Austrian Economics Austrian Economics and and

Management StudiesManagement Studies

Peter Lewin: University of Texas at Dallas

plewin@utdallas.edu

http://www.utdallas.edu/~plewin/FEE/

Conventional Wisdom: Conventional Wisdom: ““There is no theory of the firm” There is no theory of the firm” – is this true?– is this true? Neo-Classical black box – but for decades all kinds of work on the Neo-Classical black box – but for decades all kinds of work on the

nature of economic organization has been taking place. nature of economic organization has been taking place. The watershed was Coase 1937 “The Nature of the Firm” to be The watershed was Coase 1937 “The Nature of the Firm” to be

rediscovered by management and served as the basis for the “New rediscovered by management and served as the basis for the “New Institutional Economics” (Oliver Williamson 1975); also work by Alchian, Institutional Economics” (Oliver Williamson 1975); also work by Alchian, Demsetz, Klein, el. al. UCLA.Demsetz, Klein, el. al. UCLA.

Austrians? Mises has it all - Austrians? Mises has it all - Bureaucracy Bureaucracy (Nicolai Foss); Hayek – orders (Nicolai Foss); Hayek – orders and organizations. and organizations.

O’Driscoll and Rizzo - "there is no subjectivist or Austrian theory of the O’Driscoll and Rizzo - "there is no subjectivist or Austrian theory of the firm" (O'Driscoll and Rizzo 1985, p. 123) – “By the 1990s, this once empty firm" (O'Driscoll and Rizzo 1985, p. 123) – “By the 1990s, this once empty ground had become a lively bazaar of Austrian theories of the firm.” ground had become a lively bazaar of Austrian theories of the firm.” (Dulbecco and Garrouste 1999; Foss 1994; Langlois 1992; Lewin and (Dulbecco and Garrouste 1999; Foss 1994; Langlois 1992; Lewin and Phelan 2000; Sautet 2000; Yu 1999). other fringes of the economics Phelan 2000; Sautet 2000; Yu 1999). other fringes of the economics profession (Nelson and Winter 1982; Teece 1980) and from business profession (Nelson and Winter 1982; Teece 1980) and from business schools (Wernerfelt 1984) schools (Wernerfelt 1984)

Management and other literatures have much to say.Management and other literatures have much to say.

There are many “theories” of the firm – so what? How are they related? What There are many “theories” of the firm – so what? How are they related? What does it add up to?does it add up to?

* This presentation is based on “The Austrian Theory of the Firm: Retrospect * This presentation is based on “The Austrian Theory of the Firm: Retrospect and Prospect” by Richard Langlois, and Prospect” by Richard Langlois, Organization Studies, Organization Studies, forthcoming.forthcoming.

Is there a theory of the Is there a theory of the FirmFirm**

According to Coase there are cost to According to Coase there are cost to using the market – exchange using the market – exchange (transactions) costs. (transactions) costs.

There are also costs to governing There are also costs to governing (administration of ) the firm – governance (administration of ) the firm – governance costs.costs.

the boundaries of the firm are the boundaries of the firm are determined where the sum of the these determined where the sum of the these two types of costs are minimized - MTC = two types of costs are minimized - MTC = MGC.MGC.

Coasian Economics and The Coasian Economics and The size of the firmsize of the firm

Coasian Economics and The Coasian Economics and The size of the firm.size of the firm.

$

T* Number of transactions (ordered from most to least costly to execute through the price mechanism).

Costs of using the price system – transactions costs

Costs of administrative coordination – governance costs

CPS + CAC

Size of the firm.

MTC = MGC

HayekHayek 1945: “The Use of Knowledge in 1945: “The Use of Knowledge in Society”:Society”:Knowledge is idiosyncratic and dispersed Knowledge is idiosyncratic and dispersed

often tacit.often tacit.

It cannot be centralized – the special It cannot be centralized – the special circumstances of time and place – its circumstances of time and place – its emergent quality. emergent quality.

This is the famous This is the famous “Knowledge Problem” “Knowledge Problem” (Lavoie).(Lavoie).

Hayek, Coase and the FirmHayek, Coase and the Firm

Whereas Hayek abstracts away from costs of using Whereas Hayek abstracts away from costs of using markets in order to make his case against central markets in order to make his case against central planning, Coase seems to have a unified theory of both planning, Coase seems to have a unified theory of both firm and market. firm and market.

But his “theory” of the costs of internal administration But his “theory” of the costs of internal administration amounts to little more than a claim that there are amounts to little more than a claim that there are inevitably decreasing returns to the managerial inevitably decreasing returns to the managerial function (for reasons largely unspecified) and perhaps function (for reasons largely unspecified) and perhaps to other factors of production as well.to other factors of production as well.

