluation of

22
Perhaps the most prominent is Jon R. Katzenbach and Douglas K. Smith, The Wisdom of Teams:
Creating the High Performance Organization, 2003, Harper Paperbacks. Like most management books it
treats teams for the most part as ad hoc, problem solving units rather than a fundamental means of
cooperative production. The central metering and disciplinary role of the manager, central to the economic
team concept is not stressed, in fact leadership in Katzenbach and Smith’s teams need not come from the
senior manager in the group. A key word search for a selected group of academic experts and scholars on
the subject of teams turns up 0 hits in the book.
23
See for example http://www.theguardian.com/science/2015/aug/27/study-delivers-bleak-verdict-on-
validity-of-psychology-experiment-results

10
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

principals is problematical.24 Since workers place value on leisure (shirking) they likely
consider the manager’s tolerance of shirking as well as other issues. The manager’s
pursuit of “from each according to his ability” may not rank high on the list of socialist
workers’ concerns.

Corporations typically raise capital by selling promises of future payment to relatively

large groups of people who collectively own the firm. Although, the shareholders have
claims on the residual value produced by the firm, it is too costly for most individual
shareholders to invest the time and effort to be effective overseers of the firm and so they
delegate that role to a board of directors. Given the difficulty of effective individual
shareholder oversight of management shirking and the ease by which a shareholder can
simply sell and eliminate his exposure, Alchian and Demsetz (and many economists)
suggest it is perhaps better to view shareholders as investors rather than owners.25

Mutual companies and nonprofits. The ability to sell shares, which capitalize expected
future earnings, provides a market-based evaluation of corporations. Mutual companies
and non-profits do not expose themselves to this sort of scrutiny and hence we expect to
find higher levels of shirking among their executives relative to their corporate
counterparts. The heads of many large non-profits receive compensation that approaches
that of corporate officers based on the argument that their organizations are of
comparable scale. This amounts often to rewarding people for inputs rather than outputs.
It is remarkable how many charity and foundation trustees buy this argument and seem
oblivious to the managerial behavior it promotes.

Partnerships are a frequently preferred organization for team based artistic and
intellectual productions. Partnerships are closer to market-organized rather than principal-
agent contracts. Partnerships are usually self-policing (there is no manager between the
partners) and frequently organized among relatives or friends in part because they are
familiar with the others’ tendency to shirk.

24
The use of student evaluations of professors and instructors is a case where principal behavior may be
unduly influenced by agent “feed-back.” It is often difficult to distinguish the disgruntled from the
insightful and candid. Anonymity makes detection of the agent almost impossible and thus reduces the cost
in terms of anxiety over retribution for criticism and leads to more than would be the case if the critic was
identified.
25
Aggressive professional stockholders, sometimes referred to as corporate raiders, were an important but
misunderstood force for good corporate management. People like Irwin Jacobs, Carl Icahn, and T. Boone
Pickens (before his gas crusading days) identified untapped shareholder value in many companies and
worked to get management to realize it. The leveraged buyout (LBO) phenomenon of that emerged in the
1980s was epitomized by Kohlberg, Kravis and Roberts (KKR) who specialized in buying, rehabilitating,
and selling companies that had failed to aggressively pursue profits in favor of size or revenues. The late,
over-rated management guru Peter Drucker objected to corporate raiders as short-term focused strippers of
value and blamed the acquisition of large stockholding by pension funds for making takeovers easier. This
is not Drucker’s only erroneous criticism of free market economics. In contrast, scholars such as Amar
Bhide examined a large number of contested tender offers and found them to be “capitalism at its best.”
Unfortunately, many states enacted legislation making it easier for shirking executives and boards to defend
their sinecures. Fortunately, some private equity funds and some hedge funds continue the good work of
shaking up management.

11
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Employee unions are not firms but do serve as a monitoring service for members to
reduce management shirking and management of retirement and insurance funds. In some
cases unions perform transaction management functions for insurance and pension plans
and then are subject to shirking and self-interested behavior. This accounts in part for the
government regulation of union activities.

