Saturday, 3 December 2016

The division of labour and the firm: Robinson (1931)

This material relates to Robinson (1931).

One of the earliest attempts to relate the division of labour to the size of firms was Robinson (1931). In The Structure of Competitive Industry Robinson offered an analysis of the factors that determined the optimum size for a firm. For Robinson the interaction of five factors determined the size of the firm: technique, management, finance, marketing and risk of fluctuations. These various theoretical optima have then to be reconciled in the size or constitution of a real firm after allowing for difficulties and anomalies of growth. The division of labour has a role to play with regard to technique and management. Because of this we will concentrate on these two factors here.

For Robinson the optimum firm is that firm which in existing conditions of technique and organising ability produces at the minimum of long-run average costs. Under the conditions of perfect competition we would expect to see the optimum firm emerge but under conditions of imperfect competition, Robinson notes, it may not materialise. Consider, for example, the case of monopolistic competition in which a firm will be in equilibrium at less than the minimum of average cost.

The first application of the division of labour to the size of the firm that Robinson considers is the relationship between the division of labour and the optimum technical unit. Robinson follows Adam Smith in seeing three different reasons for the division of labour giving rise to more efficient production. First is the increase in dexterity of workmen; secondly, the saving of time which is commonly lost in passing from one type of work to another; and thirdly, the invention of a great number of machines which facilitate and abridge labour, and thus enable one person to do the work of many.

With regard to the issue of dexterity, Robinson notes Smith's observation that a person who works at a given task for some time is likely to develop a skill or knack for doing that task. In addition the division of labour can allow those people with a natural skill for carrying out a given task to specialise in that task.

Adam Smith (and Robinson) also saw an advantage in the division of labour in that specialisation at a task saved the time that would otherwise be spent on passing from one task to another. Time could be saved because workers do not have to move between machines or processes. Also time would be lost if machines had to be reset to perform a different function. The division of labour saves time by concentrating both workers and machine upon a given function, and a larger factory enjoys an advantage over a smaller one in so far as it makes this concentration possible.

The third economy Smith saw is due to the development of specialised equipment to carry out the tasks that the manufacture of an item is divided into. Separation of a process into its constituent parts makes development of machines to carry out those parts easier.

It is important to keep in mind when considering the size of a firm that the principle of the division of labour requires a firm of sufficient size to obtain the maximum profitable division of labour. This size will differ across industries depending on the nature of the production process for that industry and how detailed a division of labour can be implemented for that particular process. Larger firms will, often, have the capacity to implement a greater division of labour than a smaller firm, giving the larger firm an advantage in terms of efficiency.

The next issue discussed by Robinson is what he calls `the integration of process'. Robinson explains that often a large firm has fewer rather than more processes of manufacture. They can utilise a large machine which has been designed to takeover what would otherwise be a series of manual, or at least less completely mechanical, operations. A complicated machine can perform two or three or more consecutive processes and it can thereby eliminate the labour and time which would be required to up the work on each of the successive earlier machines. Only large firms can keep such a machine running at its full capacity and this fact gives the large firm an advantage over the smaller, and less mechanised, firm. But this difficulty can be overcome by the small firm as long as the size of the market for the process is large enough. If a given process requires a scale of production too great for a smaller firm the small firm can outsource the process to specialist firm. But such outsourcing if only possible if the extent of the market for a particular process is large enough to allow the division of labour to develop to the point where a specialist firm is viable. Robinson refers to this outsoucing as 'vertical disintegration'.

The second of the areas for which Robinson sees the division of labour having a role to play is with regard to management. A manager in a small firm will have multiple tasks to preform, some of which he will be good at, others that he will not be so good at. In a larger firm a division of labour can develop which allows managers to specialise on those function for which they are best suited. The larger firm gains in two ways from its division of managerial labour: 1) special abilities to be used to their fullest extent. Talents are not wasted by having managers carry out functions which could be better assigned to another manager with a particular ability at that function. 2) a manger who specialises in a given task will increase their knowledge of that task.

