“Prices are the central force directing resources and shaping consumption in a market economy. But most economic activity seems to take place without any influence from prices at all. Most employment, and in dollar terms most production, choices are not directly guided by any observable price.”
When I teach political economy, I start with the neoclassical theory of consumption, and then cover production. And I show students how miraculous is it that the actions of millions of people who have never met can be directed by prices. Resources move toward their highest valued use, and consumption goods are delivered to the consumers who want them.

For example, the United States promoted ethanol as an auto fuel. This sharply increased the price of corn worldwide. As Brazilian reporter Kieran Gartlan put it: “Higher prices are leading Brazilian farmers to plant more second crop corn this year, and the country’s modest corn exports are expected to expand [from 42 million tonnes to 48 million tonnes, an increase of 230 million bushels.]” (DTN, March 2, 2007, emphasis mine).

No one directed the Brazilian farmers to shift to corn production. The article puts it perfectly: “Higher prices are leading farmers….” The leadership comes from the prices themselves! The farmers may have had no idea why the price of corn had increased, to $4.00 per bushel. (After all, Brazil uses sugar, not corn, to produce its ethanol.) But Brazilian corn production increased within a year, by nearly 15%. No one made the farmers switch; they made choices. Other corn producers, in Argentina, Mexico, and several African countries, followed suit. No one talked about it, no one gave any orders; prices led them.

There is nothing wrong with this lesson, nothing I would change in my presentation to students. But there is a problem of emphasis, for someone who wants to understand, fundamentally understand, markets. And the problem is this: Prices are the central force directing resources and shaping consumption in a market economy. But most economic activity seems (at first glance) to take place without any influence from prices at all. Most employment choices, and in dollar terms most production decisions, are not directly guided by any observable price.

Most people work for a firm, a company, a large organization, and they have a boss. There are people who provide computer services, janitorial services, legal advice, and myriad other day to day activities who are paid a salary. They are directed by their boss, not by prices. The boss has to gauge (guess?) whether that worker is carrying her weight and adding to the profitability of the firm.

In such a setting, the boss also must try to figure out if there are enough servers or computers (my hunch? Your IT guy says, “no.” Never enough). Now, the manager does buy this equipment on the market, and pays real prices. But he doesn’t sell the computer time to the staff. He gives it away. Is it worth it, in terms of somehow increasing profits or raising the company’s share values? The boss has to guess. Many different bosses, in many different firms, make different guesses. Some of the firms are profitable, some are not. No one knows what specific choices led to increased profits, or to bankruptcy.

Then one day, in one firm, one manager, perhaps on a whim, outsources the computer services or janitorial services or the legal advice. Not to India or Ireland but simply to another company across town or across country. The boss signs a contract, after taking bids from several companies that provide similar services. These companies are forced by the scolding winds of market competition to provide excellent service at low cost. By looking at the different prices in the bids offered in this competition, the boss learns something. He learns how much the service costs to provide. And he learns how much money he saves by laying off the employees who used to provide the service in-house.

It’s hard to fire employees, particularly since most employees are smart enough to work hard enough to get acceptable performance reviews. The boss also has a hard time motivating the in-house staff, because watching each employee is expensive and tiresome. But it’s easy to fire contracted employees, because you just sign a new contract with a competitor. Why not let the market system do your motivation work? Let’s suppose that our outsourcing boss sees the company’s profits rise dramatically, and the stock price goes up 18% in six months. Life is good, for the boss.

So, one day the boss has this crazy thought. He asks himself a question that has never occurred to him before: Why have any employees at all? Why have a building? Why not just sit home, wearing his jammies and bunny slippers, sipping a nice cup of tea, and outsource everything? He can write contracts to buy parts, he can pay workers to assemble the parts, and he can use shipping companies to box and transport the product.

The boss is elated. He never really liked these people anyway. Always asking questions, constantly looking for direction and expecting him to know the answers. He fires all his employees, effective one month from now, and takes bids on all the design, parts manufacture, assembly, and shipping that those people used to do.

On day 31, after all those wasteful employees are gone and the new contracting efficiency regime is in place, the boss has a nice breakfast, pours his tea, and puts his bunny-slippered feet up on his desk at home. Checking his email, he notices he has 1,239 new messages. He turns on his cell phone, and sees he has missed 485 calls. What the heck?

It turns out that coordinating all those contract employees, and making all those different transactions work together in time and space, is a really hard job. The manager shucks the bunnies, puts on his suit, and hurries over to his primary contract supplier of inputs. “What are you doing? We have a contract!”

The supplier says, “Who are you again?”

The boss gives his name, frantically. Not one of the other contracts can be fulfilled if he can’t get these parts.

The supplier checks, “Oh, yeah, I see the order. Sorry, we’re running behind. We’ll have the stuff to you by the end of the week, maybe the following Monday.”

Within three days, the boss is fired, because the company is plunging into bankruptcy. Stock prices fall by 75%, and a desperate effort is made to rehire most of the old employees back to their old jobs.

The Theory of the Firm

If prices and competition do such a terrific job of directing resources (and they do!), then why are there firms? Why are there hierarchical organizations that are internally directed by command and control, rather than the price system? Why not outsource everything? Why don’t bosses sit home wearing bunny slippers?

Some firms come close, buying many of their inputs on the market and selling contracting for manufacture and assembly using piecework contracts with temporary workers. But many, and in employment terms most, firms are much more than a shell. What gives?

To appreciate this puzzle, let’s go back to Adam Smith’s famous “pin factory” example.