V. Team Spirit and Loyalty

Some institutions such as the military and sports teams exhibit a great deal of team spirit
and believe that it is nearly as important as pecuniary incentives. Managers and
executives have long tried to improve cooperation by fostering an identity with the firm.
Chester Barnard, an influential and pioneering management thinker, felt that:

“The most important single contribution required of the executive,

certainly the most universal qualification, is loyalty, domination by the
organization personality.”26

This notion of “domination by the organization personality” has always struck us as

creepy. Unfortunately, institutions from corporations to colleges do seek to manufacture,
instill, and enforce a notion of shared goals and objective. Apparently the selection value
or fitness of uniformity outweighs, or is believed to outweigh, the benefits of diverse
personalities. But wait, the same organizations that seek to inculcate a shared sense of
values and culture will often proclaim also their devotion to diverse opinion and
perspective. Go figure.

Firms often reveal their assessment of employee intelligence by attempting to decrease

shirking by promoting codes of conduct and a team-
building ethos. These efforts are often supported by a lot
of inane industrial poster art encouraging teamwork and
shared values.27 As we’ll see later, incentive systems
often also work counter to team spirit. Real cultures are
evolutionary phenomena that emerge as various
behaviors are selected for within the community or
corporation (the Marines really do practice what they
preach). People know the difference between the real
culture and the fantasies promoted by management and
consultants. One of the recent buzzwords is “employee

26
We have always found this statement off-putting, especially the “domination by the organization
personality” part. It seems to suggest a sort of Borg-like suppression of individuality. At best, Barnard may
have been awkwardly referring to something akin to corporate culture. See Chester I. Barnard, The
Functions of the Executive, originally published in 1938, 30th Anniversary Edition, 1968, Harvard
University Press, Cambridge, MA.
27
Despair Incorporated, a firm dedicated to “increasing success by lowering expectations,” has built on the
tradition of industrial poster art by creating their “demotivator” series. One of which is shown above. 27
One of my favorites is a full color photo of the great pyramids with the caption, “You can do anything you
set your mind to when you have vision, determination, and an endless supply of expendable labor.”

12
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

engagement” which is probably a worthy goal and sometimes a real condition but the
material strikes us as largely repackaged pieces of earlier campaigns such as
“empowering employees,” “open book management,” etc. 28

VI. Kinds of Inputs Owned by the Firm

Asset ownership tends to reside where the greatest net value can be realized. Employee
ownership of productive assets is one way to assert a claim on any residual value
produced through their use and to reduce asset abuse (a form of shirking of care and
maintenance). Observing physical asset use and care is often expensive. If possible the
firm may require individuals to own the physical assets such as tools that they use.

In some cases, such as independent cabs, individuals own their own vehicles and contract
for dispatch services and joint maintenance facilities. Most mechanics and many
technicians own their own tools and jealously guard them from careless or acquisitive
colleagues. Similar divisions of asset ownership and risk taking will be encountered later
when we look at risk sharing and crop-sharing models of incentive contracting. In later
sessions we look at Oliver Williamson’s argument that the degree of asset specificity is
an important factor in deciding which party owns an asset and the Klein, Crawford and
Alchian discussion of opportunistic behaviors such as hold-up in the determination of
governance.

VII. Firms as Specialized Markets for Collecting, Collating and Selling

Input Information

Coase saw the firm as a substitute for the market writ large – the price system. But the
firm can also be thought of as a surrogate market. Familiarity breeds knowledge of
internal resources.29 Resources compete within firms for rewards. Superior combinations
of inputs can often be more economically identified and joined with resources already
inside the firm rather than outside. Efficient production with heterogeneous resources is
not always having better resources but in knowing better the productivity of the resources
and having the capacity to adjust payments accordingly.

Alchian and Demsetz close with a provocative thought on the relationship between firms
and markets. Rather than a replacement for the market and means of suppressing the
prices as Coase proposed, could it be better to think of the firm as a form of market that
competes with other forms?

“Conceiving competition as the revelation and exchange of information

about qualities, potential uses of different inputs…the firm is a device for
28
A brief overview of open book management is at http://www.economist.com/node/13809344
29
Employers are often willing to live with a moderately sub-par employee – the devil they know – rather
than invest the time and search costs in finding a another employee of uncertain quality – the devil they
don’t know.

13
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

enhancing competition among sets of input resources…In contrast to

markets and cities which can be viewed as publicly or non-owned markets,
the firm can be viewed as a privately owned market… could consider the
firm and ordinary market as competing types of markets…Could it be that
the market suffers from the defects of communal property rights in
organizing and influencing uses of valuable resources?”

