The Competitiveness of Nations in a Global Knowledge-Based Economy
Brian J. Loasby
Decision Premises and Economic Organisation
DRUID 1998 Summer Conference
Bornholm, June 9-11
Content
In The Mechanisms of Governance (1996), Oliver Williamson
compares the decision premise, as proposed by Herbert Simon (1957, p. xii),
with the transaction as rival units of analysis for developing the economics of
organisation, and celebrates the victory of
transaction cost economics as a theory of organisational
forms. No usable analytical structure,
by contrast, has been built on decision premises. In this paper I intend to examine the
significance of decision premises, and to indicate how they may help us to understand
economic behaviour. I shall also suggest why economists have
ignored Simon’s proposal.
It is appropriate to begin by recognising
that Williamson’s own argument for basing analysis on unitary transactions
relies on the implicit proposition that the choice of decision premises for
economic theories may be decisive for the development of knowledge, though as
is usual among economists that proposition is never formally stated. It is certainly true that the premise that
economists should focus on transactions, and the costs of transactions, in
order to explain the allocation of economic activities between firms and
markets has had important consequences for the development of economic theory
and for economists’ perception of its applicability. This is just one example of the ways in which
the development of economics has been shaped by the decision premises from
which economists have worked. If
theories are logical structures, this should not be surprising; logical
reasoning can only make explicit what is already contained within the premises
on which it is based. What one can get
out depends on what one has put in. Since
no economist has any difficulty in pointing to mistakes in the basis of
reasoning by some other economists, it ought not to be difficult for all
economists to agree that the choice of premises for economic reasoning is an
important topic for discussion. That it
is nevertheless difficult to get agreement on this conclusion indicates that
there is something wrong with its premises. What is wrong, I believe, is that most
economists have very little idea how such a discussion could be organised, and, more fundamentally, that they assume, and
are encouraged by their training to assume, that the basic questions have all
been settled. One consequence, as Leijonhufvud (1998) has shown, is that economists who are
thoroughly trained to use modern decision premises have no possibility of
understanding Keynes’ theory of unemployment.
It is consistent with the assumption that all the basic questions have been settled to construct theories which implicitly assume that the basic questions about the decision premises on which economic agents base their rational choices have also been settled. Everyone knows how to decide what to do; and everyone decides in the same way. In macroeconomic theory, that allows analysis to proceed by focussing on a single representative agent; in game theory and transaction cost economics it is necessary to have at least two agents, but they are two representative agents, and can be transposed without affecting the analysis in the slightest degree. As Douglas (1995, p. 102) observes of Williamson’s work, “firms vary, but not individuals”. That, fundamentally, is the reason for “the absence of surprise, victims, and the like” (Williamson, 1996, p.46); it is also the reason why economic theories, including transaction cost theories, so rarely mention entrepreneurship, and why (with some notable exceptions known to us all) the modelling of innovation is so inadequate. The impression of the development of economics given in the textbooks (when any impression at all is given) is misleading for precisely the same reason.
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One advantage of this commonality of issues, which I have tried to use
on previous occasions, is that discussions of decision premises in the economy
and in the economics profession can illuminate each other; and though the
primary focus of this paper is the former I would like next to consider an
earlier example of a choice of decision premises which has had widespread
effects, including a major impact on economists’ understanding of the rationale
of the firm. The first half of Nero Sraffa’s celebrated article of 1926 on “The laws of return
under competitive conditions” was based on a paper published in Italian in the
preceding year, which is now available in an English translation (Sraffa 1998 [1925]. At
the head of this 1925 paper stands a quotation from Marshall’s Principles (1920,
p. 461): “The Statistical theory of equilibrium is only an introduction to
economic studies; and it is barely even an introduction to the study of the
progress and development of industries which show a tendency to increasing
return”. There is abundant textual
evidence that Marshall believed the choice of premises for economic analysis to
be of prime importance, and that he was anxious that the wrong choice should
not be made; but Adam Smith might have warned him that his own proposal to
begin with static equilibrium and then switch to evolutionary models for
advanced work created a ‘gap’ that was likely to disconcert the imagination of
economists too severely to be tolerated (Smith 1980).
