The Chronicles of a Capitalist Lawyer: Theory of the Firm

Showing posts with label Theory of the Firm. Show all posts

The failure of Boeing's outsourcing business plan by farming out most of its work to other overseas firms might be a good example of the danger of outsourcing when it is used without proper calculation. The original idea itself seems good. By outsourcing the work to other firms instead of doing it by itself, Boeing hoped to save costs. First, Boeing can choose firms which have better economies of scale (meaning that such firm have better comparative advantage compared to Boeing and therefore can produce the required products on a cheaper basis). Second, Boeing can focus its works on things that it could do more efficiently (again the idea of economies of scale). Third, by separating the works to many firms, Boeing expected that each of those firms will have less bargaining power against Boeing, lowering the chance of hold up problem for Boeing in the future (see my discussion on Hold Up problem here).

Unfortunately, this seemingly perfect plan did not work in practice. As you can see in my link above, Boeing is already three years late from the original schedule and has spent billions dollars over the budget. It is a business disaster. But why such system does not work? Before I provide my analysis, I would like to share a deal that I once did for one of my major clients.

The client wanted to build a new huge factory in order to expand its business to a new level. In the past, the client usually appointed only one single contractor to do all the work (design, procurement, and construction). However, for this particular project, the client came with a new idea. Instead of using single contractor, it first divided the works into procurement (including design) and construction. Then it further divided the procurement parts into 4 separate parts with 4 different suppliers. It was a good idea. Although the contracts became very complex, the client can save a lot of money by lowering the contract price and reduce the bargaining power of the suppliers (effectively preventing them from forcing their own terms and conditions which would usually happen when there is only one contractor/supplier).

It is interesting why my client structure could effectively work while Boeing's plan turned out to be a failure. Several factors that must be considered are among others: (i) the number of parties involved in the deal which is related to the costs for coordination, (ii) the costs for enforcing the contracts which is correlated with the degree of interdependence between the parties, and (iii) the level of technology involved in the process.

One of the most interesting examples provided by Milton Friedman on the power of free market is the story of pencil. No one knows exactly how pencils could be made, there are so many parties involved in the process and yet, firms make pencil with ease without having to be coordinated nor integrated in the process. It is the perfect example of the invisible hand, how market could work without the need of central coordination among market participants. But issues always come when we try to generalize everything. The case of Boeing can be a good example when failure occurred because lack of coordination.

In my client's case, it took a lot of effort and months of negotiation in order to coordinate 4 suppliers. Yes, there are only 4 suppliers involved in the deal, but the contract drafting process took a long time to ensure that proper risk allocation was made for each contract since even when all of the suppliers were different, each supplier's action can have a significant impact to other supplier's work. A delay in part 1 could impose delay on part 2 and so forth. In other word, coordination really matters. What happened with Boeing is that it seems that Boeing used too many different suppliers located in various parts of the world (I would assume that Italy suppliers would be totally different from Chinese suppliers). This choice of action increased the costs of coordination significantly.

This bring us to the second issue, the costs for enforcing the contract. Since people respond to incentives, if breaching the contract is more efficient than actually satisfying the contract's provisions, we could safely assume that people will choose to breach the contract. In Boeing case, it seems that it's suppliers farm out their work to another sub contractors, increasing again the costs of coordination. Surely it is standard to have contracts where subcontractors are not permitted to sub contract their job to third parties without prior approval from the work giver or that while work can be sub contracted, the liability stays with the supplier. But that kind of contract would work effectively only when the costs of enforcement is not high. If the enforcement cost is high, there would be less incentives for the work giver to enforce the contract. Even worse, since the contract value has been divided into so many suppliers, the value of each contract might be too small for each supplier, to the extent that they do not fear of any liabilities, even when they are deemed fully liable (since usually a supplier will limit its liabilities only to the value of the contract and not the whole project).

In other words, this is a reverse issue of hold up. In hold up problem, a party can increase its bargaining power excessively due to certain specific conditions or advantages that such party has against its counterpart. But in this case, the party has no incentive to work for the best interest of its counterpart because it's stake of interest is low. Even if its counterpart is in impeding doom, that would not affect its position significantly and thus it is meaningless whether the business relationship should be maintained or not.

Finally, the issue of technology is also dominant in Boeing case. What they are trying to build is a new airplane. In case you don't know, airplane can be considered as the most advance technological product in earth. It is very hard to build a plane that could work properly. That's why Boeing case cannot be compared with the success story of the car industry in terms of outsourcing their job overseas. There is a huge discrepancy between the technology needed to build a plane and the one needed to build a car. This would surely affect the amount of coordination needed between the parties. We can say that it would be better in Boeing case if they simply have more integrated coordination and conduct the work by themselves.

At this point, we reach the most fundamental question posed by the Theory of the Firm. Why people choose firm to conduct its business activities, instead of using the market? The primary answer would be the need for coordination. To the extent the costs of integrating the market process (production, manpower and capital) in a single business platform is cheaper than the costs of doing all of that via the market, rational men should choose to use the firm structure. It is a natural thing to do. Too bad that people often polarize the issue of market vs the firm into a debate of uncoordinated economy against coordinated economy as if only one is superior. A productive debate should discuss what type of economic system would work best in accordance with the situation and condition. The pencil case shows the strength of the market while the Boeing case shows that uncoordinated market process could produce inefficient result. In the end, always pick the most efficient system if we really care about the welfare of the society.

