The main objective of individuals or organisations is to maximise profits or minimise costs and this is done through the price system or price mechanism where market determine and allocate resources through price. The price of a commodity is believed to contain all the information about that commodity and so individuals or organisations have full disclosure about the commodity. This price is controlled by market forces based on the demand for and supply of such commodity. This is called the invisible hand of market, a term proposed by British economist Adam Smith.
In recent times, however, organisations have resulted in coordination in order to resolve pitfalls in the market form of resource allocation so as to minimise costs (both transaction and non-transaction). This is known as the visible hand of management.
Market system is a system in which decisions regarding resource allocation, production and consumption, price levels and competition, are made by the collective actions of individuals or organisations seeking their own advantage. Resource allocation is carried out by the forces of supply and demand, that is price of goods and services are determined by the interaction between buyers and sellers. Firms operate in perfectly competitive markets in order to maximise profits. In perfectly competitive markets, it is assumed that there is free entry and exits of firms and products are the same, as well as perfect information in the market which is represented by the price. Firms are price takers, which mean they sell their products at prices set by the markets. Firms maximise profits by producing one extra good when its additional revenue is greater than the additional cost it takes to produce that good.
For small firms, market determined price is the best option as it enables them produce based on the demand available for their product thereby neglecting the worries of waste or over stocking. But one of the strong arguments against market efficiency is the pareto optimality. Pareto optimality can be defined as the process of making a person better off without making another person worse off.
In a perfect competitive market, the allocation of resources is carried out by demand and supply forces and since firms are price takers, the higher the demand for a commodity causes an increase in the supply of the resources required to produce that commodity. This increase in supply causes an increase in the price of the commodity due to the costs incurred in producing that commodity, but demand for the commodity begins to fall as a result of the higher price. So firms that produce the commodity are left with increased production costs and excess stock while firms that supply the resources might be better off, depending on the contractual agreement they have. This explains the pareto optimality in the market, where the supplier of the resources is better off at the expense of the producer of the commodity.
The shortfalls to the market system is that price does not fully capture the information of a product, information is not perfect in the real world, firms do not operate as a single body or entity instead they are made of individuals and in the real world, firms determine economic activities based on their organisational coordination and mechanism.
As the economy grew, firms began to change their practice in order to function efficiently as well as adapt to new innovations in technology and managerial techniques (Chandler, 1977). These innovations led firms to change from a market based system of organisation to a more management controlled form of organisation.
According to Yao (1988), the substitution of more market based mechanisms such as the putting-out and inside contracting systems by the visible hand of managerial hierarchy via vertical integration of manufacturers and distributors was as a result of growth in firms and their activities.
In the putting-out system, merchants purchased materials, delivered these materials to the workers in their homes and arranged for the sale of the completed articles. The putting-out system had an attractive characteristic of preserving substantial worker autonomy. Moreover, the worker used the equipment properly since owners and operators were one and the same. However, because of the separate location of workers, inventory accumulation and transportation expenses were high. Further, this system encountered several transactional difficulties including: irregular production, loss of materials in transit and through embezzlement, slowness of manufacture, lack of uniformity, and uncertainty about the quality of the product (Babbage, 1835; Braverman, 1974; Kirkland, 1961).
One of the problems of the putting-out system was the non-existence of coordination and monitoring of the production and increased information asymmetry. The merchants have no knowledge of the level of skills and the psychology of the workers and so enter into an agreement with the worker. This is known as hidden information or adverse selection because all workers are generalized even those with a low level of skill and high level of skill. The price of workers in a market based system, which is represented by wage, does not take into consideration the various skill levels and so merchants pay a price that is not commensurate with the skill level of individual workers. Only workers have hidden information as to their level of skills. There is also the problem of moral hazard or hidden action, whereby the merchants do not know how the workers will behave after agreeing to the contracts. In the putting-out system, workers began to mismanage the resources given to them and sometimes did not meet deadline for production. This action led to increases in cost on the merchants as well as increase in stock wastages.
This led to the introduction of the inside contracting system, where by space within factories was rented to individual entrepreneurs before (as well as after) the development of a central power source. The impetus of the factory system has transaction costs origins (Williamson, 1980).
An advantage of the inside contracting system was that the firm was less burdened with increasingly difficult problems associated with production, process improvement, and labour supervision. The worker supervisor or master mechanic could obtain substantial independence and could avoid problems of marketing and finance.
According to Deyrup (1948: 149), the inside contracting system also played a fundamental role in the development of master tool building: "inside contractors were paid by the piece and hired their own labour, they benefited directly from increases in production or reductions in labour cost brought about by mechanization". This system also gave rise to increase in transaction costs due to contractual problems where by inside contractors acted recklessly at the point when contracts ended and also withheld or distorted information so as to gain from contracts.
Buttrick (1952) notes that the concern of changing pay standards generates incentives to withhold details of the production process from the performance evaluator. Labour-saving innovation was delayed until after contract renewal. Capital-saving innovation is also likely to be low since the firm can appropriate a large share of the economic gain. Moreover, it was difficult to regulate the flow of components from each contractor and inventory control procedures were inadequate. There were no specific economic incentives for inside contractors to economize on inventory accumulation. Coordination was left to informal cooperation by the foremen of the departments. Also, the quality shading problems that accompanied the putting-out system continued to plague internal organization under the inside contracting system (Bucheli, et al., 2007). The authority relationship of managerial hierarchy provided good equipment maintenance incentives compared to inside contracting since asymmetric information problems were lessened since the firm can continuously monitor production, and operations can be subject to internal audits. Removal of semi-independent profit streams and improved auditing serve to attenuate inside contracting hazards, which are derived from small-numbers bargaining, asymmetric information, and free-rider behaviour (Williamson, 1975).
The problems associated with increases in transaction costs led firms to grow and absorb the roles of contractors in the production process. These larger firms also faced the issue of deciding whether to carry out some activities or not.
Such organisational decisions depend on the rate at which an asset is used for a particular transaction, the importance of that asset to the transaction, and the uncertainty involved in undergoing any transaction.
The rate at which an asset is used within a firm affects the decision of the firm to bring such asset in-house. If it is used frequently, firms might decide to bring it in-house so as to reduce cost of transacting with external parties.
Assets that are used particularly for a transaction can either be controlled by the firm or a contractual agreement with the firm that owns the asset. Most firms would rather control the asset so as to enable monitoring, coordination and efficiency.
In conclusion, as firms grew larger and made more global transactions, the importance of organisational determined activities also increased. Firms would rather control the transactions they went into so as to reduce costs of embarking on that transaction as well as maximise profits for their shareholders. This might not be efficiently carried out by market forces and fully explained by the price system.
However, markets are still viewed as the most efficient means of distributing resources because every producer will produce at a price that it feels reduces cost and the market demand will always reflect that in the price of the commodity.
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- Braverman, H. (1974). Labor and Monopoly Capital. New York, NY: Monthly Review.
- Bucheli, M., Mahoney, J.T., Vaaler, P.M., (2007). Chandler's Living History: The Visible Hand of Vertical Integration in 19th Century America viewed under a 21st Century Transaction Costs Economics Lens. Available at: http://www.business.uiuc.edu/Working_papers/07-011.pdf [Assessed 11 November 2009]
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