Sraffa demonstrates in considerable detail
the difficulty of reconciling increasing, and also decreasing, return with
perfectly competitive equilibrium, and then without further argument ends the
paper with this conclusion: “we must then concede that, in general, commodities
are produced under conditions of constant costs” (Sraffa
1998 [1925], p. 363). Perfectly
competitive equilibrium is a fundamental and undiscussable
decision premise, and therefore the concept of increasing return can have no
place in economic theory. Sraffa’s conclusion in 1926 was somewhat different: then it
was perfect competition that had to be rejected, but static equilibrium
remained untouchable. Premises have to
be chosen to match the competence of the analyst, as Hicks (1939, pp. 83-5) was
characteristically open in admitting. Theoretical possibilities are constrained by
the perceived bounds of rationality.
Let us compare this choice of decision premise with that of Allyn Young in 1928. As Currie (1997) and Ravix (1997) have recently reminded us, Young extended Smith’s theory of economic progress through the division of labour and Marshall’s theory of internal and external economies through internal and external organisation into a vision of economy-wide interactive development. “New products are appearing, firms are assuming new tasks, and new industries are coming into being. In short, change… is qualitative as well as quantitative. No analysis of the forces making for economic equjilibrium… will serve to illumine this field, for movements away from equilibrium, departures from previous trends, are characteristic of it” (Young 1928, p. 528). For Young, it was static equilibrium that was an unacceptable decision premise; he too did not argue the case, but assumed, in opposition to Sraffa, that premises should be factually correct rather than theoretically tractable. (There is, I believe, no simple operational rule by which premises should be chosen; the choice of premises is a scientific art.) Young declared that “[e]very important advance in the organisation of production… alters the conditions of industrial activity and initiates responses elsewhere in the industrial structure which in turn have a further unsettling effect” (Young 1928, p. 533); and he observed that the costs of this developmental process are “not the ‘costs which figure in an equilibrium of costs and advantages” (Young 1928, p. 535). Some of them are clearly what Langlois (1992) has called ‘dynamic transaction costs’: the costs of changing both production methods and the organisational arrangements, within and between firms, in order to institute and then improve upon those changes.
Thus the challenge left by Marshall to his successors evoked orthogonal
responses, with potentially orthogonal consequences. From Sraffa’s 1925
paper we can derive the Chicago insistence both on using perfect competition
and on ignoring the plausibility of assumptions, and from his 1926 paper we can
derive imperfect competition theory, structure-conduct-performance models, the
identification of widespread market failure and the hostility to increasing
returns so memorably expressed by Samuelson (1972 [1967]). From Young’s premises we can derive his
own conclusion that the interactive process of increasing return is the source
of economic progress, which cannot be adequately considered at the level of the
firm alone - as Marshall’s treatment clearly indicated. Thus Sraffa’s
juxtaposition of increasing returns and the equilibrium of the perfectly
competitive firm is the logical consequence of
inappropriate premises, and the theory of the firm which arose from it the
logical response to an incorrectly-formulated problem.
Penrose’s (1959, 1995) non-equilibrium theory of the firm as an agent
of development can, however, be encompassed within Young’s premises, if it is
set in the context of Richardson’s (1972) vision of the evolving organisation of industry. We can also interpret Chamberlin’s
(1933) theory of monopolistic competition as a dynamic analysis of specialisation, innovation, and market development,
presented in a static guise (Robinson 1970). I will just pose the unanswerable question of
how Chamberlin might have developed his ideas had
Young, who had been his thesis supervisor, not died and been succeeded by
Lionel Robbins, whose own decision premises were quite different. Ravix’s (1997) argument
that Young’s emphasis on the growth of productive knowledge matched his
conception of the most effective means of progress in economic science might
bring this paper within Young’s research programme. That it is within Adam Smith’s cognitive,
sociological, and economic research programme (Loasby 1996) I am certainly prepared to claim.
If the premises from which economists work have significant effects on
the development of economics, is it not likely that the premises from which
economic agents work will have significant effects on
the choices that they make? There is
plenty of evidence of such effects, some of which I have cited myself, and much
more has been presented by, for example, Martin Fransman,
Neil Kay and Dick Langlois. But here we should notice how “thinking has
been shaped by terminology” (Richardson 1960, p. 69), or perhaps fundamentally
by the premises to which that terminology has to conform. A notable feature of Sraffa’s
papers of 1925 and 1926, to which Denis O’Brien (1984) has drawn attention, is
the assimilation of Marshall’s ‘free competition’ to perfect competition, in
which competitive activity is constrained out of existence. As Shackle (1961, p. 272) observed, the agents
in economic models do not make choices but act according to necessity. Why, then, should anyone be concerned about
the decision premises on which they act?
