The Nature of the Firm

Why don’t auto workers just manufacture pieces of automobiles and sell their work product on the open market? Why don’t I provide “actuarial analysis” from my home, sitting in my pajamas at a laptop, and sell it to the highest bidder? Why don’t software engineers write code in their basement and sell it piecemeal to interested buyers? No doubt some of this kind of freelance labor exists, but for the most part people work for firms. That is, most workers have long-term arrangements to work exclusively for a single company. They are paid an hourly wage or a salary. Some might get a sort of “performance pay” or rate for piece work, but by and large they are not selling their work product in anything like an open market.

A long time ago, this looked like an interesting puzzle to Ronald Coase. The economy as a whole is characterized by open markets and the free buying and selling of goods and services. But within the economy there are these tiny islands of socialism called “firms.” If open-market buying and selling is relatively efficient for the economy as a whole, why should individual firms resort to centralized planning? In his paper The Nature of the Firm, Coase tries to solve this puzzle.

I won’t give you a full review of the paper, mostly because I haven’t read it. You can find good discussions of it elsewhere, see here or here for example. (Seriously, listen to the Econtalk with Mike Munger. "Bunny slippers. Tell me about bunny slippers." It's priceless.) And besides it’s only 20 pages, so shame on me for not having read it yet. But I’ll give the cliff-notes version and talk about why corporate bureaucracy in practice is disappointing.

Coase’s answer was that firms reduce transaction costs between individuals within the organization. The programmer writes and maintains code for his employer for a specific purpose. He gets paid whether it’s a busy time or a relatively easy time. If the department that uses his code finds an error, he’s right there to fix it. Versus if he were selling code piecemeal, there would be no guarantee he’d have the free time to fix it. Mr. Freelance Programmer could perhaps shove a contract in a disappointed clients face and say, “Honor served. I did what you asked of me.” Of course the client could sue the programmer if they disagree about the contract's fulfillment, but this would take time and resources. Transaction costs loom large in this world of freelance labor. It would be time-consuming to pre-specify every likely contingency or disappointment in a contract, and it’s even more time-consuming to sue for breach of contract. Long-term relationships and dominance hierarchies can solve these problems. If the code breaks, your boss simply tells you to fix it. He doesn’t need to sue you, because the threat of losing your job for insubordination keeps you in line. Your annual pay-raises and bonuses are, at least vaguely and on average, related to the quality of your work, so you have an incentive to create a good work product. This is the ultimate repeat-business relationship.

The same goes for many other kinds of relationships. The auto-worker needs to reliably show up to work on the assembly line, which requires inputs from a hundred other people to keep moving. Someone could try to write a contract binding all these people together on a day-to-day basis and distribute the proceeds of selling the piece-work equitably. But it’s a lot easier for a single employer to simply buy all the machines and other capital and employ the workers on some kind of ongoing basis. Potential conflicts and legal disputes between n(n-1)/2 pairs of individuals are thus minimized. Those workers are more productive, thus there is a greater surplus for all involved parties to share, thus their pay is higher than it would be in a freelance world. Or consider a free-lance capital owner, someone who buys or builds the assembly line with the intention of renting it out at "the market price" to freelance laborers. In this messy and confusing world, I think everyone would quickly see the advantage of forming long-term relationships and dominance hierarchies. 

So why does this go so horribly wrong in the real world? Why is corporate bureaucracy so stifling? Why do some bureaucracies actively fight the lessons of Coase and erect barriers to communication? If corporate bureaucracy is supposed to minimize transaction costs, why does it seem to increase them? 

Most companies have some kind of acquisitions process, perhaps even an entire department. This is to some degree necessary. You can’t just say “yes” every time an employee asks for a new tool or shiny new toy. But often the process is ill-defined and clumsy. There aren’t enough acquisitions staff to handle the requests, or they don’t know how to prioritize the flood of requests. Almost everyone has seen something like this: “If the Acquisitions Department would just buy the damned software, the company would save thousands of dollars worth of employee hours every year. What’s the damn hold-up!?” But someone has to sift through the requests to see if they have merit or don’t. And sometimes the requester is mistaken about the value-added. Still, the process often takes way too long, or it stops because you didn’t fill out the right request form and nobody told you your request got halted. There are times when I’ve said, “If I could pay out-of-pocket and install the software or hardware myself, I would do so, because the added productivity is worth that much to me. The surplus to the company as a whole is even greater than that, but whatever. That’s their loss.” And in fact I paid for a year’s subscription to Datacamp rather than waiting for my employer to do so, because I felt I was wasting time by waiting. It was a good investment. Why did my employer erect these huge barriers to free communication? Why did it fail to reduce transaction costs? It's pretty bad when your employees are longing for an open market in order to actually get shit done. 

Some departments come up with schemes for keeping track of special requests. These can be stifling. “Fill out this form, and submit it via this web portal.” Fuck you, how about this. How about I have a conversation with one of my colleagues, one professional to another, and that colleague performs a task for me because we’re both trying to add value for our employer? “Oh, you want me to submit a ticket through the obscure internal portal that I use once a year? Okay, do you remember the instructions. No? Okay, whose department is that? Oh, I don’t have permission to use that portal? I’ll have to get access, then set up a user name and password. Oops, it won’t add me as a user. Which apparently means I already have an account? Okay, how do I recover my username or reset my password?” 

I have tremendous respect for one of my former colleagues. He basically "hired" one of our programmers to build something useful for him by buying him a few rounds of golf. This guy knew how to get some shit done, and he went outside the bureaucracy to do it. On the other hand, this is a sign of a dysfunctional bureaucracy. My friend should have been able to get the programming resources necessary to complete his project. Bad management made this impossible. The company was failing, in this instance, to perform its Coasian role of reducing transaction costs between employees. Some particularly dedicated employees essentially said, "Screw it, I'll just go out and buy one."

I don't think my past employers were particularly dysfunctional. I think it's probably like this everywhere. I don't have a solution, either. It is genuinely difficult to "manage" a very large group consisting of thousands of individuals, who sometimes have conflicting goals. Maybe organizations should "institutionalize" the process of going around the bureaucracy. Each department has a flexible spending budget for instances of "Screw it, I'll go out and buy one." The procurement department tracks these to identify where its processes are broken. Revealed preference helps identify requests that are truly needed, as opposed to requests that are frivolous. As in, "If they're willing to spend out of their own budget for this, even out of their own pockets sometimes, maybe that means it's really useful. We should probably just shell out for it."