A potential downside of the managerial division of labour is the problem of coordination. As the division of labour becomes greater the problems associated with the coordination of the different parts of the production process also increases. As new tasks are created by dividing up the production process, new administrative functions are also created to coordinate the ever more disjoint production process. The advantage that a larger firm has over the smaller depends, in a large part, on how well it solves this coordination problem.

An additional theoretical problem with Robinson's discussion follows from the implicate assumption in the competitive model that complete contracts can be written. In such a world it is not clear why a firm is needed to carry out production at all. As Coase (1937) first highlighted in a world of complete contracts any organisation form can mimic any other meaning that production could be carried out via the market just as efficiently as within a firm.

  • Coase, R. H. (1937). `The Nature of the Firm', Economica, New Series 4 No. 16 November: 386-405.
  • Robinson, E A G. (1931). The Structure of Competitive Industry, Cambridge: Cambridge University Press.

Friday, 2 December 2016

Stories from the stone age First Farmers pt.2

Neolithic Revolution the Caucasian Resurrection.

Stories from the stone age First Farmers pt.1

Out of the Stone age and into the Neolithic one of human's most incredible accomplishments 6000 yrs before the pyramids. The story of Near Eastern "The First Farmers".

Saturday, 26 November 2016

Can Trump make the U.S. a ‘global subsidy cop’?

Has Trump actually come up with something right to do with trade? Are global subsidies a bad thing? Should we complain if other countries subsidise their industries? If other countries want to subsidise our consumption of imports should we care? Scott Lincicome argues that if the U.S. wants to end the practice of other countries subsidising key industries, it would require the U.S. to clean up its own business giveaways.

Friday, 25 November 2016

Resource misallocation & productive growth

Chang-Tai Hsieh, IGC steering group member, explains why some firms are more successful than others, using Indian firms as a case study. The Indian example shows that entrepreneurs can find ways around inefficient regulation. The problem of course is that the workaround is not fully efficient, a better policy would be to remove the bad regulation in the first place. But as noted by Hsieh politicians aren't willing to go there. Another example of bad politics driving out good economics.

Wednesday, 23 November 2016

A challenge to mercantilists

A challenge from Don Boudreaux at the Cafe Hayek blog. Boudreaux issues the following challenge to any protectionist/mercantilist/economic-nationalist who might wish to take it on:
Identify one plausible economic problem caused by free trade that is unique to trade and commerce that spans political borders. Just one. That is, identify a problem with free trade that arises when people are free to buy and sell internationally but that does not arise when people are free to buy and sell intranationally.
In other words, what economic problems can we avoid by restricting international trade that we don't have to deal with in internal trade?  I've got to admit I've yet to think of anything even remotely plausible as an answer to this challenge.

The "Adaptation Cost" theory of the firm

This material is covers chapters 3 and 4 of Wernerfelt (2016). These chapters are, in turn, based on Wernerfelt (1997) and Wernerfelt (2015), respectively.

Wernerfelt considers two questions to do with the firm that he thinks important but go largely unanswered in the standard theory of the firm literature: What determines the choice between the use of the market, a firm or a contract? Why are all of these mechanisms so commonly used?

His answer to these questions is contained in the "Adaptation Cost" theory of the firm.

Start with a situation where a worker is providing a particular service to an entrepreneur. The entrepreneur's needs change so that the worker's service would have to also change if he is to stay with that entrepreneur. But the worker's productivity will suffer if he, either, changes the service he provides or changes to another entrepreneur and in either of these cases costs would have to be incurred due to the process of bargaining over the terms of a new agreement.

But the costs of worker adaptation are not just those of bargaining, there are also costs, in terms of lower productivity, if the worker has to change, either, to a new service or a new business. A worker is most efficient when he is "double specialised". That is, when he is continually providing the same service to the same business. If this "double specialisation" is not possible it is often second-best to specialise in one of the two dimensions and deal with occasional adaption in the other dimension. Some such adaptations, whether it be between two businesses or two services, are more costly than others.