In a similar vein, Bengt Holmstrom, an economist at MIT, has suggested that the
firm is a subeconomy. Holmstrom notes that employees rarely own significant
physical capital and generally supply only human capital and asks why capital
asset ownership is almost exclusively within firms. His analysis suggests that the
firm can be viewed as a sort of island economy and that owning physical assets
conveys the right to determine the rules of the game on the island.30

*********

30
Bengt Holmstrom, “The Firm as a Subeconomy,” Journal of Law, Economics, and Organization, Vol.
15, (1999) no.1

14
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Harold Demsetz, 1988, “The Theory of the Firm Revisited”

About 16 years after collaborating with Alchian on the basis of economic organization,
Demsetz returned to the topic and extended their earlier analysis.31 He also developed a
more complete critique of transaction cost economics and offered extensive thoughts on
the significance and role of information. If time permitted, this article too would be on
our reading list but for now we will limit our discussion to the famous phrase he used to
define (and to extend) the boundaries of the firm:

“The firm properly viewed is a “nexus” of contracts.”32

Demsetz explored three key questions about the contracts: (1) the persistence of certain
types of contracts found in this nexus, (2) the variation observed in other types of
contracts that are “more-or-less” included in this nexus, and (3) the (horizontal and
vertical) scope of activities covered by these contracts.

Demsetz, though he doesn’t use the jargon, had identified the broader concept we now
call an “enterprise” to encompass the firm and its suppliers, and in some cases, its
customers. By focusing on contracts and their nexus Demsetz was able to “brush aside
the questions of absolutes – “When is a nexus of contracts a firm?” and substitute instead
a question of relatives –“When is a nexus of contracts more firm-like?”33Recently, it has
become popular to refer to a firm’s ecosystem – the set of firms linked by a common
platform or system as with Apple, the iTunes Store, and the thousands of apps in the App
Store. Like many biological analogies used in business, the ecosystem concept is
suggestive of food chains and host-parasite relationships but is often handled sloppily.

The adoption of a contract-based definition of the firm is useful because it (a) allows us
to envision the spectrum of both inter- and intra- organizational arrangements and to
understand better their origin and structure, (b) provides a basis for estimating the value
of components of the firm as the asset-equivalent of the contract, and (c) assess the
relative contribution to firm value and provide management a means of focusing their
information gathering and processing efforts.

********

31
See Harold Demsetz, “The Theory of the Firm Revisited,” Journal of Law and Economics, Spring 1988,
pp.141-183.
32
Ibid, p 176 We have quoted the Demsetz’ formulation through which we became familiar with the
“nexus” concept which was likely derived from an earlier paper by Jensen and Meckling, “Theory of the
Firm: Managerial Behavior, Agency Costs and Ownership Structure” Journal of Financial Economics,
October, 1976, V. 3, No. 4, pp. 305-360. On page 8 J&M state, after referring to Alchian and Demsetz’
emphasis on contracts and central contracting, “It is important to recognize that most organizations are
simply legal fictions which serve as a nexus for a set of contracting relationships among individuals.”
33
Demsetz, op cit. p177

15
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

George Stigler’s Life Cycle Theory of Market Scale and Firm

Scope

Stigler, the 1982 Nobel Laureate in Economics, adds to our understanding of the
emergence and boundaries of firms by pointing out that transactions are sometimes
performed within firms before migrating to the market, that the production costs – not
just transactions costs – matter, and that the locus of production results from the dynamic
interplay of output market size, resource costs, and production function characteristics.

In 1951, George J. Stigler, published one of his many influential papers, “The Division of
Labor is Limited by the Extent of the Market.”34 In this article he built on Adam Smith’s
original observation and Ronald Coase’s insights into the evolution of the firm and
extended the theory to more explicitly address the scope of firms and the organization of
industries. Stigler showed that the shape of production cost functions and the level of a
firm’s output relative to the size of the market often determined which functions were
best performed within an integrated firm and which functions could stand alone and be
produced by specialist firms.

Coase explained that firms coagulated from buttermilk to perform those transactions that
could be conducted in a hierarchical setting at less cost than through the market or price
system. This transaction cost minimizing process could continue until diminishing returns
to management set in. Stigler, while accepting diminishing returns to management as a
constraint to firm size and scope, expanded the analysis of the boundaries of the firm by
looking more closely at the nature of the functions performed inside of the firm. Stigler
retained the neoclassical position that firms are essentially a set of production functions
but he recognized that there is a logic to what functions can be performed best within the
firm and best outside in the market (“outside” may mean being performed by another
firm).