Hayek’s knowledge problem applies Hayek’s knowledge problem applies insideinside firms as firms as well.well.

Hayek, Coase and the FirmHayek, Coase and the Firm

Using Hayek to rewrite CoaseUsing Hayek to rewrite Coase Coase is really about Coase is really about novelty and changenovelty and change::

Owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do. 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 commodity or service. 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. ... 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. (Coase 1937, pp. 391-392 .) .)

From this perspective we see that the essence of the firm, and its From this perspective we see that the essence of the firm, and its source of advantage over product markets, lies in its flexibility in source of advantage over product markets, lies in its flexibility in circumstances of change and uncertainty. circumstances of change and uncertainty.

By substituting an employment contract for a spot contract in output, By substituting an employment contract for a spot contract in output, “the buyer” can manage economic activity in real time. which action “the buyer” can manage economic activity in real time. which action x ∈ Ω the worker will perform (Simon). x ∈ Ω the worker will perform (Simon).

The uncertainty is about which task will be needed at a particular The uncertainty is about which task will be needed at a particular moment, not about the set of possible tasks or the precise nature of moment, not about the set of possible tasks or the precise nature of those tasks. – (Alchian, Demsetz, Williamson) those tasks. – (Alchian, Demsetz, Williamson)

““costs of using the price system”: moral hazard, principal-agent problems, costs of using the price system”: moral hazard, principal-agent problems, information (not knowledge) asymmetry, and what Williamson took to information (not knowledge) asymmetry, and what Williamson took to calling “opportunism.” calling “opportunism.”

Within the mainstream economics literature, this concern with incentives Within the mainstream economics literature, this concern with incentives quickly came to dominate and largely crowd out explanations from quickly came to dominate and largely crowd out explanations from coordination3 (Langlois and Foss 1999). coordination3 (Langlois and Foss 1999).

an intellectual opportunity to bring Austrian ideas to bear on the Coasean an intellectual opportunity to bring Austrian ideas to bear on the Coasean question.question.

Using Hayek to rewrite CoaseUsing Hayek to rewrite Coase

Both production and exchange depend on Both production and exchange depend on idiosyncratic local knowledge idiosyncratic local knowledge

““the knowledge of the particular circumstances of time and place” (p. 522). the knowledge of the particular circumstances of time and place” (p. 522). This is in contrast to the notion that, especially in production, the relevant kind This is in contrast to the notion that, especially in production, the relevant kind of knowledge is explicit (“scientific”) and thus easily transmitted and used. of knowledge is explicit (“scientific”) and thus easily transmitted and used.

The problem of The problem of coordinationcoordination of both production and exchange involves of both production and exchange involves making making the best use of dispersed knowledgethe best use of dispersed knowledge

which “depends on whether we are more likely to succeed in putting at the which “depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans in with those of others” (p. 521). enable them to fit their plans in with those of others” (p. 521).

This is ultimately This is ultimately a dynamic problem a dynamic problem not a comparative-static one: not a comparative-static one:

““economic problems arise always and only in consequence of change” (p. economic problems arise always and only in consequence of change” (p. 523). 523).

Using Hayek to rewrite CoaseUsing Hayek to rewrite Coase

Capabilities and CostsCapabilities and Costs There have emerged two essential There have emerged two essential

components of an Austrian theory of the size components of an Austrian theory of the size of the firm: of the firm:

economic capabilities economic capabilities

&&

dynamic transaction costs. dynamic transaction costs.

CapabilitiesCapabilities Capabilities: firms as well as individuals are likely Capabilities: firms as well as individuals are likely

to have different sets of “knowledge, experience, to have different sets of “knowledge, experience, and skills” - Edith Penrose (1959) and George and skills” - Edith Penrose (1959) and George Richardson (1972), but was largely reinvented in Richardson (1972), but was largely reinvented in the work of Nelson and Winter (1982), Teece the work of Nelson and Winter (1982), Teece (1980), and others. (1980), and others. Richardson – the finest critique of perfect competition Richardson – the finest critique of perfect competition

around – influenced by Hayek – helpful imperfections around – influenced by Hayek – helpful imperfections in a world of interactive uncertainty.in a world of interactive uncertainty.

Penrose – student of Machlup – influenced by Penrose – student of Machlup – influenced by Boulding – resources (capabilities) change over time – Boulding – resources (capabilities) change over time – excess capacity develops. Sparked the RBV of the firm.excess capacity develops. Sparked the RBV of the firm.

Tacit and dispersed Tacit and dispersed knowledge.knowledge.

Michael C. Jensen (1939-)

Economic organization must solve two different kinds of problems – Jenson and Meckling Explicitly echoing Hayek The rights assignment The rights assignment

problem: problem: determining who should determining who should exercise a decision right.exercise a decision right.