The basic theory of the Adaptation Cost theory was developed in two papers by Wernerfelt, Wernerfelt (1997, 2015). To begin with the 1997 paper (chapter 3 of Wernerfelt 2016). The focus is on workers who supply businesses with services. The problem is that the needs of the businesses change. Three mechanism to deal with the changing needs are considered: employment, sequential contracting and price lists. In chapter 3 adaptation costs are mainly price determination costs only, since production costs are held constant.

Under the employment mechanism, workers and entrepreneurs negotiate on a once-and-for-all basis over the wage and a large set of services to be supplied on demand. This is similar to the situation in Simon (1951). Here a firm is made up of an entrepreneur and a number of workers who provide the entrepreneur with services via the employment mechanism while the scope of the firm is determined by set of workers thus employed by the entrepreneur. The downside of this is that since there are a large number of things to be bargained over the initial bargaining costs are large, but once agreement is reached there are no further costs incurred so the gains from trade are realised in each period.

Under the sequential contracting mechanism a new price gets negotiated whenever the business's requirements change and thus bargaining costs are incurred on each such occasion. However as the bargains are simpler than those required for the employment contract - the parties are bargaining over a single, known service - the per-occasion bargaining costs are lower.

With the price list, a set of price are agreed upon ex ante and then the list is referred to as needed. As with the case of sequential contracting the per-service bargaining costs are low but if the initial bargaining is over a very long list of prices those costs are high. Here the diversity of needs - how long the price list needs to be - is important to the relative attractiveness of the mechanism.

When the need for a change in service adaptation arise with sufficient frequency, the folk theorem allows us to assume that all trades are efficient under the employment and sequential contracting mechanisms, while under the price list mechanism all trades actually covered by the list are efficient. An implication of this is that there are no trading inefficiencies and thus the only bargaining costs involved are those associated with the mechanism process itself. Given this, the performance of each of the three mechanisms depends only on the costs of adapting to changes in the requirements of the businesses.

In the employment mechanism, costs are a one-time thing related to the negotiation of the wage agreement; for the sequential contracting mechanism the costs are the per-occasion costs of agreeing a price for that particular event; while for the price list mechanism the costs are those one-time costs involved in negotiating the price list plus the loss in the gains from trade for any situations not covered by the list.

Given that the employment mechanism has the lowest costs of adaption - just a verbal instruction - there exists a region in the parameter space, situations in which needs change frequently, in which the employment mechanism (weakly) dominates the other two mechanisms, see Figure 1.

From Figure 1 it is clear that price lists are good when they can be kept short, i.e. there a small number of services needed, sequential bargaining is good when changes are infrequent and employment is good when needs change frequently and many diverse adaptations are required.

Next consider the Wernerfelt (2015) paper (chapter 4 of Wernerfelt 2016). Importantly in this case adaptation costs are expanded to include the costs due to less efficient production. Specifically Wernerfelt assumes that there are gains from specialisation - where specialisation implies little in the way of adaptation - along two dimensions, first businesses and second, services. The former is modelled as an increase in adaptation costs for the worker each time he wants to service a different business. The latter is captured by assuming different workers are good at different things. In this situation three mechanisms are compared: employment, sequential contracting, as before, and markets. Again it is assumed that trade is ex post efficient in all three mechanisms. Wernerfelt concentrates on minimising adaptation costs.

Under the employment mechanism performance is delineated by the gains from trade in each period minus the one-off costs of negotiating the employment contract. The performance of sequential contracting is the gains from trade minus the bargaining costs incurred each period. The important thing about the market mechanism is that it allows workers to specialise in the services at which they are most efficient. "For example, instead of being superintendents they can be plumbers, carpenters, or electricians" (Wernerfelt 2016: 19). The advantage of this is that the gains from trade are increased but the disadvantage is that workers incur business adaptation costs (lose gains from specialisation) every time they switch businesses.

Wernerfelt shows that there are three regions in the parameter space in which each of the three mechanisms (weakly) dominates both of the two other mechanisms.

The relative performance of each of the three mechanisms depends on the frequency with which the needs of the businesses change, the gains from specialisation in an particular service, the business adaptation costs and bargaining costs. See Figure 2 and Figure 3.