The fit between the cost minimizing scale of production for a firm and the extent of the
market is a powerful evolutionary force in the life of organizations and their markets
especially in the early days of an industry. Stigler built on the fact that most finished
products are composed of intermediate products with separate and separable production
functions. These intermediate stages and products correspond roughly to the popular
notion of a value-added chain.

Stigler asked, “What production processes do firms conduct internally and why?” He
found that the shape of production functions relative to the scale of the market explained
the economic degree of vertical integration in many cases. Adam Smith’s insight about

34
George J. Stigler, “The Division of Labor is limited by the Extent of the Market”, Journal of Political
Economy, Vol. LIX, No. 3 (June 1951); reprinted in George J. Stigler, The Organization of Industry, (1968,
Richard D. Irwin, Homewood Illinois) pp129-141

16
 Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

the division of labor applied to firms as well as workers. As the market gets larger, firms
often specialize more.

Stigler’s model is sometimes referred to as an “industry life cycle” theory of the firm.
Firms often go through a cycle of early vertical integration, a period of industry and firm
growth, and then at some point, a period of sloughing off functions and “outsourcing” as
the markets for intermediate goods matures and specialized firms emerge. During an
industry’s decline, shrinking markets for intermediate goods may cause the remaining
firms to re-acquire the means of producing them. There is thus a dynamic interaction
between firms’ scale and degree of vertical integration and their habitat or market
environment.

Early U.S. cotton textile mills often built and maintained almost all of their machinery,
produced the cloth, and conducted direct marketing activities. As the market expanded,
specialists in textile machinery emerged to serve the industry. As the textile industry
declined, some of those machinery specialists moved horizontally into other types of
machinery such as paper mills, textile equipment for other fabrics, and such things as oil
burners and refrigerators. The growth of the market led to the creation of specialized
firms to which the previously fully integrated companies looked for intermediate goods
or, in today’s terms - “outsourced” those functions.

Stigler’s analysis opened up the classical “black box” model of the firm and peered
inside, laying the groundwork for the examination of why firms performed certain tasks
and not others. A vertically integrated firm conducts two or more of the steps necessary
!
$"
AC! to produce a good or service. The figure illustrates
! a vertically integrated firm that conducts internally
AC 1!
three processes: a continuously decreasing cost
2P!
Y 3! function Y1, a continuously increasing cost
P
1! function Y3, and a U-shaped cost function Y2.
Y!
Assuming that the rates of output for all functions
2
are fixed relative to one another, we can add up the
P
Y1! Y costs at each output level to determine the
1!

integrated firm’s average cost function at each rate

0"
Q1! Q!2
Output"
of output as shown by the heavier curve at the top
of the graph.

Now, if the industry grows it may become feasible for a specialized firm to conduct the
decreasing cost function Y1 independently and to sell that factor to the other firms, the
originally vertically integrated firms will buy the factor Y1 at a price lower than they
Previously produced it.

The cost of the “outsourced” resource is shown by the dashed straight line that replaces
Y1. By acquiring resource Y1 from an outside supplier our average cost curve is lowered
over the relevant range of production. The change in the total average cost curve, also
shown as a dashed segment, illustrates the new lower costs of the final output. As the

17
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

market grows, this process can occur over and over if the function Y1 (or for that matter
any of the cost functions) is found to have separable decreasing cost components.

In some cases, an otherwise increasing cost function, such as Y3 above, may have
separable sub-functions subject to economies of scale and can be produced by specialists
when the market grows large enough.

