Alchian, Armen A., and Harold Demsetz, “Production, Information Costs, and Economic Organization”, The
American Economic Review, Vol. 62, No. 5 (Dec., 1972), 777-795
A&D present a theory of the firm. The authors view the firm as a contractual structure with (1) joint input
production, (2) several input owners, (3) one party who is common to all the contracts of the joint inputs, (4)
who has rights to renegotiate any input’s contract independently of contract with other input owners, (5) who
holds the residue claim, and (6) who has the right to sell his central contractual residual status. This contractual
structure arises as a means of enhancing efficient organization of team production, but is deterred by costly
monitoring problem. A&D then analyze the implications of their theory in the framework of various forms of
organization (e.g. profit-sharing, socialist, corporations, etc.). Finally, A&D conclude by liken the firm to a form
of efficient market in that information about he productive characteristics of a large set of specific inputs is more
How is the relationship between a firm and its employees different from that of a customer and his grocer?
It is the team use of inputs and a centralized position of some party in the contractual arrangements of all other
inputs. It is the centralized contractual agent in a team productive process – not some superior authoritarian
directive or disciplinary power.
I. The Metering Problem
[Def] Meter: to measure and to control
Task of the economic organization: metering input productivity and metering rewards. The metering can
sometimes be resolved through exchanges in a competitive market.
Relationship between metering and productivity: contrary to classical assumptions that productivity
automatically creates its reward at zero cost, A&D believe that it is reward that induces productivity. Further, if
an organization meters well, then reward and productivity would be highly correlated, and productivity would be
II. Team Production
[Def] Team Production: production in which (1) several types of resources are used, (2) the product is not a
sum of separable outputs of each cooperating resource, (3) not all resources used in team production belong to
When? Team production will be used if it yield an output enough larger than the sum of separable production of
inputs (perhaps for other uses) to cover the cost of organizing and disciplining (detection, policing, monitoring,
measuring, or metering) team members.
Shirking: assume that both leisure and higher income enter a person’s utility function, then an individual would
work until his MC of working (MR of leisure) = MR of working (MC of leisure). Because detection is costly, a
worker’s cost of leisure decreases. In addition, part of this cost (of leisure) will be borne by others in a team
production, but other teammates will only monitor him(lazy worker) to the extent that MC of detection = MR of
detection lower productivity and more shirking.
Market solution to shirking: market competition can attenuate shirking, but its power is limited. If the
employer (not a teammate) offers a higher than market-equilibrium wage, then workers outside the firm would
compete for a job in the firm, thus threat of replacement would retrain worker shirking in the firm. However,
since workers outside the firm may be uncertain about their productivity in the firm, competition from the
outside may not be a strong enough deterrent. Furthermore, since every new entrant in the team must by def has
promised to receive less reward or produce more, the new entrants faces even more incentives for shirking. This,
the power of market competition to restrain shirking is limited.
III. The Classical Firm
Monitors: One method of reducing shirking is for someone to specialize as a monitor to check the input
performance of team members. The specialist who receives the residual rewards will be the monitor of the
members of the team.
[Def] Ownership/employer of the classical(capitalist, free-enterprise) firm? Rights (1) to be a residual
claimant, (2) to observe input behavior, (3) to be the central party common to all contracts with inputs, (4) to
alter the membership of the team, (5) to sell these rights.
2 necessary conditions for the emergency of the firm when utility is non-pecuniary: (1) it is possible to
increase productivity through team-oriented production, but it is costly to directly measure the marginal outputs
of the cooperating inputs and thus hard to restrict shirking through market mechanisms, (2) it is economical to
estimate marginal productivity by observing or specifying input behavior classical capitalist firm
[Def] Classical capitalist firm: a contractual organization of inputs with (1) joint input production, (2) several
input owners, (3) one party who is common to all the contracts of the joint inputs, (4) who has rights to
renegotiate any input’s contract independently of contracts with other input owners, (5) who holds the residue
claim, and (6) who has the right to sell his central contractual residual status
Compared to other theories of the firm: Coase’s theory is incomplete in that it doesn’t explain the
circumstances under which the cost of “managing” resources is lower than the cost of allocating resources
through market transactions. In addition, A&D note that the firm is the only possible outcome when the factor
of “team production” is taken out.
IV. Types of Firms
A. Profit Sharing Firms: the larger the number of residue claimants, the less each person gets, and the more
likely he is to shirk. Profit sharing is more viable in small teams where the cost of specialized management
of inputs is large relative to the increased productivity potential in team effort, e.g. artistic or professional
B. Socialist Firms: essentially a politically induced profit-sharing firm. Since these firms are not freely-formed
but politically imposed (e.g. Jugoslavia), shirking must be a big problem without some “special” (politically
induced) management techniques. In practice, in Jugoslavia, there exist employee committees that monitor
C. The Corporation: they arise because of the need to acquire large amount of capital. However, due to its
size, it is ineffective to have every stock owner participate in the decision making process. More effective
control of the corporation activity is achieved by transferring decision authority to a smaller group, whose
main function is to manage teams and inputs. An important feature of corporation is the stock-holder’s
right to sale his shares when he disapproves of firm practices, rather than try to control the decision of the
management. The policing of managerial shirking is controlled by stockholder’s votes, particularly the
frequency in which the stockholders are able to vote in blocs. However, the right of stockholders to sell his
share when he is displeased with the company performance/management makes decisive action against
shirking management harder to achieve.
D. Mutual and Nonprofit Firms: since future profit is not a driving force for management, it is likely to find
greater shirking in these firms.
E. Partnership: market organized team activity with no employer/employee. These teams are usually very
small to prevent excessive dilution of effort through shirking, and are usually formed by individuals who are
relatives or long-standing acquaintances, because they are familiar with each other’s work characteristics and
tendencies to shirk.
F. Employee Unions: specialized monitor hired by employees to monitor those aspects of employer payment
most difficult for the employees to monitor.
G. Team Spirit and Loyalty: since every team member would prefer a team in which no one, including
himself shirked, team spirit and loyalty is welfare-enhancing in the sense that it enhances a common interest