For more on the pin factory illustration, see “I’ll Stick With These: Some Sharp Observations on the Division of Labor”, by Mike Munger. Library of Economics and Liberty, April 2, 2007.

The pin factory showed the power of the market, through division of labor. The factory divides pin-making into a number of smaller, more specialized, tasks. Increased dexterity, improved tools, and economies of scale raise productivity so much that just a few workers could make thousands more pins than they could themselves use. So, we conclude, markets organize huge quantities of labor into more and more productive tasks.

Or… do they? What would a pure “market” pin factory look like? Nothing done in-house, only out-house! There would be no direction, no hierarchy, only individuals responding on their own to prices of inputs and outputs. The first man draws the wire, and then take bids. The high bidder pays for the wire, get his change back, and then carries the wire to his own shop, where the cutting machine can be stored safely. Then the cutter sells the little pieces of wire.

One potential buyer might be a pin sharpener. He calls several cutters, and checks out their reputations on Epinbay, a bulletin board that describes buyer reputations. (This is 1776; I mean a literal bulletin board, with wet scraps of paper blowing in the wind, held in place by sharpened pieces of cut wire, since there are no pins yet).

And so on. Each step, each break in the production process from one artisan to another, would require negotiations, a transaction, payment, and transportation of the product to the next step.

Obviously, that’s silly: no pin factory could work that way. The cost savings from division of labor would be swamped by the increased cost of negotiating and carrying out transactions, and monitoring quality. That’s why the “firm” is not really a market at all. This factory is instead a group of individuals who have contracted to cooperate in a particular way that saves the costs of conducting and monitoring separate transactions. The contract extends across the individual workers, and provides for a scheme of payments that focuses on wages of labor, rather than prices of commodities. The form of the contract negotiated by each worker is for a much longer term than a one-off purchase or sale transaction.

Coase 1937 on “the firm:”

It is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist… An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism. The economic system “works itself.” This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives. This is necessarily so if there is to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism… .Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except in so far as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. (P. 387; emphasis added)

The task of the economist, then, is to explain two phenomena with just one theory. First, why are firms more efficient than markets at organizing some transactions? Second, if firms are so efficient, why are there any market transactions at all? What determines the margin where the firm stops organizing additional transactions internally, and buys goods or services instead through the market?

The problem was stated in just these terms by one of the pioneers of the transactions costs approach, Ronald H. Coase. His remarkable 1937 paper in Economica contained two key insights. First, firms are contractual means of reducing transactions costs. Division of labor requires groups, sometimes large groups, of workers. But it would be too expensive and time-consuming to negotiate sales of labor, services, and products at every stage of production. So, an entity called “the firm” is created, which specializes in directing these activities. Firms compete with each other, but within the firm, activities are directed by command and control.

Second, Coase argues that the optimal size of firms responds directly, though in undirected ways, to market forces. This is true both for vertical integration (owning suppliers, and retail outlets) and market share (the number of units sold, total). So the market is at work after all, since the expansion or contraction of the firm is directed by prices and the actions of consumers and suppliers. Firms that guess wrong, and expand (or contract) too much will lose profits, and may even be “selected” for extinction by bankruptcy.

Final Thoughts

In this essay, a serious question has been asked, and I want to make sure the reader sees why it is important. Outsourcing, either across town or across a huge ocean, is a form of transforming a transaction from one organized within a firm to one organized through a market. All firms use some combination in-house work and outsourcing (no computer company makes its own furniture, grows the wheat for bread in the employee cafeteria, or makes waste paper baskets). Where is the line? How does the company decide what to buy, and what to produce?

For more on firms, see Risk, Uncertainty, and Profit, by Frank Knight.

The answer is: profits. The company has to decide which approach, at every stage, costs less, improves quality, or in some other way increases profits. Price is an important consideration, of course, for managers. But the day-to-day activities of most employees, in most firms, are not directed by prices the way that price directs the choices of farmers. Workers are for the most part paid salaries, or by the hour.

Ah, you might say, but that’s where prices come in! Workers work, and change jobs, for wages. Sure, and the Brazilian farmers could change jobs, too. They could go from being farmers to woodcutters, or factory workers. My point is that the farmer looks to prices to say “What will I plant today?” The worker in a firm doesn’t look to price, but rather asks his boss, “What will I do in the plant today?”

Most importantly, bosses can’t contract out all the activities of the firm, in most situations. The coordination and monitoring function, as some of the authors in the “further reading” section below argue, may be the real reason that firms exist. The problems of transactions costs, and management, are complex and hard to solve. If you want to run your own firm, make sure you keep your wing-tips, or at least a pair of sensible pumps. You are going to be doing a lot of walking around and giving instructions to people who don’t have prices to direct them.

Further Reading

Alchian, Armen A., and Demsetz Harold, “Production, Information Costs, and Economic Organization”, American Economic Review, Vol. 62, No. 5., pp. 777-795, 1972.

Chandler, Alfred. The Visible Hand: The Managerial Revolution in American Business. New York: Belknap, 1993. (2nd edition).

Coase, Ronald H., “The Nature of the Firm”, Economica 4, pp 386-405, 1937.

Benjamin Klein, Crawford, and Armen Alchian. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics. 1978.

Williamson, Oliver E., Markets and Hierarchies: Analysis and Antitrust Implications, NY: The Free Press, 1975.


*Michael Munger is Chair of Political Science at Duke University.

For more articles by Michael Munger, see the Archive.