Stigler’s explanation of the Industry Life Cycle sheds a great deal of light on why firms
integrate vertically and disintegrate and why vertical integration for “strategic” reasons is
so hard to pursue profitably if some functions exhibit decreasing costs beyond the firm’s
level of output. The ILC also helps to explain why many firms in small and developing
countries that do not have ready access to larger markets are overly vertically integrated
and inefficient relative to peers in larger markets. While some politicians prefer to shield
such “infant” industries from competition, they are unlikely to achieve the scale or
economies of firms able to specialize in various production functions.
!
P"
Stigler discusses briefly how market
!
! MC! imperfections either from government-
T!
induced distortions or monopoly power
B! are important force for vertical
S! integration. He notes the spate of vertical
A! integration during and succeeding World
MVP!
R! War II prompted by price controls and
allocations. The regulated price (OA)
resulted in output OM which was valued
0" M! N! Q" at OB by buyers who received their
allocated inputs on a non-price basis. The
combined value to sellers and buyers from a market-clearing price would be the shaded
sort-of triangle RST. Vertical integration was one way to obtain the value and
circumvent the price control system. Similar incentives to vertically integrate may arise
under cartels and monopoly power in one of the pertinent markets.

18
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

Division of labor and outsourcing (an aside)

We can synthesize some of the points made by Coase, Alchian and Demsetz, and Stigler
to understand better the phenomenon of “outsourcing.” Coase didn’t explicitly state but
suggests that transactions are initially performed within markets and later migrate to
firms as their ability to economize on transactions costs provides them an advantage.
Alchian and Demsetz extended the notion of firm creation by noting that firms facilitated
a different, more productive, form of production involving team-based cooperation.
Stigler pointed out that a function or process may originate within a firm and later
migrate to the market.

“Outsourcing” is reviled by many but it need not lead to loss of employment. In Stigler’s
model, the activity moves outside the original firm but not necessarily outside the
domestic market. In part this is because the outsourcing company is often founded and
staffed by people from the original vertically integrated firms and in part because the
increased economic efficiency and lower prices in the sector doing the outsourcing may
increase demand in that sector and others. The lower prices that the outsourcing firms can
offer by exploiting increasing returns stimulates their growth and attracts more
customers. A common error of politicians is to bemoan the shrinking of firms through
outsourcing without recognizing the growth of the outsourcers and the gains from
increased efficiency and trade.

The clustering of specialized firms producing intermediate goods is partly a result of the
division of labor and reflects the fact that many companies in some industries trace their
origins to a common ancestor. Some of that division into separate offspring results from
specialization in various production cost functions. Clustering is also a function of
transportation, inventory, and communication costs. Paul Krugman resuscitated economic
geography and location theory by emphasizing the importance of increasing returns in
determining the emergence of clusters.

Industrial clusters are, in effect, large local marketplaces for specialized resources. New
firms in these areas do not need to be vertically integrated. Industrial clusters (a sort of
commercial habitat) are one reason new firms are able to be up and running very fast.
Experienced people, specialized equipment, and established distribution channels can be
assembled or tapped into quickly. But in some industries, information and
communications technology make it possible to assemble teams from widely separated
geographies.

In some cases a new firm may find that nearly all of the specialized productive
capabilities exist in competitive markets and is able to assemble what is often but
misleadingly called a “virtual firm.” 35 Nike is frequently cited as an example of a virtual

35
The notion of a “virtual” firm, while catchy can be misleading. A firm is a real firm if it does something
real, as Nike clearly does, the firms that conduct the functions that Nike purchases are also real firms. The
appellation virtual for the coordinated production of the firms seems to place an exalted role on Nike’s use
of and coordination of other people’s skills and assets - thus avoiding capital investments – something we
all do every day. The term may suggest also that it is an inherently better form of organization or a structure

19
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

firm that focuses on product design and marketing while relying on a network of
independent contract manufacturers to actually produce the products. In many respects,
Nike demonstrates Coase’s point about the firm existing to perform what it can execute
more efficiently than the market but in this case the transactions costs of working through
the market in many cases is less than internal organization through hierarchy. Nike also
exploits the vertical disintegration of production activities described by Stigler. Elements
of Nike’s overall production function is apparently additive and separable and it appears
that it performs internally only those functions which require close cooperative, joint, or
team production as predicted by Alchian and Demsetz. Nike is also a good exemplar of
Jensen and Meckling and Demsetz’ later observation that a firm is a “nexus of contracts”
and helps us visualize the broader production concept of “enterprise.” Employee welfare
activists and unions do not recognize the separation of production functions and seek to
hold Nike and other firms responsible for the conduct of their suppliers.

We expect that most of the functions outsourced exhibit decreasing costs per unit over a
significant range of output. In other words, at some point, entrepreneurs realize that a
particular function could be done more efficiently at a scale beyond that attainable by the
vertically integrated firms. This is consistent with the observed popularity of outsourcing
administrative and support functions such as human resources; billing and collections,
information technology management, etc. Once their central management and related
systems are established, these firms can expand output at incremental costs consisting
largely of additional specialists.

