Chapter Content
Also, this theory really had pretty limited influence on businesses themselves. In my experience, the average business person thinks economics is about predicting growth, inflation, you know, interest rates. They want those predictions, but they don't really trust them, which is probably wise.
So, um, there was this guy, Sir Denys Henderson, a lawyer, and he was the chairman of ICI, which was like, the big industrial company in Britain back then. He became the president of the Society of Business Economists, and he basically called a meeting to complain that economists weren't really helping businesses enough. I mean, he was mostly mad that they couldn't predict the crazy economic stuff that happened in the seventies and eighties, which, fair enough.
The Society, they got two people to respond, and one of them was Sir Alan Budd, he had a bunch of government and private sector jobs, Treasury advisor and all that. And he explained, basically, that economics is complicated, it's non-linear, and you can't really make reliable predictions. And then I chimed in and said, well, you know, maybe looking at firms and markets on a smaller scale, microeconomics, could be more useful to business people than trying to predict the whole economy. I tell you what, by the end of the night, Henderson was practically tearing his hair out. He just kept saying, "I need to know!" He wanted those predictions, badly.
I never forgot that event, you know, especially when I saw what happened at ICI later on. But, really, I remembered it every time someone asked me, like, "What's the exchange rate between the dollar and the pound going to be in ten years?" And my answer, and I really believe this, was always something like, "Tell me why you need to know that, and maybe I can help you ask a better question that we can actually answer." Usually, that didn't go over very well. A lot of the time, their boss had asked them, and they needed to, well, keep the boss happy, or they needed it for a spreadsheet, or, the classic one, if I couldn't give them the number, they knew someone else, probably at an investment bank, who would. And that was that. They'd hang up.
You see, that "need to know" thing, it's just, like, everywhere. People always want certainty, even when it's impossible. It's not a new thing at all. I got pretty lucky, being able to work in academia and meet real business people like Henderson. It helped me understand what economics can do, and, more importantly, what it can't do.
You know, models, like the ones by Jensen and Meckling, they assume that everyone's "rational" and just trying to get the most for themselves. They're "small worlds," where you can list everything, put a number on it. You can use math to make predictions. A lot of economic thinking assumes that people are familiar with the model itself or they act as if they were.
These models are helpful for thinking about how to organize and manage companies. But they're not exactly reality, you know? They're not as real as some models in science might be. Hayek, he put it really well in his Nobel Prize lecture, "The Pretence of Knowledge."
Hayek said, math lets you describe a pattern, even when you don't know all the numbers that will make it real. The problem is, it makes people think they can actually predict those numbers, and that's why everyone's always looking for those quantitative constants.
He went on to say that compared to the precise predictions in the physical sciences, that kind of pattern prediction is a second best. But the danger is thinking you need to do more to be scientific. "This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm."
Real business people, they live in "large worlds." The problems aren't well-defined, and there's no one right answer. And even later on, you might not know what the "right" answer was. Effective decision-makers, they don't try to maximize things. They don't have, and can't have, all the information they need. They're dealing with radical uncertainty. They often don't know what will happen, or even what *could* happen.
So, you know, we have to give up on "the pretense of knowledge." People still need to act, even when things are uncertain. The answer isn't to keep asking impossible questions, like, "I need to know." The answer is to change the problem so you can actually get information that helps decision-makers deal with the real issues.
Like Ansoff said, economists didn't really talk about corporations for a long time, even though they're obviously important. There was this economist, Robert Hall, he said that the economists near the Great Lakes, Chicago, Rochester, Minnesota, they were more conservative than the ones in California or New England.
Okay, so, Ronald Coase, he wrote this article in 1937 called "The Nature of the Firm." He wrote it when he was only twenty-one, after visiting Detroit. It's a really important article. But it didn't get much attention at first. It only became famous after he moved to Chicago. After a dinner party at the home of Aaron Director, brother-in-law of Milton Friedman. Coase moved to Chicago and stayed there the rest of his life.
You know, newspapers have this habit of writing obituaries for famous people who are still alive, but old. My obituary of Coase was at the Financial Times for like twenty years before he actually died in 2013 at the age of 102.
In Coase's article, he said that the size of a company depends on which is cheaper: using the market or using a hierarchy. Sometimes it's better to find the best price through the market, and sometimes it's better to tell people what to do within a company. Getting a price in the market is always costly. On the other hand, people might not always do exactly what they're told inside the company.
The choice between markets and hierarchies depends on how much investment is needed for a specific relationship. This is a big part of Oliver Williamson's work. In 1900, some fishermen in San Francisco agreed to go to Alaska to catch salmon for fifty dollars each. But once they got to Alaska, and it was too late for the canners to find other fishermen, the fishermen demanded one hundred dollars each. The canners agreed, but when the fishermen got back to San Francisco, the canners only paid them fifty dollars. The courts sided with the canners.
In pretty much all relationships, people make investments. That includes spending time, money, giving up other options. The fishermen sailed to Alaska, the canners didn't look for other crews. The change in bargaining positions after agreements are made is called the "hold-up" problem. The courts didn't like the fishermen exploiting the "hold-up" problem. But other cases are more complicated.