There is one reason which should concern economists whose own methodological decision premises include theoretical coherence. Within such a tightly constrained model it is impossible to find any explanation for firms, or markets, or money. All that we observe is a complete set of interlocking individual routines. Just as Hicks (1982, p. 7) discovered sixty-five years ago that we must introduce uncertainty as a premise before we can consistently introduce money, so Knight in 1921 and Coase in 1937 recognised that uncertainty was a logical prerequisite for a theory of the firm (though Coase disagreed with Knight’s specific reasoning). As Oliver Williamson has repeatedly emphasised, transaction cost theory cannot get started without some restrictions on
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rationality. The
difference between Williamson and Coase, to which we
will return, is that Williamson believes that what is decisive is the threat to
incentive-compatibility which is posed by particular conjunctures of bounded
rationality, whereas Coase believes that these
threats do not provide any systematic basis for discriminating between market
transactions and internal governance.
Simon’s conception of bounded rationality may perhaps be understood as
truncated rationality, in which the set of decision premises has to be
abbreviated and simplified in order to be amenable to the limited human
capacity for logical processing. If the
processing is strictly logical but limited, it is an obvious inference that
decisions are to be explained by the way in which the premises are truncated;
hence Simon’s proposal to take the decision premise as the unit of analysis. In the background, as indicated by Simon’s
frequent use of chess as the archetypical example, there is usually the shadow
of a fully specified problem that would be accessible to anyone with sufficient
cognitive capacity. A similar shadow
lies in the background of the analysis of ‘information’ in economics, including
transaction cost economics; a full information set always exists but is costly
to acquire and may be inaccessible to some agents. That incomplete information, unlike bounded
rationality, does not preclude formal optimisation is
the consequence of some incoherence in the analytical premises, as has often
been pointed out. The truncated
rationality which substitutes rational expectations for the unattainable stability
theorems of intertemporal general equilibrium,
makes co-ordination failure undiscussable (Leijonhufvud 1998, pp 18 1-2). That is not an issue for this paper; it may be
dismissed with Knight’s (1933, p. xiv) observation that he was “puzzled at the
insistence of many writers on treating the uncertainty of result in choice as
if it were a gamble on a known mathematical chance”.
My own view is that a conception of truncated rationality as an
approximation, good or bad, to a fully-specified problem greatly understates
the difficulties that we face through the intersection of complexity,
interdependence, and cognitive limitations; rational choice is impossible, not
because of difficulties with formal reasoning but because there is no way of
knowing that the premises for such reasoning are correctly specified. Our logical processing must therefore be based
on a problem formulation which cannot replicate the phenomena for which we
substitute it. The normal situation is
not one in which we have to truncate a known full set of premises (such as the
rules of chess) but one in which we have to impose a set of premises that we
believe, or hope, will be adequate. “It
is clear that to live intelligently in our world… we must use the principle
that things similar in some respects will behave similarly in certain other
respects even when they are very different in still other respects” (Knight
1921, p. 206). It is obviously important
that the similarities should be important and the differences irrelevant; but
whether this is so for any decision must depend, in ways which can never be
known for certain, on the particular circumstances of that decision. But since logical reasoning cannot do more
than reveal what is already contained within the premises -though that can sometimes be
a great deal - it must
follow that we determine, consciously or unconsciously (and usually the
latter), the conclusions that we reach when we select our premises.
Our conclusions may therefore be in error because the selection of premises is faulty; and this selection must be made by non-logical means. “[T]he identification of ideal with empirical statements is not deductive. Having neglected the uncertainty in our premises, we can never be sure of the logical necessity of our conclusions. Every theoretical calculation becomes metaphorical” (Ziman 1978, p. 27). This is true of economic theory, as of all sciences, and of decisions in business and in our daily lives. The choice of premises for scientific analysis sets limits to our knowledge;
but without such constraints no knowledge is possible. Similarly, the choice of decision premises by
economic agents sets limits to their actions, but without such limits no
reasoned action is possible. Moreover,
knowledge may be false, and actions may be mistaken. The recognition of these limitations has
logical implications for the conduct of scientific research and of economic
activities.
