The central question presented in Milgrom and Roberts is why an organization controlled by a central authority cannot replicate the performance of a decentralised organisation. Economists when writing about firms, historically, compare it with characteristics of markets. They argue that the success of markets in western society means that other economic organisations only occur due to failures in the market. They also state that given the apparent success of the market why not always rely on the market solution? There is however, considerable opposition to this view.
Others believe that a market is essentially a primitive way of organising activity and that it worked in the middle ages but now with more complicated multi level/stage processes it is redundant and this has lead to large integrated firms. They argue that if the market works so well, why don’t firms get more inputs from independent suppliers in the market? Why do firms have their own marketing, accounts departments etc? Why do they only sell their own products? This essentially leads to the central question; why cannot a large firm (or centrally planned economy) always operate at least as efficiently as an unorganised, chaotic market?
Knight (1971) proposed that financial constraints of a founder could restrict the growth of entrepreneurial firms and that the free rider problem could restrict the growth of partnerships. However, for large publicly listed firms he could only speculate that motivational issues involving staff was the reason for restriction of growth and to properly assess this as a reason assumes that such firms have no access to market like incentives packages. Coase (1937) was the first economist to look at firms in terms of what functions they did internally and which they sub contracted.
He believed that there were different costs associated with activities done within the firm and done in the market. Transactions in the market have negotiation and price calculating associated costs. Coase unfortunately fails to discuss any costs uniquely associated with the firm. He does say that firms have a finite amount of managerial talent and therefore to take the best advantage of a society’s managerial talent involves an economy with many firms. Recent studies show that markets economise on the communication and information needs of individuals and provides incentives for resource efficiency and innovation.
Whether the price system does economise on information and communication has been analysed and it has been discovered the minimum amount of communication is the announcement of price by the seller and the auctioneer. Marschak and Radner (1972) stated that local knowledge is required and some co-ordination between dispersed decision makers is vital. We know that markets can fail to be the cheapest way of communicating production information; also, traditional markets can fail in various ways of providing incentives efficiently or correctly. These failures are as follows;
Markets provide incentives to producers by burdening them with the full responsibility of their decisions but that responsibility maybe impossible if they have limited financial resources or are risk adverse. A solution for this is to substitute the monitoring of inputs for output based incentive schemes, this means moving away from traditional markets into a more formalised organisation. Other factors such as externalities also provide reasons to move away from market-based activities to this more formal structure. Formal organisations also seem to be preferable when talking about costs involved in market relationships.
Such relationships assume there is a surplus to be gained from a particular relationship, but there are inevitable bargaining costs associated with this. These may be avoided by setting up terms of transactions ex ante, but if it is a complicated transaction, this may be unfeasible. This is where a relational contractual agreement can cut out the bargaining costs, vertical integration being the most extreme of these agreements. There are inevitable costs in market-based transactions and therefore there must be inevitable costs in non-market arrangements. This raises an important question.
If the most efficient way of doing a transaction is through the market, we can assume a firm will do this, but any variations from a purely voluntary exchange will involve a central authority. Even if this authority only intervenes when the intervention is efficient, we have to ask why a centralised authority using selective intervention cannot perform at least as well as the market most of the time and better than the market some of the time? The simple answer is that the very existence of a central authority changes the way the system works even when intervention is not helpful. This is because of a variety of reasons.
The first of those reasons is opportunistic behaviour on the part of the authority. This can be by considerations of efficiency and by personal interest in the form of bribes. There is the possibility of alleviation by regulation by an independent third party. Even if the authority is commonly known to be immune to bribes and generally public-spirited, it may be appropriate to limit its influence. This could be to provide the correct incentives to others in the organisation and to this they must commit to go against its own interests in the future. A good example of this is drug patents.
The authority must agree to give patents to a company for a new drug to give them incentives to discover new drugs but once the drug has been made the patent goes against the authorities principle of free competition. The other major factor in the costs related to centralised organisations is the reputation issue. Firms will exchange defective goods or treat staff well go guarantee prosperous future relations with customers or employees. The efficacy of the reputation mechanism is directly related to how much the firms gain by cheating, how well it becomes known and how easily it can rebuild its reputation ex post.
This means that a formalised structure of large forms will be effective in using the reputation mechanism. In contrast, the reputation mechanism cannot operate in fluid unorganised market conditions where there are little repeated transactions such as in the middle east. Only in more developed markets with repeated transactions and with extensive trader, communications do market reputations matter. Therefore, the market is not seen as an individual organisation but as a whole category and therefore the distinction between organisations and the ‘market’ is somewhat blurred.