“Production, Information Costs, and Economic Organization,” by Armen Alchian and Harold Demsetz, is probably the former author’s most cited academic article (638 cites according to ideas.repec.org). In it, he advances a theory of the firm that both builds from and adds on to Ronald Coase’s transaction cost theory of the firm. It may be surprising to find out that, in the same sense, Alchian and Demsetz’ theory adds on to Ludwig von Mises’ theory of economic calculation. The argument advanced in Alchian and Demsetz (1977) is that it can be cheaper to organize a firm as a means of calculating the marginal productivity of inputs, rather than rely on exchange across markets (i.e. the pricing process).

Before explaining Alchian and Demsetz’ idea in further detail, allow me to review Mises’ theory of economic calculation. Hopefully, my explanation will help emphasize the similarities in both theories. If you read this blog often, you will probably find the (next) paragraph on Mises repetitive.

A big question that early Marginalists were interested in answering is: how are factors of production (inputs) valued? We know that consumers’ good values are derived from their potential to directly satisfy ends. But, inputs are means to an end — they are not the final product. The answer is that the value of an intermediate good is derived from the final product. Austrians refer to this as imputation, whereas others may know it as derived demand. The follow-up question is, how are these values conveyed to us? For example, how does a producer really know how much each unit of input is really worth? Mises’ answer is that a money-using economy, with a competitive pricing process — where input owners and input buyers can bid and bargain against each other — will establish prices that help convey information on the value of the factors of production. In other words, competitive prices will approximate the marginal value of inputs; at least, they give an idea of what these marginal values might be.

This is exactly the same starting point for Alchian and Demsetz. Oftentimes, production requires what they refer to as the “team use” of inputs. They explicitly define “team use” as a situation where the product of two or more inputs is not a simple additive function (i.e. the marginal product of input plus the marginal product of the second input), but where the product is more than what could be produced by the inputs separately. In these situations, it’s very difficult to know how much any given input is responsible for the output. Further, if we’re talking about labor, or non-labor inputs with multiple owners, this difficulty in separating marginal product creates an incentive to shirk, because it’s difficult to adjust incomes to those input’s marginal product. One method of alleviating the problem is to organize production within a firm, where the purpose of the firm is to help meter (measure and control) the marginal product of the input.

The costs of measuring and/or controlling the marginal productivity of an input in team production are transaction costs. In a frictionless world, the price you pay for a good or service represents the other person’s opportunity cost — the opportunity they forgo to enter into exchange with you. Transaction costs, then, are costs that are not related to the other person’s opportunity costs. They are costs to using the pricing process. In the case of Alchian and Demsetz (1977), the relevant transaction costs are informational. Because the marginal productivity of an input isn’t just known — and a competitive price won’t reflect this value accurately, because of the incentive to shirk (free ride) —, in team production there exist positive transaction costs, which is the price of metering marginal productivity. The firm organizes in response.

One solution the authors offer — what they call the “classical firm” — is the manager, or someone who “specialize[s] as a monitor to check the input performance of team members” (p. 158). How does the firm monitor the monitor, so to speak? It can offer that person the residual between total output and the total costs of the inputs. There is therefore an incentive to maximize team production. Based on this person’s observations then, the return to each input can be changed, and the inputs themselves can be changed. Apart from the emphasis on (a different kind of) transaction costs, we see the Cosean element to the argument: the firm organizes to allocate resources without use of the pricing process (because, in some cases, this kind of organization is less costly, on net, than a decentralized market). In reality, firm hierarchy can be more complicated than this (and the authors do discuss some different, modern firm dynamics, under the lens of their theory), but the general concept remains the same.

Mises presented the pricing process as the solution to a specific information problem: calculating the rewards input users had to distribute back to the factors of production. Alchian and Demsetz, it’s true, are arguing that the pricing process, under certain conditions (i.e. team production), is not the most beneficial method of calculating marginal productivity. The incentive to shirk is a free riding problem, and this creates an opportunity for an externality: some of the costs of shirking are externalized to the input users or to the other inputs. Competitive prices may not reflect those goods’ marginal productivity. Therefore, alternative methods of economic calculation are organized: the firm. It, in my opinion, makes the theory of economic calculation that much richer, because originally the theory did not tackle certain real world frictions.

There is another Austrian theme that I interpret in Alchian and Demsetz (1977): the role of entrepreneurship. In Competition and Entrepreneurship, Israel Kirzner defines entrepreneurship as the task of being alert towards opportunities to profit, where profit is the residual between revenues and costs (i.e. a disequilibrium between the prices of outputs and the prices of inputs). The reality of disequilibrium — one friction Austrians have never shied away from — and the role of the entrepreneur is a central element in the original theory of economic calculation. Because prices will never fully represent a good’s marginal rate of substitution, there is an entrepreneurial role in bearing the risk to search for and take advantage of profitable opportunities. The entrepreneur acts as a coordinator. Within the firm, the concept remains the same. For Alchian and Demsetz, using Kirzner’s terminology, the monitor is an entrepreneur who earns a profit by best using a given pool of inputs in team production. The monitor is either rewarded or punished, through profit and loss, based on his ability to measure and control each input’s marginal productivity.

I’m sure others have already made the same inferences as me, but I have never read something that explicitly connects these three theories (Mises’ econ. calculation theory, Alchian’s and Demsetz’ theory of the firm, and Kirznerian entrepreneurship). I think it helps cast the development of transaction costs theories, including theories of the firm and, more broadly, New Institutionalism, in a new light, and it presents this latter work as an extension to important Austrian themes. It also goes beyond “core” Austrian theory — the pricing process — by providing a much more complete theory of the division of labor and exchange, where there are alternative institutional frameworks of allocation that the individual can rely on. It’s also interesting to note how the theory of entrepreneurship is present in all of these alternative frameworks.