Production, Information Costs, and
Economic Organization
BY ARMEN A. ALCHIAN AND HAROLD DEMSETZ*
The mark of a capitalistic society is that
resources are owned and allocated by such
nongovernmental organizations as firms,
households, and markets. Resource owners
increase productivity through cooperative
specialization and this leads to the demand
for economic organizations which facilitate
cooperation. When a lumber mill
employs a cabinetmaker, cooperation between
specialists is achieved within a firm,
and when a cabinetmaker purchases wood
from a lumberman, the cooperation takes
place across markets (or between firms).
Two important problems face a theory of
economic organization-to explain the
conditions that determine whether the
gains from specialization and cooperative
production can better be obtained within
an organization like the firm, or across
markets, and to explain the structure of
the organization.
It is common to see the firm characterized
by the power to settle issues by
fiat, by authority, or by disciplinary action
superior to that available in the conventional
market. This is delusion. The firm
does not own all its inputs. It has no
power of fiat, no authority, no disciplinary
action any different in the slightest degree
from ordinary market contracting between
any two people. I can "punish" you
only by withholding future business or by
seeking redress in the courts for any failure
to honor our exchange agreement. That is
exactly all that any employer can do. He
can fire or sue, just as I can fire my grocer
by stopping purchases from him or sue
him for delivering faulty products. What
then is the content of the presumed power
to manage and assign workers to various
tasks? Exactly the same as one little consumer's
power to manage and assign his
grocer to various tasks. The single consumer
can assign his grocer to the task of
obtaining whatever the customer can induce
the grocer to provide at a price acceptable
to both parties. That is precisely
all that an employer can do to an employee.
To speak of managing, directing,
or assigning workers to various tasks is a
deceptive way of noting that the employer
continually is involved in renegotiation of
contracts on terms that must be acceptable
to both parties. Telling an employee to
type this letter rather than to file that
document is like my telling a grocer to
sell me this brand of tuna rather than that
brand of bread. I have no contract to continue
to purchase from the grocer and
neither the employer nor the employee is
bound by any contractual obligations to
continue their relationship. Long-term
contracts between employer and employee
are not the essence of the organization
we call a firm. My grocer can count
on my returning day after day and purchasing
his services and goods even with
the prices not always marked on the goods
-because I know what they are-and he
adapts his activity to conform to my
directions to him as to what I want each
day . .. he is not my employee.
Wherein then is the relationship between
a grocer and his employee different
from that between a grocer and his cus-
* Professors of economics at the University of California,
Los Angeles. Acknowledgment is made for financial
aid from the E. Lilly Endowment, Inc. grant to
UCLA for research in the behavioral effects of property
rights.
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778 THE AMERICAN ECONOMIC REVIEW
tomers? It is in a team use of inputs and a
centralized position of some party in the
contractual arrangements of all other inputs.
It is the centralized contractual agent
in a team productive process not some
superior authoritarian directive or disciplinary
power. Exactly what is a team
process and why does it induce the contractual
form, called the firm? These problems
motivate the inquiry of this paper.
I. The Metering Problem
The economic organization through
which input owners cooperate will make
better use of their comparative advantages
to the extent that it facilitates the payment
of rewards in accord with productivity.
If rewards were random, and without
regard to productive effort, no incentive
to productive effort would be provided
by the organization; and if rewards
were negatively correlated with productivity
the organization would be subject
to sabotage. Two key demands are placed
on an economic organization-metering
input productivity and metering rewards.'
Metering problems sometimes can be
resolved well through the exchange of
products across competitive markets, because
in many situations markets yield a
high correlation between rewards and
productivity. If a farmer increases his output
of wheat by 10 percent at the prevailing
market price, his receipts also increase
by 10 percent. This method of organizing
economic activity meters the
output directly, reveals the marginal product
and apportions the rewards to resource
owners in accord with that direct
measurement of their outputs. The success
of this decentralized, market exchange in
promoting productive specialization requires
that cha