Markets and firms

Ricen~heEwrwmiche

(1995)49,89-95

Book reviews Markets and firms Transaction Costs, Markets and Hierarchies. Christos Pitelis, Ed. oxford: Basil Blackwell. 1993. vii + 280 pp. Business Organization and the Myth of the Market Economy. By William Lazonick. Cambridge: Cambridge University Press. 1993. xiv + 372 pp. (pbk). Rejuvenating the Mature Business: The Competitive Challenge. By Charles Baden-Fuller and John M. Stopford. London: Boutledge. 1992. xi +232 pp. Reviewed by: bfARJNA BIANCHI Dipartimento di Economia e Tkrritorio, Universita’ di Cassino, c Cassino, Italy Introduction The debate on the role of the market with its impersonal and decentralized co-ordinating mechanisms, and on alternative forms of institutional arrangements based on more direct and planned decision rules, has received a fresh impulse in the recent newinstitutionalist analyses of firm organization. Transaction cost theory in particular, by suggesting that governance structures such as firms can assure efficiency gains over costly market transactions, has inspired a host of new enquiries on the emergence and functioning of this organization form as distinct from the market. As Pitelis reminds us in an opening survey of the issue, the merit of this new research stream has been to gradually transform economic theory from a mono-institutional theory, to a poly-institutional one (Pitelis, 1993: p. 6). A second analytical problem, strictly linked to the first, is that in an economic world of multiple institutions which change and interact, it becomes crucial to specify the decision process of the agents of change: are they simply adaptive, constrained maximizers over a given array of alternatives, or innovative builders of new ones? The three books reviewed here, address these themes from different perspectives. F’itelis’ book starts with a critical analysis of the logical implications of transaction cost theory in order to suggest a new interpretation of the role of the firm. Lazonick uses comparative historical analysis to explain firm dynamics. BadenFuller and Stopford explore the internal mechanisms and problem situations of business decisions from a business point of view. 0035-5054#&5/010089+07

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1. Markets and Hierarchies The collection of papers edited by Pitelis, lkzsuction Costs, Murkets and Hiemnchies, though acknowledging the merits of transaction cost theory 0, is homogeneously critical of this approach. The first point of critique is the basic Coasean idea that markets and firms simply represent alternative ways of performing the similar function of allocating scarce resources. In this way, the fundamental differences between the two institutional structures are left unexplored (Sawyer; p. 31), and any specification of the nature of the firm is simply modelled on the market concept (Fourie; p. 53). On the contrary, says Fourie, if we identify the general nature of firms with the management of some production process, the whole logical chain is inverted. Firms- as in the case of self-sufficient units of production-an exist without markets, but markets cannot exist without firms: markets simply link preexisting firms. Firms log@lly precede markets, and cannot be reduced to a device for the reduction of transaction costs (Fourie; p. 44). Pitelis in fact argues that what best describes the Coasean firm is a hierarchical employment relation whose mison o%tre lies in furthering the benefits of the division of labour in both production and exchange. Within Coase’s perspective instead, what is explained are the changes in the organizational forms of firms, not the existence of the firm as such. Kay too emphasizes that misconceptions about the &m (false hierarchies, he calls them) derive from an exclusive market or contract-based framework. For Kay, Williamson (who defines transaction as transference across technologically separable units) represents any transference as contractual even if it is not (as in the case of simple physical transference). In this way, the comparative foundation of Williamson’s analysis is seen to be simply between external and internal markets, not between markets and hierarchies (p. 247). Also, the role of asset specificity in explaining vertical integration is questionable. Asset specificity can in fact favour, rather than prevent, market solutions, as in the case of the mutual dependence created by firm-specific expertise; and, vice versa, asset non-specificity can create market problems, for example by making property rights protection ineffective (p. 249). How, though, do ha emerge? TCT’s inability to answer this crucial question Hodgson sees as its basic fault. In this approach, genuine uncertainty and bounded rationality are thought to be responsible for transaction costs, but the discovery of more efficient organization solutions seems to be costless. If, however, we introduce evolutionary tools to explain how governance structures are selected, then, as Hodgson also shows, new problems arise, such as group selection and the question of efficiency. One instance of the problem of group selection related to the