At this point I should make clear three drastic restrictions on the
premises for this paper. First, I shall
be concerned only with decisions that are taken for what are considered to be
good reasons, though certainly not only with decisions that turn out well. This excludes many decisions, which need to be
understood for any comprehensive explanation of the working of an economy - or the working of the
economics profession; but ‘rationality’ is such a core concept in economics
that it is appropriate to focus here on reasoned decisions. Like Williamson, my presumption in what
follows is that agents are seeking efficiency; but it is obvious that they do
not always achieve it. Like Hayek, I
believe that we need to understand success before we can explain failure; but I
also believe that what we need to model are processes which are inherently
fallible, and not simply because of an error term. Human decision processes are fallible, and it
is the need to impose premises that makes them so. Second, we should note that routine behaviour is also governed by the equivalent of decision
premises, in the form of a classification system to which phenomena are
assigned and a set of actions to which categories are matched (as is
illustrated by classifier models). An
investigation of these premises would therefore be entirely appropriate for an
examination of the importance of decision processes, but in order to focus on
rationality it will not be attempted here.
The third restriction is that, in conformity with the concept of
truncated rationality, I shall assume the faultless application of logic (which
is rarely observed in practice) and concentrate on the variety of ways in which
problems may be truncated, or framed. Because
no framework will be best for all purposes there is always a potential for
failure through applications which turn out to be inappropriate; the ‘logic of
appropriateness’, correctly applied, ensures internal but not external
coherence. But in addition to examining
specific situations, we should recognise that an
efficient system response to bounded rationality, and specifically to the
insufficiency of any single set of premises, is offered by the division of labour; the differentiation of knowledge sets may be the
source of substantial gains from specialisation. (Smith’s, Marshall’s and Young’s arguments were
much wider than this, but we will keep to the narrower line, which is
represented by Knight.) The division of labour is, in part, a means of economising
on rationality through the specialisation of decision
premises, and thereby increasing its productivity. But one consequence is that knowledge becomes
increasingly dispersed and asymmetric. Not
only will different specialists know different things; they will formulate
their knowledge in different ways, which may make communication difficult, and even sometimes dangerous because the
receiver’s interpretation may be inconsistent with the sender’s intention. Information has no significance without
context. Co-ordination may therefore be
problematic even in a world of universal benevolence.
We can now identify four themes for analysis and empirical study. The first is the distribution of different clusters of premises within the economy, or the pattern of specialisation in decision making. (This we might call Knight’s theme.) The second is the relationship among those within a particular specialism: how are they grouped and what contacts do they have? (The obvious reference here is to Marshall’s Darwinian emphasis on variation within a trade, and the process of critical examination and amendment within industrial districts.) The third is the pattern of premises currently favoured in that specialism, and the implications for what those who work within it can and cannot do, and for what they can and cannot perceive: compare Sraffa’s premises with those of
6
Young. (This theme is
represented in this Conference by Martin Fransman and
Dick Langlois, among others.) The fourth is the relationship between
different categories of specialists. (We
think naturally of George Richardson.) Here
are the basic issues of economic organisation. It is my view that a fundamental premise for analysing them is the context of the growth of knowledge;
reasoning in terms of fixed information sets is as likely to lead to misleading
conclusions as reasoning in terms of given products and technologies in the
1930s. Opportunism, on the other hand,
although significant does not seem to me fundamental to an explanation of
industrial organisation. It needs to be incorporated at an early stage,
but the problems and opportunities of developing and co-ordinating
knowledge deserve priority.
