This is the second post in my little project of self publishing my PhD Thesis.  Last week I introduced an econometric analysis of the impact of Information Technology (IT) firm size.  This time it is a more theoretical paper that presents a model for examining the impact of different types of IT on the structure of organizations.  In particular, it compares having no IT, with centralized IT (think mainframes) and networked IT (think Internet and Intranet).

I was particularly happy with how this paper came out because it addresses a fundamental problem in economics: the organization of economic activity in firms versus markets.  In re-reading the paper I found that I don’t actually bring this point out very well at all because I focused the paper too much on different organizational forms (inside of firms).  So I will try to do a better job in this little recap / introduction.

Ever since Coase published his seminal essay on The Nature of the Firm, there has been a long running inquiry into a fundamental question of economics: why are some activities carried out in the market and others inside of firms? Coase and subsequent writers focused on the idea of differing transaction costs, but the precise mechanism by which transaction costs would be different in a market versus inside firms were hard to pin down. That changed with the work on principal agent problems and incentives.  Tons of different economists contributed to this. I was fortunate to have one of them, Bengt Holmström, as one of my thesis advisors.

One of the key insights coming out of Bengt’s and others’ work is that firms exist to reduce incentives.  Why would you want to reduce incentives?  In order to get better coordination.  If you pay people a flat wage then you can direct what problems you want them to work on and how you want them to work together on those problems.  In fact, much of what companies do in HR and compensation, such as reviews, goals, options, bonuses, etc. is aimed at restoring some additional motivation in the face of much reduced incentives. Effectively you can think of this issue as a coordination - initiative tradeoff frontier.  You can get more coordination inside of a firm than in the market by reducing individual initiative.

What my paper does is explore the shape of the coordination - initiative frontier based on different types of information technology.  I distinguish between three different scenarios: no IT, centralized IT and networked IT.  I examine how these three different scenarios would play themselves out in the absence of incentive problems, i.e. when everybody does the “right” thing to maximize joint production.  That analysis provides a baseline for looking at the incentive case.  In the incentive case people look to their own benefit first and thus exert less effort if their incentives are muted.

The key findings are summarize in the following diagram

The diagram shows the location and shape of the coordination - initiative frontier.  The first key finding is that having information is a good thing as the frontier for both IT cases dominates the one without IT.  The second key finding is that that networked IT dominates central IT case: it is possible to achieve full coordination at a much higher initiative level than with centralized IT.

In the paper I interpret this result along different organizational forms inside the firm.  But it would be just as correct (and looking back at it more relevant) to classify this as the historical change that we have experienced from mostly individuals in the market (agriculture, crafts, trading), to having large hierarchical firms (industrial society), to replacing those hierarchies with networks (now).  That of course is a very nice fit with what I and others have been arguing in the Peer Progressive agenda.