Economics 103

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Economics 103

• Lecture 20
• Economic Organization

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The last lecture argued that PR systems were
designed to mitigate TC problems.
We can think of a spectrum of organizations.
Today well start at the left end of the spectrum
and work our way over.
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Why is production organized within a firm?
Think of how differently
is from
In all cases, firms are designed to make the
incentives of workers compatible with those of
the owners of capital.
Depending on what is being made, the firm might
end up being complicated or simple.
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The Family Farm
- lets consider a very simple industry.
- at one time virtually everything was organized
around the family.
- now family production dominates only in
farming and procreation.
Why is it if you run a cow/calf operation, you
do it as a family, but if you grow chickens
youre controlled by
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The advantage of large scale, factory production,
is the gains from specialization.
On an assembly line you have to monitor
workers. Often this isnt too hard to do.
When will workers be able to cheat/shirk the
firm?
When nature plays a large role.
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The problem with farming, compared to other types
of production, is it takes place outdoors.
Nature plays a large role (good and bad).
Thus wage workers can blame low crops on the
weather.
Which means workers can shirk a lot and get away
with it.
The result is that farms are owned by single
farmers and their families in order to save on
the TC of monitoring workers.
This is why families still dominate in the
Biological stages of farming, but not the other
stages.
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In the late 19th century factory farms, so called
Bonanza Farms started in the Red River Valley.
Some of the largest farms ever.
Hailed as the new age of farming.
Yet in 20 years they were taken over by
-
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The costs of monitoring farm hands turned out to
be enormous.
The gains from specialization turned out to be
trivial.
Why?

When does farming become factory like?
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1. When you can eliminate the role of nature.
These firms are enormous.
2. When the gains from specialization increase.
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The combine provides an interesting example of
how technology can influence TC, and therefore
influence the organization of the farm.
Before there were combines, grain was cut,
bundled, stored, and then separated with a
threshing machine.
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Threshing required huge skills lots of gains
from specialization.
As a result, there were threshing firms.
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The Combine, literally combined all of these
jobs, so that even an academic could run one.

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Given the better roads, and the increasing size
of combines, however, the gains from
specialization have increased, and once again,
were seeing this part of farming being
organized by firms.
-
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So farming provides a nice example of the
trade-off between transaction costs within a
firm and the gains from specialization within.
Lets move from this one type of firm, to one of
the most successful firms the world has ever
seen.
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The British Navy Rules

• RN was extremely successful during the last 150
  years of the
• Age of Sail.

? Many theories why -- Continental social
upheaval -- better morale, diet, weapons, ships,
etc. -- none of these fit all of the facts.

• A better explanation is that they devised a
  better system of
• incentives relative to other navies,
  especially the French.

         
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Why No Navy Should Have Functioned
? Nature played a huge role. -Captains had
only general orders blockade, patrol,
escort, engage enemy. - Ships were at
the mercy of the wind. - Ships were mostly
in unchartered waters.
? Captains and Admirals had two strong incentives
not to fight. -- They were the most
likely on board to die in battle.
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How was Admiral Nelson killed?
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The second reason was
-- They got rich taking valuable merchant vessels
that were easy targets.
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What Was The British Solution?
?
?
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The British Record
? Killed or Wounded
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? Ships  
Yet the British had no technical or personnel
advantage.
What was the organizational solution that solved
the major TC problem?
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• What Was the Incentive System?
•  
• Captains and Admirals were paid too much.
• --pay was mostly in the form of prizes taken in
  battle.
•  
• -- -- given the large potential prize,
  unemployment was
• costly.

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However, the Prize System in the Navy created an
Incompatible Incentive

• Payment by prizes encouraged the taking of easy,
• non-military, prizes.

Hence monitoring was done and involved a strict
series of rules.
1. Fighting in a line c
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2. The Weather gage
The weather gage could reduce your fire power.
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3. Articles of War.   -critical one must engage
the enemy if in the same class or die. -Byng
an encouragement to all the others. -ruled
out excuses on the weather.
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How Were Errors Detected? --- Discontinuous
Promotion.
-- one became a lieutenant through exams. -- once
a captain promotion was automatic. --one
could be stuck at lieutenant all ones life.
There had to be openings in the Captains
list for promotion (a necessary
condition not a sufficient one).
--lieutenants job was to watch the captain and
keep a separate log. He was the watchdog of
the navy, every ship had at least one
lieutenant.
-- incentives to lie were kept in check by having
more than one lieutenant, the master also
kept an independent log, and patronage of
the captain was important as well for promotion.
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Evidence
? Privateers --

• Army
• --

JPJ.
? Steam --
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The French

• The French were not as dependent on their Navy
  for national
• protection, and used their Navy mostly for
  protection of trade
• routes

? Seemed to have a first-best prior of naval
action.

• They were biased with strong priors and by the
  time they
• extracted the proper signal it was too late.