An exploration of these themes is far too large a task for the
remainder of this paper. I will strictly
limit my present agenda to indicating some of the implications of bounded
rationality for the relationships between individuals and the groups of which
they are members or with which they interact. It is convenient to begin with the problems
faced by each individual in trying to behave reasonably. How is a situation to be framed in order that
we may select an action; how are we to close our model in order to put logic to
work? Our cognitive powers are so
limited in relation to the complexity around us that we very often feel in need
of some assistance in filling the gaps. If we always had to give conscious thought to
our decision premises we would make very few decisions. We therefore often look around for help,
hoping to follow the example of someone who may be more skilful in coping with
a particular kind of situation. It is in
this search for good practice that Choi (1993) finds
the origins of institutions, which we use as ready-made decision premises. Institutions help us to close our decision
models and thus permit logical deduction within a plausible framework. Furthermore, shared conventions help us to
understand the behaviour of those who share them, and
create the possibility of tacit co-ordination. What frameworks are plausible may vary between
groups and over time; and institutions may accordingly be local or general, and
may change.
Any society requires some institutions of very broad scope; more specialised groupings, such as the community of economists,
develop more specialised premises which both assist
the individual and facilitate co-ordination within particular areas of
interest. All effective human
interaction depends on intersubjectivity - for example, the shared attribution
of ‘moneyness’ to certain pieces of paper, the shared
interpretation of marks on other pieces of paper as the tracks of subatomic
particles, the shared belief that replicator dynamics
provides insight into biological processes or the fortunes of a group of firms,
the shared response that a report from a firm’s research department defines a
productive opportunity. The division of
cognitive labour focusses
the attention of each category of specialist on particular phenomena, on
particular ways of classifying them, and on particular ways of formulating
problems in order to make them accessible to particular logical techniques and
the experimental techniques which are associated with them it allows those
within each category to learn from each other, even if they are in competition.
A firm is such a specialised grouping, which must draw on the institutions of a wider society in order to get started but then develops particular institutions on which individuals come to rely for simplifying their own decision making and as a basis of co-ordination within the organisation. If we begin, like Coase, with a theory of market co-ordination, but with a more detailed appreciation than Coase had acquired in the early 1930s of the reliance of rigorous theory on prices that are both
costlessly known and known to be equilibrium prices, then
we can regard the firm as a substitute for a set of contingent claims markets (Loasby 1976, p. 65) and as an arena for equilibrating
processes; but if we also take account of Young’s vision of economic progress,
we can also regard each firm as part of the mechanism which propels economic
systems away from previously-existing equilibria. They are local centres
of specialision in coping with particular kinds of
uncertainty. This is Knight’s (1921, p.
255) explanation of the firm as an entrepreneurial creation, which Casson (1982, p. 373) has acknowledged as the basis of much
of his theory of entrepreneurship. “Men
differ in their capacity to form correct judgements
as to the future course of events in the environment. This
capacity, furthermore, is far from homogeneous, some persons excelling in
foresight in one kind of problem situations, others in other kinds, in almost
endless variety” (Knight 1921, p. 241). Casson (1982, p. 23)
defines an entrepreneur as “someone who specializes in taking judgmental
decisions about the coordination of scarce resources”, and begins his analysis
with the absorption of uncertainty; but, recognising
the contributions of Schumpeter and Penrose, he then develops the role of the
entrepreneur as innovator.
“With uncertainty present,… the primary
problem or function is deciding what to do and how to do it” (Knight 1921, p.
268), and if powers of deduction are assumed to be infallible but limited, the
quality of decisions depends on the quality of the premises. Knight notes that this quality improves with
experience of particular kinds of situations, and that this improvement takes
time (Knight 1921, p. 243), thus providing a basic reason why the boundaries of
a firm should be fairly stable and why performance within those boundaries may
get better; the possibility of such improvement was crucial to Smith’s and
Marshall’s theories of economic development. Casson’s emphasis on
the importance of each entrepreneur’s distinctive way of organising
information as a basis for distinctive rational decisions, which has been a
continuing feature of his work (Casson 1997), is also
an emphasis on the importance of the scope of each business and the accumulation
of experience, and therefore implicitly on the premises for decision making.
Search is organised on the basis of
locally-corroborated conjectures, and the costs of decision making are reduced
by postponing decisions and then simplifying the postponed decisions by a
commitment to particular relationships, and thus to particular decision
premises. Though Coase
(1988 [1937]) explains
that the creation of a firm leads to the avoidance of subsequent market
transactions, he does not go beyond the foundational contract by which a firm
is constituted to discuss the costs of creating an organisation,
and does not refer to Marshall’s (1920, p. 377) emphasis on the capital which
any successful business must invest in building up its internal and external organisation. He
therefore never quite states that the costs of a series of transactions, or a
series of acts of governance, may be reduced by appropriate investment, as Casson (1982) does in explaining why firms make markets. Both Coase and Casson, however, are in effect writing about the organisation of knowledge, which provides credible premises
for later decisions.