Firms in rapidly growing industries should be prone to spinning off functions and relying
on specialist suppliers. This is consistent with the evolution of the computer and health
care sectors. Early computer makers produced internally much of the electronic
components in their machine, but now all rely on a worldwide network of specialized
chip, drive, and screen makers.36

Of course, another stimulant to outsourcing arises when any of the intermediate cost
functions can be produced at a lower cost by another firm either at home or in another
country because the costs of inputs, say, labor are lower. Using the increasing cost
function Y3 from the graph above as an example, this is equivalent to a downward shift of
the Y3 curve and hence the total average cost curve. This is a matter of comparative
advantage and not a consequence of Stigler’s notion of the subdivision of functions
stimulated by increases in market size.

Economists view outsourcing (even to foreign countries) as a rational competitive

response to the relative costs of performing a function. Just as we’ll see that Alchian
argued that the evolutionary pressure of positive profits shaped and selected for firms,
shedding internal functions isn’t really an entirely discretionary choice dependent on

worth pursuing in its own right, ignoring the underlying economic foundations of firm scope and scale. We
prefer the term network manager to describe this sort of distributed operation.
36
Chip makers a la Intel and AMD are specialist firms with modest diversification. In other cases such as
screens, the parent may be diversified but the producing entities are specialized.

20
Class 2 Notes on Alchian and Demsetz (1972), Stigler (1951), Economics of Business, S1600,

management’s personal preferences as made clear in Jack Welch’s explanation as relayed

by Steven Kerr:37

“He (Welch) said let me give you some facts of life. We build washing
machines, dryers, refrigerators, and things like that in Louisville, Kentucky.
There are very aggressive unions and they get employees high wages. So let
us say our employees get $25 an hour in Kentucky. It takes 5 hours of labor
to build a box. …We build a box that costs $75. I get the same job done;
same quality box in Mexico at $4 an hour that would make the box cost
$20. Hence, I am spending $55 more to buy that box. Now, why don't I go
to Mexico? Because the public opinion reaction would cost me more than
$55 a box. I do not want to move the work to Mexico. Nevertheless, how
can I afford not to go? Because Whirlpool and Maytag look at the same
costs and they do not go either. It is not worth the bad publicity to them.
However, the Japanese and Korean producers are making the box in the
lower cost country. Their appliances will be just as good as ours will. They
will sell for $55 less. Consumer magazines, who would be yelling if we
were going offshore, will now recommend that people buy the Korean
machine because it is a lot cheaper and just as good. They are right. Jack
Welch would say, "It's not up to us." In other words, you cannot decide not
to send jobs to where cheaper labor is unless the society wants to put in
protective laws against it so you will be able to do it and still be
competitive. However, with the protective laws, there will be fewer imports.
You are protecting the employees who are working but now everybody in
America is spending much more to buy the same product. …
Congratulations, you have now made the cost of going to Mexico higher
than the cost of making it in Louisville, and now we will not go. If you are a
politician, you can say you saved jobs and tell your constituency you have
just increased the cost of the product by $55. Anybody can do that. That is
not skillful.”

Stigler pointed out also that protectionists' fears of undeveloped countries leapfrogging
developed economies by adopting current technology and methods are probably
overblown. The developing country’s educational system may not be able to produce
enough employees with the skills necessary to staff complex functions. Developing
countries, especially those that are restricted from trading freely with large markets,
usually experience difficulty nurturing large vertically integrated firms. Their
comparative advantage most often lies in labor-intensive activities, hence the frequent
charge of labor exploitation. Without access to larger markets, entrepreneurs will be
unable to specialize in the decreasing cost functions in which they might otherwise be
competitive. Globalization, especially the spread of tariff-free trading blocs, increases the
effective size of markets, reduces the costs of external sourcing, and promotes
specialization by both domestic and international organizations.

37
Kenneth R, Thompson, “A conversation with Steven Kerr: a rational approach to understanding and
teaching ethics. (Interview),” Journal of Leadership & Organizational Studies, December 22, 2006. Also
available on-line at http://www.accessmylibrary.com/coms2/summary_0286-29101977_ITM

21