the Modern Business Enterprise

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Traditionally the market mechanism has been responsible for the effective allocation of resources, however as goods and services began to increase in complexity firms began to internalise different activities taking on an organisational structure. This allowed them to benefit from administrative coordination and reduced transaction costs. The role of management became essential to coordinate and monitor the various activities which, in part, replaced the role of the market mechanism as the allocator of resources. The most effective allocation is achieved with a regulated combination of organisations transacting in the market but just how effective is dependent on the type of resources within the market. Not regulating the market sufficiently was a major contributor to the recent economic crisis.

By definition a perfectly competitive market is efficient but in reality the market fails to maximise the efficient allocation of resources. Traditionally the market has determined how resources are allocated. In a perfectly competitive market this allocation is dependent on the equilibrium price where demand is equal to supply. Adam Smith described this market mechanism as the invisible hand of the market whereby everyone pursues their own interests creating the ‘general utility of society' (Bishop, 1995, p165). This model assumes firstly that the products within the market are identical; secondly that the market consists of a number of small participants and finally full information assuming price is a sufficient statistic. Perfect markets by definition are Pareto-optimal, if the allocation of resources is Pareto-optimal ‘no one can be made better off by changing the allocation of resources without anyone becoming worse off.'(Douma and Schreuder, 2008, p40). Therefore a perfectly competitive market is efficient by definition as individuals demand and supply what they want at the given price. In reality markets are not perfect and there are efficiencies to be gained by the introduction of organisational structure.

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Organisations provide a solution to some of the inefficiencies of the market as an allocator of resources and as a result managers have taken a more dominant role. Chandler (1977) argued that the invisible hand of the market was replaced by the visible hand of management within the ‘modern business enterprise' as a result of specialisation, internalisation and developments in technology. He describes the traditional American firm before 1840 as owned by ‘an individual', only producing one good and ‘operated out of a single office'. These types of firms ‘were coordinated and monitored by market and price mechanisms' whereby resources are supplied and demanded at the equilibrium price (Chandler, 1977, p79).‘An economy is efficient when it is impossible to get more output from existing resources' (Fitzroy et al, 1998, P162) and so markets are not efficient. The division of labour, referring to the introduction of specialisation in a particular task in the firm, was effective due to the development of task specific skills and therefore work became quicker and more accurate, it also saved time transferring the products between stages of production. While these factors improved efficiency it was the environmental change of the innovation of machinery that allowed ‘one man to do the work of many' (Douma and Schreuder, 2008, p7) that led to specialisation having such a profound effect on the potential output of a firm.

The ‘modern business enterprise' according to Chandler consisted ‘of many distinct operating units' ‘managed by a hierarchy of salaried executives' (Chandler, 1977, p79). This type of system was the beginning of an organisational structure. These firms began to set up or procure other activities outside of their traditional processes, referred to as internalisation. ‘The internalisation of many units permitted the flow of goods from one unit to another to be administratively coordinated' (Chandler, 1977, p80). For specialisation and internalisation to work the different activities had to be coordinated and monitored. The owner was no longer capable of monitoring and coordinating alone and so middle management was essential. As a managerial hierarchy began to emerge owners began to take a back seat in decision making and it became the managers who made the decisions on how to coordinate the resources of the firm and thus took the role of the invisible hand of the market, what Chandler refers to as the visible hand of management. Management also began to coordinate an organisations future allocation of resources in the form of strategy.

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The role of management developed in the ‘modern business enterprise' the separation between ownership and control increased. Jensen and Meckling (1976) argued that there is an inverse relationship between on-the-job consumption and the amount of ownership an employee has of a firm and so it is inefficient for management and ownership to be separate as they will be less efficient in the way they carry out business processes. So while the organisation may save on administrative coordination they may lose efficiency as the priorities of management are not aligned with those of the company. To prevent this organisation's must provide incentives and monitor performances both which have a cost and so there is inefficiency to having a managerial hierarchy as opposed to using the market.

According to Williamson (1985) under the conditions of high complexity and uncertainty it is more efficient for transactions to take place within an organisational structure. Coase (1937) states that ‘the operation of a market costs something and by forming an organisation and allowing some authority (an 'entrepreneur') to direct the resources, certain marketing costs are saved' (Douma and Schreuder, 2008, p47). ‘Transactions costs arise principally when it is difficult to determine the value of the good or service' (Ouchi, 1980, p130).