Since I call myself the Capitalist Lawyer, it's hard for me to resist the temptation of enrolling in one of my law school's courses: Law and Political Thought - Neoliberalism and Its Critiques. After all, I always believe that you can't properly learn a thought if you don't learn its critiques. One of the required readings in this course is Naomi Klein's book, the Shock Doctrine. The basic idea of her book is that the globalization of neoliberalism is primarily caused by the shock doctrine, where neoliberalism supporters use a crisis in a particular place in the world to spread their ideology in an effective way, ensuring that the changes can be made in a massive scale and that such changes would be almost irreversible once they are established as governmental policies.

To add the spices, the book also shows how the shock therapy is administered to various part of the world such as Chile (Auguste Pinochet case), Iraq (the oil companies saga), Asia tigers (the 1997 crisis where Indonesia was part of the victims), China (Deng Xiaoping reformation and the Tiananmen Square) and also England's liberalization (under Margaret Thatcher rule). Furthermore, she also believe that all of these disasters were caused by the idea of Milton Friedman, the famous economist from the University of Chicago. Milton Friedman who was very famous for his teaching on the power of freedom, free market and limited government was blamed as the prime perpetrator of neoliberalism. He was also quoted as the guy who first started the idea of using crisis as a way of spreading ideology.

I must say that reading her book, I am not convinced that there is a strong relationship between the idea of Milton Friedman and the administration of the shock doctrine. It seems that most, if not all, of her critiques and evidence used in the book are precisely not a part of Milton Friedman teachings, nor should they be considered as a part of the original idea of neoliberalism. I would say that she has mixed neoliberalism with corporatism and/or crony capitalism which should be rejected from any point of view.

First of all, using crisis as a starting point of spreading your idea is totally legitimate. Through out the history, we have seen numerous times how crisis change how people perceive the world. If it is not because of the Great Depression in the 1930s, Keynesianism would never had the chance to spread. No one would believe that the solution for depression is additional government consumption. And if it is not for the 2008 crisis, no one would write books on Keynes revivalism. I think the reason why crisis is so effective to spread new ideas is simply because during crisis, people are shocked, their previous believe is shaken, they are vulnerable and would easily see any other new alternatives as the solution. This is what we call as hindsight bias.

Unlike her idea, that shock therapy is a bad idea, I believe that crisis is neutral. Any person can use a crisis for his own advantage, including spreading his ideas. Whether such idea is good or not is a separate matter and history will usually determine the longevity of an idea, whether it will survive for a long time or not. The same thing also happened in Indonesia during the 1966s. When Sukarno fell from his throne and Indonesia was consumed by more than 600% rate of inflation, it was also the right time to dethrone the socialism ideology and replace it with a balanced government intervention-free market economic system. In reality it was a success until Indonesia was turned into a state of crony capitalism and ended badly in the 1997 crisis. If we don't have such crisis, who knows where will our beloved country actually end. Maybe worse than now.

Second, her stories show how dictators use their power to force the free market idea into the society and how corrupt governmental officials cooperate with corporate officers for the sake of their own profits and interests (business lobbying is a serious problem, even in the United States). While that might be true, I don't think that represents the vision of Milton Friedman on capitalism and freedom. The capitalism that I know and believe as the best economic system for the welfare of society does not support dictatorism nor does it support crony capitalism. The capitalism that I know also does not support absolute freedom where business firms can do everything without any liabilities whatsoever. That does not make any sense. Economics teaches us that there are externalities that can be produced by a party against the welfare of the society and that in order to enable the market to work efficiently, such party must be held liable and internalize the costs that it has imposed to the society.

This is where I think Naomi Klein miscalculated her own idea. She work really hard to show how evil Milton Friedman is and how bad neoliberalism is, where government is being stripped from their power and the state assets are sold to several oligopolists who then control the market for their own benefits. Yet in reality, none of these represent neoliberalism thought. Minimum government should not be translated into: "you can do whatever you want". It means that the government should not try to be too big and then used by various interest group for their own purposes. We know that government consists of people, and we also know that they are not angels. To believe that government would always consist of good people would be as naive as believing that the market would always full with good people.

Ronald Coase in his famous Theory of the Firm has shown that firms, coordinated and integrated business units where capital, management, and employee meet and work together, exist within the market. Some empirical researches also show that 50% of the businesses conducted in the market are being run by firms. In short, this means that coordinated effort is necessary and also useful to the extent that the costs of doing so is cheaper than doing transactions via the market. So naturally, there is a balance between coordinated economy and uncoordinated economy where the invisible hand will work.

So in the end, what is neoliberalism? I am still looking for the answer during the course. But I don't believe that it should be placed in the same place with dictatorism and crony capitalism. The idea to promote the welfare of the society by maximizing the freedom of the people and limiting the role of the government in order to make it focus on its essential duties should never be used to justify greed and crimes. It is stupid if you think everything should not be regulated, but that's just the same with the idea of regulating everything. I'll update this issue once I finish the course.