Consider Figure 2. Markets are good when workers' between-business adaptation costs are low, that is, the gains from business specialisation are low and thus workers can cheaply switch between businesses; sequential contracting is good when changes in needs are infrequent; and employment is good when the cost advantage of service specialists are small and needs are changing quickly.

Another parameter is shown in Figure 3. Here "service specialisation" - the gains from specialisation in a particular service - is considered. Markets are good when service specialists are a lot more efficient than an employee carrying out many different tasks.

Wernerfelt (2016: 59) illustrates the effects of specialisation, switching costs and adjustment frequency with the example of the maintenance of a medium-sized apartment building,
The owner [of the building] will typically have an employee, the superintendent, perform minor repairs (``the toilet leaks"). The building generates a steady flow of small problems, they tend to be urgent, and the superintendent can solve each of them pretty well. On the other hand, certain minor renovations, such as those having to do with electricity (``install LED light bulbs in public spaces"), are normally done through the market. The jobs are often larger, service specialists can do them better, and the building does not need a full-time electrician. Major renovations, for which advance planning reduces the need for in-process changes, are typically governed by a bilateral contract subject to occasional, though typically costly, renegotiations.

The same example can illustrate the effects of size. A landlord who owns just one or two units will typically go to the market even for minor repairs because these units do not generate enough work to support a superintendent. On the other hand, very large landlords, such as universities, typically use specialist employees (their ``own" electricians) for both repairs and minor renovations.

The major prediction of this theory is that the more frequent are changes in needs the more attractive the employment contract becomes.

  • Simon, Herbert A. (1951). "A Formal Theory of the Employment Relationship", Econometrica, 9(3) July: 293–305.
  • Wernerfelt, Birger (1997). "On the Nature and Scope of the Firm", Journal of Business, 70(4): 489-514.
  • Wernerfelt, Birger (2015). "The Comparative Advantages of Firms, Markets, and Contracts", Economica, 82 no. 236: 350-67.
  • Wernerfelt, Birger (2016). Adaptation, Specialization, and Theory of the Firm: Foundations of the Resource-Based View, Cambridge: Cambridge University Press.

Tuesday, 15 November 2016

The division of labour and the firm: Stigler (1951)

"The division of labor is not a quaint practice of eighteenth-century pin factories; it is a fundamental principle of economic organization."
Stigler (1951: 193)

The following discussion covers material from Stigler (1951) which is one paper that offers a theory of the boundaries of a firm based on the division of labour. Interestingly Adam Smith, despite his famous discussion of the division of labour in the pin factory, did not develop a theory of the firm based on it.

Stigler begins his argument by saying that the division of labour, and its limit due to the extent of the market, lies at the core of a theory of the functions, and thus the boundaries, of a firm. Stigler outlines this theory in the second section of his paper.

In this theory a firm is seen as engaging in a series of distinct operations leading to the production of a final product. That is, the firm is partitioned not among its input markets but among the functions or process that determine the scope of its activities. And thus determine the firm's boundaries.

To allow the graphical representation of the firm's costs of production we will assume that the average costs of each activity depends only on the rate of output of the firm. In addition, if we assume that there is a constant proportion between the rate of output of each activity and the rate of output of the final product then all the cost functions can be drawn on the same diagram and the vertical sum of these costs will be the conventional average cost curve for the firm. With reference to the diagram below to produce q units of final output requires a given number of units of activity 1, costing C_1(q), a number of unit of activity 2, costing C_2(q), and a number of units of activity 3, costing C_3(q). These costs can be summed to give the average cost of production for q units of output, C_1(q)+C_2(q)+C_3(q).

With respect to the shape of the average cost curves for the various activities, some are increasing continuously (C_1), some are falling continuously (C_3) and some are conventionally U-shaped, (C_2).

Now consider the Adam Smith's idea that the division of labour is limited by the extent of the market. First take the activities for which there are increasing returns, Why doesn't the firm exploit the returns more fully and in the process become a monopoly in the output market? Because as the firm expands outputs other activities also have to be increased and some of these are subject to diminishing returns and these cost increases are such that they overwhelm the cost advantages of the increasing returns and increase the average cost of the final product. So why then does the firm not abandon these C_3-like activities and let some other firm (and thus industry) specialise in them to exploit the increasing returns fully? At a given time the market for these activities may be too small to support specialised firms. Given this firms must perform these activities for themselves.