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firm is the problem of appropriability raised by Dow. If ex ante side payments cannot be arranged among the individual input suppliers, and they are not costless (as tacitly assumed by TCT), then the expost distribution of quasi-rent is decisive for the viability of governance structures (pp. 102 ff.). In contrast with the market-centred view of the firm, the authors in Transaction Costs, Markets and Hieramhies variously suggest that we regard the firm as a cohesive, durable institution (Fourie), as one centre of strategic decision making (Cowling and Sugden), and as a collective entity to be analysed with the tools of the ‘old”, rather than the %ewm, institutionalism (Hodgson). The question of power relations and the role of the state are also discussed in the book. The declared purpose of the book, which follows an already vast literature on the topic, was that of providing a comprehensive critical assessment of transaction cost approach. Though this has been accomplished, the crit&al aspect really overwhelms any constructive role. In addition, the portrayal of the firm here is just embryonic and scattered. But mainly, and surprisingly, the book shares with Williamson a complete lack of theoretical interest for the innovative organization, and for the analysis of the learning capabilities which characterize growing firms. 2. The value-creating firm The aim of Lazonick’s book, Business Organization and the Myth of the Market Economy, in contrast to Pitelis’, is precisely to develop a dynamic theory of the ti. The firm for him is the modern managerial corporation as it started to take shape at the beginning of the century, first in the U.S. economy, later in Europe and elsewhere. Lazonick’s method is that of comparative historical analysis. The theoretical reference points are the historical work of Chandler and Landes and the insights of Marx, Schumpeter and Marshall on the process of economic change. The main line of reasoning is prompted by two basic questions (p. 15): how do firms create new value, i.e. desirable goods at affordable prices? What are the value-creating internal capabilities of the firm? These in fact are the basic questions, says Lazonick, that a business organization must deal with in order to transform “the fixed costs inherent in its investments into revenue-generating products” (p. 92). The value-creating process starts with the choice of the investment strategy, of the investments in technological and organization capabilities that commit financial resources and represent the firm’s tied costs. An innovative strategy-as opposed to a purely adaptive one which simply adopts well-known technical

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specifications-requires time to generate revenues and therefore implies high fixed costs (HFC) (p. 133). The choice of the innovative strategy, therefore, places the firm at a cost disadvantage relative to its more adaptive rival, which may be using a known, lower fixed cost strategy. But it also carries with it the potential of yielding a competitive advantage at high levels of output when, and if, the HFC can be transformed into low unit costs. How this potential can be exploited is not known in advance but depends on the ability of the firm to develop, discover and organize the capabilities necessary to create those quality-cost combinations that constitute the innovation. The paradigm of this value-creating enterprise is the Chandlerian multidivisional firm, which was able not only to create and exploit the economies of scale and speed disclosed by new technologies and by vertical integration, but, more fundamentally, to realize a corresponding organizational innovation based on the creation of a centre of strategic decision in the figure of chief saleed managers (Chandler, 1990,1992). Lazonick is also concerned with TCT and devotes two chapters to a comparison between Williamson’s and Chandler’s approaches. By presenting a very detailed comparison based on the history of some successful big businessesS, Lazonick is able to show that, despite Williamson’s claim to the contrary, the two approaches differ deeply. Rather than responding to known transaction costs activated by asset specificity and limits to rationality, Chandler’s firm is engaged in an activity of product and process innovation that requires the constant production of firm-specific assets and skills (p. 203). In this way the firm builds an organization structure, exhibiting both increased specialization and co-ordinated behaviour, which systematically unbinds cognitive limitations (pp. 229 ff.). Correspondingly, market transactions are expanded and created anew, out of the firm’s need to sell a high level of throughput. In brief, if in TCT internal organization is a symptom of and an answer to a market failure, in Chandler it is an organizational success, which develops resources, human and otherwise. The theoretical conclusion that Lazonick draws from this new approach is that with the emergence and success of managerial firms, capitalistic economies have moved away from market coordination toward the planned co-ordination of their productive activities (p. 13). The neoclassical theory of the market economy, with its assumption that perfect markets always assure the most efficient outcomes, is simply a myth. It is the innovative planned hierarchy that establishes the path of superior standards of economic performance. This repeatedly stressed conclusion about the demise of the market, however, is strangely at odds with Lazonick’s theory of the firm. Via a curious logical short circuit, the =market”, whose

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co-ordinating role Lazonick sees as fading, here receives no other specification than that which we find in standard economic textbooks: impersonal, atomistic and non-strategic. This market may well be dead, but the market as strategic competition not only continues to operate in Lazonick’s theory, but plays an enlarged role. Lazonick’s basic idea that more innovative strategies have high investment costs, but also the potential of high competitive advantages, depends on the premise that there exist competitive market incentives and pressures. It is the market that provides innovative firms with their economic problems and rival solutions, with customers and their desires; and it is the market that supplies the social test of firms’ economic performance. Though the market’s role is more complex than a purely co-ordinating one because, in the presence of conflictual interests, it also must produce cooperation rules, its spontaneous social cohesive force is only reinforced by the historical cases described by Lazonick. e 3. Rejuvenation