In his second article on the firm, Coase (1988 [1972], p. 63) recognised that “the costs of organizing an activity within any given firm depend on what other activities the firm is engaged in”; that is presumably why “General Motors [is] not a dominant factor in the coal industry or why A & P [does] not manufacture airplanes” (Coase 1988 [1972], p. 65). It should be noted that Coase’s interest in the scope of a firm is not focussed on vertical integration. However he does not say why the costs of organising activities should not be additive. The explanation lies in the possibility of reusing knowledge - in the present context in the possibility of applying the same set of decision premises over a wider range or a longer series of decisions (Loasby 1976, pp. 72-3). A firm provides
8
an agreed
framework of decision premises which both facilitates decision making and
generates a pool of experience which may be used to simplify these premises and
make them more precise (Williamson 1967, p. 136), thus making additional
managerial services available, as Penrose (1959, 1995) has explained.
Penrose has shown how the emergence of such additional managerial
services may lead to the extension of the scope of a firm’s activities, which
in the present context may be expressed as the extension of well-established
decision premises to a new line of business. Contrary to a common assumption in economic
theory, it is never possible to reuse knowledge without cost; but the costs of
reuse within a well-functioning organisation can
often be much lower than the costs of reuse outside. Thus, as Langlois
(1992) has pointed out, extensions of scope may be motivated less by the desire
to protect rents than by the high costs of transferring knowledge to other organisations which are unfamiliar with the appropriate
decision premises. A firm may also have
advantages as an instrument of local co-ordination because it can internalise important externalities through the
specification of the agenda and the criteria for decisions (Loasby
1976, pp. 76-8).
The organisation of resources within an
administrative framework (Penrose 1959, 1995, p. 149) is in part the organisation of compatible decision premises for the
effective use and further development of the knowledge which is distributed
within the firm. Not all firms succeed
in establishing such compatability; and if they do
they face two insidious problems: first, they may fail to make adjustments as
their environment changes, and second, the price of compatability
may be the suppression of enterprise within the firm. The danger of suppressing variety in the
process of maintaining internal coherence may however be mitigated by the
variation between the firms within an industry in the minor premises which they
use to interpret their experience. This
variation not only promotes the development of the economy; firms may be able
to benefit from the activities of their rivals. The importance of interfirm
variety used to be well recognised within the
chemical industry, in which access to knowledge created by rivals through
cross-licensing, and the role of research departments as importers of
technology were major premises of strategy; but it is often overlooked in the
pursuit of global scale.
The suppression of necessary variety may be particularly serious if a
firm seeks to internalise a cluster of activities
which though complementary are sharply dissimilar (Richardson 1972). The difficulties of matching disparate ways of
thinking while maintaining the match between each way and its own particular
field of application may be very great; and the concentration of the power to
decide in order to prevent the opportunism that specificity of knowledge
appears to make possible is liable to impede both the present use of that
specific knowledge and its further development. Interfirm
collaboration, of varying degrees of formality, is often a sensible response to
the dilemma of organisational versus activity-focussed compatability, because
this minimises the interface between very different
ways of structuring problems and facilitates the development of very specialised skills to cope with these difficulties, with
the aim not of reducing the costs of this class of transactions but of maximising their net value (Kay 1997).
All organisational design is conjectural (Egidi 1992). In order to make problems manageable it relies on a combination of opposing principles of decomposition and aggregation: issues which are believed to be sufficiently similar are bundled together (remember Knight’s necessary but dangerous principle for living intelligently), and separated from other issues by the definition of each manager’s responsibility, which is at once a grant of independence and a prohibition of
tresspass. Problems and perceptions are framed in a way
that, it is hoped, will keep down the costs of decision without significantly
damaging their quality. The organisational definition of decision spaces creates the
local environments within which the trial and error learning takes place that
drives economic progress according to Smith’s basic principle. But this learning is itself subject to error:
the inescapable difficulties of identifying causality in any complex system
(the Duhem-Quine problem) are aggravated by the
falsehoods that are necessarily incorporated in any organisational
design (Levinthal 1996) and which are reinforced by
the natural human tendency to take credit for success and assign the blame for
failure elsewhere. This propensity to
error strengthens the argument for variety across firms, and also supplies a
cognitive underpinning to Young’s (1928) association of increasing returns with
a changing organisation of industry.