The control or agency problem: The control or agency problem: ensuring that self-interested ensuring that self-interested decision agents exercise their rights decision agents exercise their rights in a way that contributes to the in a way that contributes to the organizational objective. organizational objective.

Dispersed knowledge and Dispersed knowledge and Capabilities.Capabilities.

Jensen and Meckling (1992, p. 251) point there are Jensen and Meckling (1992, p. 251) point there are basically two ways to ensure such a “collocation” of basically two ways to ensure such a “collocation” of knowledge and decision-making: knowledge and decision-making:

““One is by moving the knowledge to those with the One is by moving the knowledge to those with the decision rights; - Firms.decision rights; - Firms.

the other is by moving the decision rights to those the other is by moving the decision rights to those with the knowledge” – Markets.with the knowledge” – Markets.

(Jensen and Meckling 1992, p. 253). (Jensen and Meckling 1992, p. 253).

Dynamic Transactions CostsDynamic Transactions Costs Transactions Costs my be static (mundane) or Transactions Costs my be static (mundane) or

dynamic (real time) dynamic (real time) Mundane Costs: information costs, including moral hazard and asset Mundane Costs: information costs, including moral hazard and asset

specificity. specificity. Dynamic Costs: costs of creating, adapting or redeploying capabilities in Dynamic Costs: costs of creating, adapting or redeploying capabilities in

the face of change - more interesting circumstances involving learning the face of change - more interesting circumstances involving learning and the generation of new productive knowledge. and the generation of new productive knowledge.

Location of capabilities.: At any historical instant, relevant capabilities may be located Location of capabilities.: At any historical instant, relevant capabilities may be located predominantly in markets or predominantly in firms. seizing an entrepreneurial opportunity predominantly in markets or predominantly in firms. seizing an entrepreneurial opportunity requires creating capabilities that do not yet exist, it may prove cheaper to do so using the requires creating capabilities that do not yet exist, it may prove cheaper to do so using the structures of ownership and authority that we call a firm than by somehow transferring the structures of ownership and authority that we call a firm than by somehow transferring the relevant knowledge to contractual partners. relevant knowledge to contractual partners.

The pattern of existing capabilities in firm and market. The pattern of existing capabilities in firm and market. The extent of the market and the level of development of market-supporting The extent of the market and the level of development of market-supporting

institutions. institutions. The nature the economic change called for. (Visible and Vanishing Hands).The nature the economic change called for. (Visible and Vanishing Hands).

Coase: The size of the Coase: The size of the firm.firm.

“It should be noted that most inventions will change both the costs of organizing and the costs of using the price mechanism. In such cases, whether the invention tends to make firms larger or smaller will depend on the relative effect on these two sets of costs. For instance, if the telephone [or the internet] reduces the costs of using the price mechanism more than it reduces the costs of organizing, then it will have the effect of reducing the size of the firm.” (Coase 1937, p. 397n.)

Ronald H. Coase (1910-)

Capital and its structureCapital and its structure Austrian literature has always featured prominently Austrian literature has always featured prominently

in management studies because of in management studies because of entrepreneurship – Kirzner and Schumpeter. entrepreneurship – Kirzner and Schumpeter. Entrepreneurial studies are on the rise.Entrepreneurial studies are on the rise. Recently the other, closely related, more Recently the other, closely related, more

fundamental, Austrian element is Capitalfundamental, Austrian element is Capital Going back to Menger and (especially) Böhm-Bawerk - capital is not Going back to Menger and (especially) Böhm-Bawerk - capital is not

a homogeneous factor of production but a complex structure of a homogeneous factor of production but a complex structure of relationships among specialized assets according to degrees of relationships among specialized assets according to degrees of “roundaboutness” of production. “roundaboutness” of production.

The real economic significance of the heterogeneity of capital lies in The real economic significance of the heterogeneity of capital lies in the fact that each capital good can only be used for a limited the fact that each capital good can only be used for a limited number of purposes. number of purposes.

Smith: division of labor; Hayek: division of knowledge: Lachmann: Smith: division of labor; Hayek: division of knowledge: Lachmann: division of capital.division of capital.

Over time the capital structure becomes more complex, specialized Over time the capital structure becomes more complex, specialized – contains more complementary relationships.– contains more complementary relationships.

Capital ComplementarityCapital Complementarity Two types of capital complementarity: Two types of capital complementarity:

plan complementarity: the complementarity of capital goods within the framework plan complementarity: the complementarity of capital goods within the framework of one plan, brought about directly by entrepreneurial action. The making and of one plan, brought about directly by entrepreneurial action. The making and revision of such plans is the typical function of the entrepreneur. revision of such plans is the typical function of the entrepreneur. Capital Capital combinations combinations and and capital regroupingcapital regrouping..

structural complementarity: the over-all complementarity of capital goods within structural complementarity: the over-all complementarity of capital goods within the economic system. Brought about indirectly by the market, viz. by the interplay the economic system. Brought about indirectly by the market, viz. by the interplay of mostly inconsistent entrepreneurial plans. (Lachmann 1956.) of mostly inconsistent entrepreneurial plans. (Lachmann 1956.)

