Markets in the Firm

INTRODUCTION

Why is it that major world economies appear to be enjoying a sustained period of solid growth without the emergence of growth-destroying, wage induced inflation?  Inflation may occur as a result of other factors, but the wage-push dragon appears to have been slain.

It seems to be agreed that structural and continuous productivity improvement is the explanation [1], but why is this happening?  The information technology revolution is often cited as the cause, as is fear of losing one's job.  But neither of these explains or gets to the essence of the welcome transformation in workplace behavior.  Certainly IT has contributed by causing a spectacular collapse of transaction costs.  However, alleged fear of losing ones job is not supported by empirical analysis. [2]

In answer to the riddle the proposition presented here is that market principles have began to penetrate the internal management of firms.  When firms adopt internal markets, as opposed to being run as command and control collectives, the search by their personnel for higher incomes is tempered and constrained by firms' performance in external markets.  When command and control operates, wage reviews are dominated by warlike standoffs between workers and management where each party attempts to capture the benefits of the firm for itself.  Under command and control, external market signals relevant to the firm are ignored as the politics of envy, egotism and winner-takes-all corrupt decision-making and force staff costs up beyond the capacity of the firm to pay.

In societies dominated by command-and-control firms, the combined weight of thousands of firms paying more than their market performance can induce wage-led inflation.  But under markets in the firm, remuneration is not artificially controlled by the managerial elite but rather is the outcome of thousands of small price and other market signals that individuals constantly transmit to one another.  The result is increased income for internal staff, as their self-interested search for higher incomes is self-financed by leading to improved firm performance.  This causes the productivity explosion.  Firms that fail to share their market success with staff lose the staff upon which the success is built and ultimately collapse.  In this model the internal market is as important to a firm's success as the external market.

The debate over the Phillips curve -- "the notion that there was a permanent trade-off between inflation and unemployment, so that policy makers could choose from a menu of alternative rates of inflation and unemployment;  the higher the rate of inflation they were willing to tolerate, the lower the rate of unemployment they could achieve" -- has continued since its debunking by Milton Friedman in 1967. [3]  Friedman noted that it continues to be a popular idea particularly among lay and journalistic commentators.  Friedman introduced the idea of the "natural rate of unemployment" to which "the level of unemployment would tend whatever the rate of inflation" [4] and that to push unemployment below its natural rate required accelerating inflation.

It has since been argued that the natural rate of unemployment no longer applies.  However, Edmund Phelps, one of the inventors of the natural-rate theory, retorts that "The model's inventors never viewed the natural rate as a constant.  It is simply an economic variable determined by non-monetary forces". [5]  Further, "the real forces of enterprise and finance ... are the ultimate drivers of unemployment".

Whatever the merits of the two theories, the general idea is that unemployment has a structural floor (even if shifting) below which it cannot fall without inducing growth-destroying, wage-push inflation.  But if Phelps is right, the trick is to unlock the "forces of enterprise and finance" that allow us all to seek as much work and income as we want without triggering wage-induced inflation.

Is this possible?  Yes, if the principles of free exchange apply in the hitherto sacrosanct command and control zone:  the internal operations of firms.  Further, applying markets within firms is perhaps the final and full development of the non-monetary structural forces that could drive the natural rate of unemployment to zero.  To explore this theme further requires a revisiting of the concept of the firm itself.

THE FIRM AND CONTROL

The modern understanding of the firm starts with Ronald Coase's idea of transaction costs.  Coase famously argued in 1937 that the firm exists because it provides a structure that contains transaction costs.  However, it is less often noted that Coase argued that the containment of transaction costs was dependent on control exercised by an entrepreneur through the master-servant legal employment relationship. [6]  It has been taken for granted that without this right of managers to control employees, transaction costs could not be contained.  The prevailing idea of the market economy, then, is one in which free transactions occur between firms but do not and cannot occur within firms.  This limited view of markets dominated the theory and practice of management throughout the 20th century.

Command and control management won great prestige between the 1920s and the 1970s [7], when the Taylorist or scientific approach to management prevailed.  Taylorists held that it was possible to assess and formally structure every process and action required in a firm and that every employee subordinate to senior management would exercise thought and initiative only to the extent allowed by management.  This approach achieved its apogee of sophistication under Elliot Jacques as late as the 1980s. [8]  Jacques, a psychoanalyst by background undertook detailed studies of human behaviour in bureaucracies, and on that basis constructed a theory of management in which every function in a large organisation could be scientifically analysed for the "time span management" required to facilitate the function.  This made it possible to construct and apply a precise bureaucratic structure.  Under it, staff remuneration and ambition were determined by the firm's bureaucracy, thus establishing order, control and harmony.  Disharmony occurred only when staff sought to break free from the structure.  Jacques' principles continue to be applied in some of the world's largest mining companies, the US military, and elsewhere.  Interestingly, Jacques himself was careful to state that his principles did not apply to small business and in his own experience failed in the academic and education areas.

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