As Marshall emphasised, the importance of
firms in economic development lies in their organisation
of knowledge. (That
this organisation might become seriously defective
was a problem that can readily be discerned in Marshall’s (1919) Industry and Trade). In the process they are sometimes - though certainly not always - more effective than market
relationships in “transforming a conflict system into a co-operative system” (Levitt and March 1995, p. 12); but this is not to be
explained solely, or even mainly, by their power to curb opportunism. Indeed, what is striking to anyone who
observes human behaviour is how many occasions for
opportunism are not taken; and this no doubt requires explanation.
Adam Smith, we should not forget, had a
theory of moral sentiments which is still applicable to small and relatively
stable communities, which may include organisational
groupings; but self-interest may often be sufficient to explain why we so often
accept other people’s premises for our actions . It is
so much simpler than constructing our own; indeed, as has already been pointed
out, we do not have the capacity to supply more than a small proportion of our
own premises for making sense of the situations that we encounter or for
deciding what to do about them.
The more complex our economy and our society become
the more dependent we are on premises which are supplied by other people.
It is often a relief rather than a cause
for complaint to accept the decision premises of an organisation
rather than provide our own; many people prefer employment to independence. When we recognise
the cognitive problems of constructing a coherent preference ordering it is not
even difficult to understand how we may come to internalise
organisational preferences, notably in the form of
corporate culture, which for good or ill inhibits challenge to the current
institutions, and may even make those institutions undiscussable
(Argyris 1994). Many economists, it may be observed, seem to
be very comfortable with the decision premises in which they have been trained,
and some find it hard to perceive what there might be to discuss about them.
Chester Barnard (1938) emphasised that it was the recipient of any communication who decided whether it was authoritative; and all of us are very happy to find sources of communication to which we can grant authority, even when we could apparently do better for ourselves by ignoring them (Reynaud 1996). Firms provide an environment in which members may develop good reasons for deciding whose authority they can rely on as premises for their own decisions - or as we might say, who can be trusted - for no organisation can work effectively unless each of its members is prepared to accept the word of many others, most of whom are not their formal superiors. As Kay
10
(1997, p.
215) has pointed out, it is very often the case that people agree to work
together not because they trust each other but in order to discover whether
they can reasonably trust each other, which of course cannot be done without exposing
oneself to opportunism. But if knowledge
is specialised, trust is indispensable. What is missing in the analysis of organisational equilibria which
is based on transaction costs is the effect of process on attitudes and
arrangements; and it is missing because the premises of the analysis exclude
it.
A firm is an interpretative system, within which people develop common
ways of understanding, and common ways of responding to what they believe they
have understood. Especially in a new
firm, there may be a strong entrepreneurial element in this interpretation; as
Martin Fransman (1995) has emphasised,
a firm may be the location for the construction of beliefs by which
interpretative ambiguity is resolved. Ambiguity,
of course, is also the arena for opportunism, and it is not unknown for people
to construct beliefs in which they have no faith but which they use to deceive
others; but the desire to impose order is so insistent that almost any pattern
which is not incompatible with our presently serviceable set of connecting principles
may seem preferable to fragmented knowledge, and crowd out opportunism. Often it crowds out the entrepreneur’s own
opportunism; Schumpeter was probably right in his implicit assumption that
entrepreneurs believed their own promises.