Still, it wasn't the fisheries that interested the freshwater economists. It was the car factories by the Great Lakes. In 1926, General Motors bought Fisher Body, which made the metal bodies for their cars. It's the most talked-about business deal among economists. Fisher Body needed special equipment to make the right shapes for the metal. But once they had that equipment, it was only useful for making parts for General Motors, and General Motors depended on Fisher Body. Like in Alaska, the bargaining positions changed a lot after the investments were made.
Two of Coase's colleagues at Chicago, Armen Alchian and Harold Demsetz, said that you could avoid the hold-up problem by writing a really detailed contract. They said the only difference between markets and hierarchies is whether you take someone to court or talk to HR. And everyone would know the outcome, so there'd be no need for court or firings.
Like a lot of economic models, the value is in understanding why it doesn't work. The world is really uncertain. Information is incomplete. You can't write a contract for everything that might happen. Not only don't we know what will happen, we often don't even know what *could* happen. Unexpected things will require adjustments. But by that point, everyone's already committed.
Vertical integration, when a customer buys its supplier or the other way around, can fix a power imbalance. Then there's no reason to take advantage of the other side, because you *are* the other side. If making a part required special tools and knowledge, then those things would need to be in the same company. So, in 1926, General Motors bought Fisher Body. At least, that's the story.
Coase hung out with the conservative faculty at the Chicago law school. Another Chicago scholar, Richard Posner, led the "law and economics" movement. Posner was really smart and worked really hard, teaching, writing, and being a judge at the same time. His idea was that the law can be seen as contributing to economic efficiency.
Other academics and lawyers promoted these ideas, and many universities studied "law and economics." The Olin Foundation, started by a chemical engineer and conservative businessman, John M. Olin, gave a lot of money to develop "law and economics." George Mason University in Virginia specialized in this approach. It was associated with a lot of conservative "freshwater" thinking.
That article by Jensen and Meckling in 1976 on the theory of the firm was really important for the law and economics movement. They said that a corporation is just a convenient way for individuals, like shareholders, investors, employees, customers, and suppliers, to make agreements. The corporation just makes it easier to deal with agreements. Everyone's just looking out for themselves, and everything's transactional. Jensen and Meckling and their followers denied the importance of group organization.
The "nexus of contracts" idea is different from the idea of corporate personality. That older idea says that the firm has a life of its own, separate from its stakeholders. The firm owns assets, not the shareholders, and the directors and employees owe duties to the firm. The corporation has rights and obligations, like free speech or religious freedom. It can commit crimes and has legal and political representation.
There's a conflict between corporate personality, where the firm has its own identity, and the Jensen and Meckling view of the firm as a "nexus of contracts." Easterbrook and Fischel, who followed Jensen and Meckling, said, "The corporation is not real. It is no more than a name for a complex set of contracts among managers, workers, and contributors of capital. It has no existence independent of these relations." They developed this idea in their book on the economics of corporate law.
The "nexus of contracts" idea became really popular in law and economics and accounting in the late twentieth century. It's weird timing, though. The economy was dominated by big corporations run by professional managers, and small businesses were less important. Also, manufacturing with assembly lines was being replaced by flexible teams of knowledge workers. Reality and academic thinking were going in opposite directions.
Jensen and Meckling's idea from the Midwest in the 1970s is basically the same as the Marxist view of the capitalist firm from 1848, also it is consistent with Ayn Rand's libertarian views.
It's not just the future that's uncertain. We don't have perfect information about the present, either. And information isn't evenly distributed. The knowledge and problem-solving skills needed to run a company are spread out among employees, customers, and suppliers. So, how can you write contracts so that everyone contributes as much as possible? Contract design can get these people to use their knowledge and skills to achieve the company's goals. This is the principal–agent problem. Relationships inside and outside the company can be seen as problems of contract design.
This view of contracts led to economic and legal approaches to the theory of the firm coming together, helped by the law and economics movement. The hold-up problem and the principal–agent problem would keep economists busy for a long time. The Nobel Prize in economics went to Coase and Oliver Williamson for their work on markets versus hierarchies, and to James Mirrlees and Eric Maskin, who studied contract structures. Hart and Holmström also shared a Nobel Prize for their work on contracts.
Meyer, Milgrom, and Roberts replaced Scherer from the bookshelves of modern graduate students – although that text was itself superseded by that of Jean Tirole who also received the Nobel award. For these recent writers, the principal–agent problem shapes the structure of the organization. Meyer, Milgrom, and Roberts wrote that "although delegating authority to those with the information needed to make good decisions is an important part of good organization design, it is of little use unless the decision makers share the organization’s objectives. We have already mentioned incentives as a way to align individual and organizational objectives … incentives and delegated authority are complements: each makes the other more valuable." Their solution is to create incentives so that individuals act as if the company's goals were their own. The principal–agent problem tries to find ways to get subordinates to pursue the company's goals. But what are those goals, and who decides them?