In a perfectly competitive market this price is determined by the market mechanism but in application informational asymmetries exist, making efficiency difficult when setting up contracts for transactions. Williamson (1985) refers to the behavioural assumption of the informational problem of Bounded rationality that ‘the capacity of human beings to formulate and solve complex problems is limited' (Douma and Schreuder, 2008, p163). An organisation reduces the informational asymmetries as relationships are developed and the company specific information is already known. It also reduces the risk of opportunism as it is not beneficial to act opportunistically against other people in the same organisation. It is more efficient when organisations exist to minimise transaction costs than in a market of small firms. Managers are also beneficial to increase the efficiency in resolving conflict and having experience in the specific activity they specialise in as career managers. Spence argued that by signalling a market can recover from market failure as described by Akerlof in the example of the market for lemons (adverse selection) and so the market can recover from failure (Lofgren et al, 2002). In the case of a market that consists of simple goods and services that are fairly stable it may be inefficient to transact through an organisation as there is very little cost in the market to determine the price and the cost of paying management and administration will exceed the amount saved.

Hayek (1945) argued that no individual is capable of holding all the information required to make an effective decision on the allocation of resources. It is the equilibrium price of the market mechanism that contains sufficient information to make a decision and thus the market which ultimately allocates resources. ‘In a system where the knowledge of the relevant facts is dispersed among many people, price can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan' (Hayek, 1945, p70). So it is not the managers who have replaced the market mechanism instead they continue to use it to coordinate the resources.

Ouchi (1980) has argued that a third explanation on an efficient outcome on transactions can be achieved by the concept of ‘Clans' whereby ‘Industrial organisations can, in some instances, rely to a great extent on socialization as the principal mechanism of mediation' (Ouchi, 1980, p132). In this case both market and organisational transactions are made efficient by the individuals desire to cooperate to get the best outcome. So it is not necessarily the market or the organisational structure that produce the most efficient allocation of resources.

Due to the nature of people and the nature of capitalism opportunistic behaviour goes unregulated and so people work only to maximise their own gains, efficiency and long term stability are not prioritised. Organisations exist in order primarily to maximise profit not to make the market more efficient. As organisations gain power unregulated they can create a situation where they gain profit above the normal. This is especially true in the case of a monopoly where an organisation can decrease quality and increase price because customers have no choice. Regulation is therefore required in order to prevent an organisation holding more market power than is efficient. A lack of regulation played a huge role in the recent financial crisis as too many people relied on the market to regulate itself.

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In conclusion it has been the market that has traditionally coordinated the allocation of resources but, as argued by people such as Williamson, there is a cost of transacting within a market. Organisations are able to reduce these costs by internalising these transactions and as a result are capable of being more efficient than the market. Even greater efficiency can be gained from administrative coordination between activities and as a result management is essential to coordinate and monitor. The benefits are only gained from a regulated combination of both market and organisational structure. While organisational structure can improve the efficiency of the allocation of resources it remains the market that is the dominant allocator.

References

* John D. B. 1995. Adam Smith's Invisible Hand Argument. Journal of Business Ethics. 14(3). pp. 165-180.

* Douma, S. and H. Schreuder. 2008. Economic Approaches to Organisations. Essex. Pearson Education Limited.

* Chandler, A. 1977. The Visible Hand. Cambridge. Harvard University Press. (As reprinted by Putterman, L and R. S. Kroszner in ‘The Economic Nature of the Firm' Chapter 6). pp. 78-85.

* Fitzroy, F. R., Z. J. Acs and D. A. Gerlowski. 1998. Management and Economics of Organization. Essex. Pearson Education Limited.

* Jensen, M. And W. Meckling. 1976. Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. Journal of Financial Economics. 3. pp. 305-360.

* Williamson, O. 1985. The Economic Institutions of Capitalism: Firms, Markets and Relational Contracting. The governance of contractual relations (Ch.3). (As reprinted by Putterman, L and R. S. Kroszner in ‘The Economic Nature of the Firm' Chapter 9). pp. 125-135.

* Coase, R. 1937. The Nature of the Firm. Economica. 4. pp. 386-405 (As reprinted by Putterman, L and R. S. Kroszner in ‘The Economic Nature of the Firm' Chapter 7 pp. 89-104).

* Ouchi, W. G.1980. Markets, Bureaucracies, and Clans. Administrative Science Quarterly. 25(1). pp. 129-141.

* Lofgren, K. G., T. Persson and J. W. Weibull. 2002. Markets with Asymmetric Information: The Contribution of George Akerlof, Michael Spence and Joseph Stiglitz. Scand. Journal of Economics. 104(2). pp. 195-211.

* Hayek, F. 1945. The Use of Knowledge in Society. The American Economic Review. 35. pp. 519-530. (As reprinted by Putterman, L and R. S. Kroszner in ‘The Economic Nature of the Firm' Chapter 4 pp. 66-71)

* Williamson, O. 1996. Industrial Organization. Cheltenham. Edward Elgar Publishing Limited.

* Milgrom, P. and J. Roberts. 1992. Economics, Organizations & Management. New Jersey. Prentice-Hall Inc.