In models of efficient and inefficient allocation, strategy can hardly
be other than an efficient set of paths through a decision tree or a set of
actions by which to gain some monopolistic advantage. But business strategy, like military strategy,
belongs in a world of uncertainty; it is a means of resolving ambiguity into a
coherent set of major premises which promotes the compatability
of decisions over time and across decision makers. Soon after he had joined the research departmnent of a Division of ICI, my former colleague Frank
Bradbury was writing down the formulae for some chemical compounds that he
thought might have some commercial application when his manager walked past;
after scanning the list he simply asked “Where’s the chlorine, Frank?” At that time the Division produced chlorine in
large quantities as a by-product, and its researchers had considerable
expertise in chlorine chemistry; it was therefore natural to impose the use of
this by-product and these skills as decision premises for research. In a similar fashion, at a time when BP had an
unmatched reputation for discovering productive oilfields but not for marketing
the products, the Research Director of BP Chemicals told his research staff “The
objective of this Department is to shift crude”. Another aspect of this overall strategic
emphasis was the readiness to divert an oil tanker already approaching the Grangemouth refinery near Edinburgh to Rotterdam in
response to a slight rise in the spot market price.
Strategic decision premises provide structure to a complex set of decisions which might otherwise be incoherent. But no choice is without opportunity costs, and the pathology of the focus which is provided by strategy is bias. Both technological foresight and technological oversight may often be explained by the decision premises on which crucial decisions were based. For example, neither the top management of major corporations nor a technologically-based firm of consultants could see any reason why anyone should buy a photocopier to do what was already accomplished by a typist using carbon paper (Brown 1997, pp. 97-8); the contract by which IBM bought DOS from Microsoft, and which now appears to have been a disastrous blunder by the former and a brilliant coup by the latter, was carefully tailored to the localised decision premises of both parties, neither of whom was blessed with rational expectations (Porac 1997); and the precisely-calculated performance limits of optical lithography rested on well-defined physical, technical and production
constraints which proved not to be binding (Henderson 1995).
On the other hand, a novel set of
decision premises may lead an entrepreneur to deduce the possibility of a major
innovation. It is not necessary for any
single premise to be new; as Schumpeter (1934) claimed, what matters is the
combination, though what he did not emphasise is that
this combination may follow a good deal of development in what are to become
the components of the new vision.
Decision premises are required for decision processes. Theories of equilibrium states, even when
based on the concept of rational choice, have no place for decision processes,
for in equilibrium there are no decisions to be made. The best theorists have recognised
that behaviour out of equilibrium cannot be analysed with the standard and type of rigour
that is now expected, and so they choose theoretical premises which exclude it.
One of the attractions of game theory is
that there are no out-of-equilibrium moves; and one of its limitations is that
there is no credible method of dealing with multiple solutions or with
inconsistency within the logic of backward induction. Transaction cost economics, as a theory of
efficient allocations, is essentially an equilibrium theory, and also avoids behaviour out of equilibrium; thus the transaction is
indeed the appropriate unit of analysis and the decision premise is not.
If economics is to be defined as the study of fully-defined allocation
problems, in which it increasingly appears that the key requirement is
incentive compatability based on rational expectations,
then that is the end of the matter - except perhaps to tidy up a
few internal inconsistencies by deleting such concepts as money and the firm as
an organisation. But modern economics began with a theory of
economic development, propounded by a man who was deeply concerned with the
possibilities of human understanding, human communication, sensible action and
the possibilities of self-deception. Within that tradition it seems important to
pay attention to the formation and development of the premises on which people
reason and the knowledge and skills which they may acquire as a consequence of
economic organisation.
However, although I hope to have shown that thinking about decision
premises can be enlightening, I do not think that this should be the primary
unit of analysis for the study of economic organisation.
That place I believe should be filled by
the concept of the activity, linked with the concept of capability as it has
been by Penrose and Richardson. Activities and capabilities are highly problematic,
very diverse, and may be combined and developed in many ways; therefore they
merit a great deal of attention, in which the causal links with organisation should be bi-directional. Activities are linked by interfaces, which are
justifiably the special concern of transaction cost economics. However, I agree with Coase,
and with Demsetz (1997), that
problems of knowledge which do not qualify as agency problems provide
important theoretical premises for explaining the choice of transaction mode. I would go one stage further, and argue that
the management of a class of transactions, or of a particular governance
relationship, is itself an activity, and the effectiveness of that management
depends on the evolved capability of the person, or persons, who are doing the
managing. Since management requires
decisions, its quality depends upon the managers’ decision premises. Therefore the analysis of transaction costs
and of decision premises should be incorporated within the analysis of
activities and capabilities, which is fundamentally an analysis of processes
and institutions.
12
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