Lachmann insists, the function of the entrepreneur is “to specify and make Lachmann insists, the function of the entrepreneur is “to specify and make decisions on the concrete form the capital resources shall have. He specifies decisions on the concrete form the capital resources shall have. He specifies and modifies the shape and layout of his plant, which is something he and modifies the shape and layout of his plant, which is something he cannot do to his typists, desirable though that may seem to him. As long as cannot do to his typists, desirable though that may seem to him. As long as we disregard the heterogeneity of capital, the true function of the we disregard the heterogeneity of capital, the true function of the entrepreneur must also remain hidden. In a homogeneous world there is no entrepreneur must also remain hidden. In a homogeneous world there is no scope for the activity of specifying” (Lachmann [1956] 1978, p. 16). scope for the activity of specifying” (Lachmann [1956] 1978, p. 16).

Organization, change and Organization, change and modularitymodularity

Systemic Change: When the change requires systemic innovation, Systemic Change: When the change requires systemic innovation, internal coordination may be cheaper; internal coordination may be cheaper;

Autonomous Change: When change requires autonomous Autonomous Change: When change requires autonomous innovation, market coordination may prove cheaper (Langlois innovation, market coordination may prove cheaper (Langlois 1992; Teece 1986). 1992; Teece 1986).

Modularity: Whether systemic innovation is required will depend Modularity: Whether systemic innovation is required will depend on the modular structure of the technologies and organizations on the modular structure of the technologies and organizations involved (Langlois 2002; Langlois and Robertson 1992, Lewin 2005).involved (Langlois 2002; Langlois and Robertson 1992, Lewin 2005).

Modularity refers to degrees of connectedness and interaction at Modularity refers to degrees of connectedness and interaction at different levels. It is a principle of organizing capabilities to achieve different levels. It is a principle of organizing capabilities to achieve a division of labor/knowledge/capital. Benefits include:a division of labor/knowledge/capital. Benefits include: Knowledge economiesKnowledge economies Enhanced flexibility – reducing the vulnerability of specialization that comes Enhanced flexibility – reducing the vulnerability of specialization that comes

with capital complexity.with capital complexity. Therefore, greater, more rapid, learning and adaptation.Therefore, greater, more rapid, learning and adaptation.

Back to Richardson and Back to Richardson and PenrosePenrose

George Richardson (1972) focused not on George Richardson (1972) focused not on assets but on activities complementary in the assets but on activities complementary in the chain of production. chain of production. Similar and dissimilarSimilar and dissimilar. Thus . Thus firms will tend to integrate not into firms will tend to integrate not into complementarycomplementary activities (unless they are also activities (unless they are also similar or unless they have to) but into activities similar or unless they have to) but into activities that require similar capabilities. that require similar capabilities.

As Penrose (1959) - firms create managerial As Penrose (1959) - firms create managerial resources (capabilities) in the course of carrying resources (capabilities) in the course of carrying out their activities. out their activities.

Taking StockTaking Stock Many Austrian ideas today are being extended by legions of Many Austrian ideas today are being extended by legions of

academics elsewhere in the academy, albeit not those in the academics elsewhere in the academy, albeit not those in the mainstream of the economics profession. mainstream of the economics profession.

Resource Based View Resource Based View (RBV) of the firm (Mahoney and Pandian (RBV) of the firm (Mahoney and Pandian 1992; Wernerfelt 1984, 1995) grows explicitly out of Penrose, and 1992; Wernerfelt 1984, 1995) grows explicitly out of Penrose, and the so-called the so-called dynamic-capabilities approach dynamic-capabilities approach (Teece, Pisano and (Teece, Pisano and Shuen 1997) is closely related. Shuen 1997) is closely related. Modularity coordinationModularity coordination, especially , especially in the face of radical uncertainty and of tacit and localized in the face of radical uncertainty and of tacit and localized knowledge. Most recently a knowledge. Most recently a cognitive theory of the firmcognitive theory of the firm (building (building on Simon and others). on Simon and others).

The bad news is that these important ideas are still far from having The bad news is that these important ideas are still far from having been absorbed by the mainstream. The good news is that there is been absorbed by the mainstream. The good news is that there is still much for Austrians to do, and to claim already to have done, in still much for Austrians to do, and to claim already to have done, in the theory of the firm. the theory of the firm.