The shift of focus to firms’ organizational solutions has also shifted attention to the micro-micro elements of firm behaviour, a necessary shift, as Williamson has often stressed. Many instances of these micro-micro features of the ways firms decide and choose can be found in the business literature. The book, by Baden-Fuller and Stopford, Rejuvenating the Mature Business: The Competitive Challenge, captures these decisional problems in the critical phase of firms’ changing strategies when trying to invert the path of economic decline and disappearance. Though their sometimes normative and pedagogical style may sound foreign to theoretical economic ears, their discussion of firms’ strategies of change highlights the same topics as discussed in this review with an attention even more focused on the firm’s learning mechanisms. Two basic features distinguish *dynamic” businesses from merely mature ones. One is behavioural, and consists of the ability of dynamic organizations to think of technological, organizational and environmental constraints as problems in need of new solutions rather than as given binding forces. The second is strategic, and represents these firms’ ability to create value for all their interest groups: not only for shareholders, but also for customers and employees, and for suppliers and distributors. To illustrate this point, a market that shows excess capacity, falling demand and profit losses sends signals of a very unpromising industry performance. The constrained maximization approach would suggest that firms operating in these markets cut investment and production. Some rejuvenating British companies that the book analyses, such as Cook (steel casting) and Hotpoint (appliances),

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behaved differently. The first, facing at the end of the 1970s an unprecedented fall in sales, did not scale down or seek a high-value differentiated niche, but remained in the lowest price segment of the market, and started to invest in customer service and product quality. The second company was able to show that the excess capacity of the appliance market of the 1980s was, in fact, an excess of ‘outdated capacity”. It started to invest in new plants, new distribution systems and new products. For both companies, these strategies allowed profit increases, more quality improvements and bigger market shares. (A similar story has been told for the rebirth of Chrysler: Ingrassia & White, 1994.) For the authors, these answers, now well known but novel at the time, are instances of strategies capable of combining actions that were hitherto thought to be impossible or incompatible Op.53). For example, high quality, variety, speed, miniaturization and low costs might seem to be opposites. In the dynamic firms, however, these opposites become part of a single strategy; to achieve both at once is just the challenge (cf. p. 134). Cook has provided both quality and low costs, Hotpoint variety and low costs. Benetton has done the same in fashion, Courtelle in coloured acrylic fibres, Richardson in cutlery. But this way of rethinking options requires a completely new approach to the way the organization works. Simply reducing defects involves new approaches to managing, to gathering information and to exercising control. It requires changes in the co-ordination of efforts not only within the firm but also across firm boundaries (p. 60). Not only is learning new methods necessary but also new methods of learning and experimentation become the targets of the resulting new organizations. Conclusions It has become an interesting research tool to represent the firm organization as a pool of capabilities for managing change. As Loasby (1991) puts it, in a world of change, where errors are likely and we are bound to expect the unexpected, we can also do something to prepare for it (1991: p. 3). Some of the features of the firm here passed under review represent devices for handling change; both defensive devices for preventing change to be disruptive, and offensive ones for expanding the opportunity set through the creation of new knowledge (cf. Langlois & Robertson, 1993: p. 5). Seen in this way, the three books we have considered provide apt indications of the kind of problems firms face in a world of strategic competition and innovation. The last two contribute positively to an analysis of the dynamic answers innovative firms have found and of the capabilities developed in the process.

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The market mechanisms that emerge from the interaction of these new learning organizations and which provide the incentives for growth continues instead to be overlooked. And, within the market, there is still an agent who, unaccountably, continues to be neglected as a mere passive maximizer: the consumer. References Chandler, A.D. Jr. (1990). Scale and Scope. The Dynamics of Industrial Capitalism. Cambridge, MA: Be&nap Press. Chandler, A.D. Jr. (1992). Organizational capabilities and the economic history of industrial enterprise. Journul of Economic Perspectives, 6,79-100. Ingrassia, P. & White, J.B. (1994). Comeback: The Fall and the Rise of the American Automobile Industry. New York: Simon & Schuster. Langlois, R.N. & Robe&on, P.L. (1993). Business organization as a coordination problem. Business and Economic Theory, 1, l-11. Loasby, B. (1991). Equilibrium and Evolution. An Exploration of Connecting Principles in Economics. Manchester: Manchester University Press.