Thus, both managerial and technical factors
explain why the average cost curve
may, after a
certain level of output, level, flatten out and then slope upwards.
Firms, of
course, try to circumvent these constraints. Much organisational innovation
and
experimentation, ranging from franchising to cooperatives and multidivisional
planning, is
targeted at overcoming potential diseconomies of scale.
The net
effect of these measures on the evolution of optimum firm size defies
simple
generalisation. As we shall see in the next chapter, there is no universal
trend
towards larger firm size. There indeed seems to be a large range of output
where the
average cost curve is flat and the optimum firm size remains indeterminate.Many
different sizes of firms can be equally efficient. This is consistent
with the
observation that both small and large firms are able to coexist profitably
in many
industries.
A second implication is that the long-run
average cost curve is likely to be
much flatter
than the short-run cost curve. In the long run, firms can adjust their
plant size
and try to deal with congestion problems. Hence the rise in costs will
be less pronounced. Fewer costs
will be fixed in the long run.
The transaction
costs approach
A curious feature of a market economy is
that the price system is used to allocate
resources
everywhere – except within the firm itself. Within the firm, the allocation
of
resources, the assignment of functions and the distribution of rewards are
determined
by management. Professor Ronald Coase elaborated on this point in
a well-known
passage:
Outside the firm, price movements direct
production, which is co-ordinated through series of exchange transactions on
the market. Within a firm, these transactions are eliminatedand in place of the
complicated market structure with exchange transactions is substituted the
entrepreneur co-ordinator, who directs production. It is clear that these are
alternative methods of co-ordinating production.
Why is coordination the work of the price
system in one case and of management
in another?
Coase’s response was that firms exist because they economise on
transaction
costs. For example, an employee in a firm agrees to work for a certain
remuneration
and, in return, undertakes to carry out whatever reasonable tasks are
assigned by
management. This saves two types of cost, which would have been
incurred had
each of these tasks been negotiated through an item-by-item market
contract:
special contracts do not have to be made with each factor with which
labour works
and the cost of specifying future duties is avoided.Thus, by hiring an employee
on an annual or permanent basis, the firm economises on transaction costs.
Two types of transaction costs are of
particular relevance to the firm:
1. Motivation costs, which arise because
of asymmetric information. For example,
by hiring on
a long-term basis, with a promotional ‘ladder’, the employer
hopes to
give the employee a stake in the business which will cut down on
monitoring
costs and minimise costly arrangements for protecting the firm
against opportunistic
behaviour, or shirking, on the part of employees.
2. Imperfect commitment. Two parties may
wish to bind themselves to honour
promises
they would like to make but which, having made, they may later
have an
incentive to renounce .The market system may not be able to provide them with
such an arrangement. A firm canget around this difficulty, however, by building
up a reputation for reliabilitythrough repeated execution of contracts and fair
dealing with customers andstaff._14
The diverse nature of transaction costs enables
us to explain the reasons why
firms exist,
why the optimal size of the firm is bigger in some industries than in
others, and
why firms choose different modes of organisation. Certain types of
activity
will be conducive to the formation of cooperatives; others to cottage
industry;
some to public ownership; others to private ownership. The transactions
approach can
be used to explain why some people are hired on one-off contracts,
while others
are offered long-term contracts. Tasks can be subcontracted
through the
market system and agents motivated by franchises and licences rather
than by
outright hiring as employees. Another implication of the theory is that,
as
technology and markets change, the organisational mode can also be expected
to change.
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