Wednesday, December 23, 2015

The Firm as a Time Lord

Why does some economic activity happen in the form of buying and selling within markets, while other economic activity happens through an administrative process of  planning and actions taking inside of firms? What factors affect the decision of whether firms will tend to take a certain activity in-house, or instead will contract to buy that activity in the market? A recent article in The Economist ("Time and the Company," December 5, 2015), offered an intriguing take on this classic question:
"In the 1930s Ronald Coase, an economist, argued that firms existed to perform tasks that entrepreneurs were unable to do easily through markets. But another way of thinking about firms is that they are time transformers, mediating the different time horizons of customers, staff, suppliers and owners. Bondholders, for example, want a steady stream of payments over decades, a stream derived from customers paying instantly for products that take weeks to make and transport and that are sold by staff who are employed for years. The company is the body that can satisfy all of these constituents. This capacity to straddle time frames is most extreme in banks, which raise money in the form of deposits that can be withdrawn immediately and extend that money as loans that take years to repay, an inherently risky process known as `maturity transformation'. But the transformation of time is the business of all companies, not just financial ones."
At least to me, this comment doesn't seem quite fair to Coase and his classic 1937 article "The Nature of the Firm" (Economica, November 1937, pp. 386-405). (Those not familiar with the article will find it a readable trove of insights. A fundamental insight of economics going back to Adam Smith is how supply and demand through the price mechanism operates like a pattern of unconscious cooperation. But as Coase writes, these arguments for the merits (or problems) of the price mechanism don't apply very well to the decision-making that happens within large firms--and these large firms had exploded onto the scene and multiplied in the decades before Coase was writing in 1937. As Coase wrote, quoting D. H. Robertson, firms are "islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”

It's true that Coase emphasizes that an underlying justification for firms is that using the price mechanism and the market is costly, because it required negotiation of contracts. Coase wrote (footnotes omitted):
The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organising” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.
In that spirit, much of the work by economists since then on the theory of the firm has looked at difficulties of writing contracts that would specify under all circumstances what property rights would emerge. For a recent example of thinking along these lines Philippe Aghion and Richard Holden wrote an essay "Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years?" for the Spring 2011 issue of the Journal of Economic Perspectives (25:2, pp. 181-97).

However, other parts of Coase's 1937 argument do emphasize that firms are straddling a time dimension. For example, Coase writes:
There are, however, other disadvantages-or costs of using the price mechanism. It may be desired to make a long-term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided. Or, owing to the risk attitude of the people concerned, they may prefer to make a long rather than a short-term contract. ... It may well be a matter of indifference to the person supplying the service or commodity which of several courses of action is taken, but not to the purchaser of that service or commodity. But the purchaser will not know which of these several courses he will want the supplier to take. Therefore,  the service which is being provided is expressed in general terms, the exact details being left until a later date. All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser, When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a " firm " may be obtained.' A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory. It is obviously of more importance in the case of services--labour--than it is in the case of the buying of commodities. In the case of commodities, the main items can be stated in advance and the details which will be decided later will be of minor significance. 
In some ways, thinking about the nature of the firm as straddling a number of different economic relationships that involve different time horizons is not fundamentally different than an approach which looks at why firms may arise out of incomplete contracts. But the emphasis on different time horizons offers a different slant. In recent years, for example, the time horizons of many players in economic markets have changed: the time horizons of how long investors are willing to wait for a payback; the time horizon of new products emerging; the time horizon of how long workers and their employers expect them to remain with a single firm; and so on. As the time horizons of different players evolve, and the boundaries of what firms will choose to include or to leave out would evolve as a result.

Note: Some may be puzzled by the phrase "Time Lord" in the title of this post. Congratulations! You are even more detached from popular culture than I am, which is not a small achievement. There is a popular television show called Dr. Who, in which the main character is a "Time Lord." Ask a teenager for details.