But with an expansion of the market for the increasing returns activity firms specialised in that activity would develop. The firms currently carrying out this activity for its own consumption would forgo this activity and let it be taken over by a new (monopoly) firm. This monopoly could not fully exploit its market power however since it has charge a price which is less than the average cost of production for the firm abandoning the activity. As the market for this activity grows even larger the number of firms specialising in it grows. That is the industry becomes increasingly competitive.

The abandonment of this activity by the original firms will change the cost function for each firm. The cost curve, C_1, will be replaced by a horizontal line (the black dashed line in the diagram above) in the effective region. This also changes the average cost curve for the final product with the new curve (black dashed curve in the diagram above) being lower than the current curve.

What about the increasing cost case? Why not abandon or reduce use of those activities with increasing cost? Much of the previous discussion carries over to this case with the exception that as the market and the industry grows the original firms does not have to stop utilising that activity completely. Part of the needed use of that activity can still be produced in-house without high average (and marginal) cost, with the rest being purchased via the market.

  • Stigler, George J. (1951). "The Division of Labor is Limited by the Extent of the Market", Journal of Political Economy, Vol. 59, No. 3 June, pp. 185-193.

Sunday, 6 November 2016

Private funding of the Parker fight

Related to my previous posting on the withdraw of public funding for the Parker fight in Auckland comes this news from the New Zealand Herald on pay-for-view prices for the event.
Pay-per-view prices for Joseph Parker's heavyweight world title fight are set to go sky high, with punters and pubs expected to cop the fallout from Auckland Council's refusal on ratepayer funding.

The Herald on Sunday understands from a well-placed source that the pay-TV price for Parker's fight against Andy Ruiz Jr next month could now be set between $70 and $100.
The first point to make here is that this is one way for the event to be paid for by those who want to see the event.

The Herald also states,
The expected pay-TV spike comes after Auckland Council's events and economic development arm, Ateed, threw in the towel on funding the fight with ratepayer money.
Now for the bit I don't get about all of this, Why does the Herald journalist think that the pay-TV price has anything to do with public funding? I mean if the profit maximising price for screening the event is around $70 to $100 without public funding then why isn't this the profit maximising price with public funding?

If market conditions are such that the promoter can charge in the $70-$100 range for the fight when there is no public funding then those same conditions mean he can charge the same even with public funding. This basically just turns the public funding into a rent for the promoter.

It's a strange old world: good sense from JAFAland.

This bit of good news comes from
Just as they appeared set to announce Parker would fight Andy Ruiz Jr for the WBO title in the city on December 10, Auckland council's events arm Ateed have withdrawn their support for the event, leaving it in a state of limbo.

Ateed Chief Executive Brett O'Riley confirmed last night: "Ateed will not be providing financial sponsorship to Duco to stage the Parker/Ruiz fight."
O'Riley said it was not clear if staging the fight in Auckland would have "the desired outcomes of Auckland's Major Events Strategy" so the decision was made "not provide financial sponsorship for the fight."

It is understood Ateed's contribution was going to be "hundreds of thousands of dollars".
Looks like the ratepayers of Auckland have dodged a rather large bullet here.

From another Herald article comes this comment from Howick councillor Dick Quax who is opposed "throwing public money at a private event",
"Did anyone go to Zaire following the rumble in the jungle between George Foreman and Muhammad Ali. I don't think so," said Quax in a reference to the perceived benefits for Auckland.
Questions have to be asked as to whether the fight is a goer without some form of public money and if it isn't is there a justification for staging it in New Zealand. If there are real economic benefits to the fight being in Auckland why can't private funding be found to keep the fight there? If the private sector are not welling to back the event then does this tell us they really don't think they can capture (now or in the future) enough of the supposed benefits to justify backing the fight? Does this, in turn, suggest that the benefits aren't there? In which case why have the fight here?