Markets and Hierarchies, and Software

I originally wrote this entry on September 16, 2004, and published it on blogs.sun.com.

Some in the open source community, who may have had a chance to glance through The Cathedral and the Bazaar, will most probably miss that the contrast between "Markets" and "Hierarchies" is nothing new, at least to the institutional and transaction-cost economists. (To be fair, Eric Raymond does briefly mention some papers based on Ronald Coase's work, including some by Harold Demsetz.)

My own understanding of the topic is based on Oliver Williamson's works on Markets and Hierarchies. [I can only say that I was extremely lucky to have a chance to learn more about his ideas in the course of an independent study with Williamson while I was at Berkeley earlier this year. It was a very rewarding experience.]

In fact, I'd very much like to see more applications of Williamson's ideas to Open Source economics and to software economics in general.

In short, there's a place for hierachies and there's a place for markets. As the economy evolves, relations of exchange could be brought into the market or into hierarchies. What matters is transaction costs. Whichever exhange relationship (market, hybrid or hierarchy) reduces transaction costs will be taken up. These ideas are also echoed by Douglass C. North in his investigation of how economic structures evolve.

Only the Resourceful Survive

I originally wrote this entry on September 15, 2004, and published it on blogs.sun.com.

I drove my daughters back from El Camino Youth Symphony violin practice tonight and was wondering why we could not simply and conveniently ride a train home.

We were driving in my (still quite inefficient) compact European car, and with two additional passengers, I had the luxury of driving in the carpool lane. I don't often get to ride in the carpool lane. So, I was quite surprised when I kept passing the many, many SUVs in the non-carpool lanes, each with a single driver inside.

What an odd sight!

My immediate thought was whether we could claim to have an efficient economic organization in the Bay Area? I don't think so. (Given equal purchasing power, it still takes me less time and effort, per transaction, to buy a certain quantity of yogurt in Tehran, where I visit my grandmother, than it does in San Jose, where I live with my family.)

Note that I'm not criticizing SUV owners, drivers or buyers. People often own and use things that they believe they need. In fact, I constantly toy with the idea of owning an SUV. (It could make life much easier.) What I'm questioning is the organizational aspects that help drive and accentuate such needs at a larger level.

According to Chester Barnard, an organization has to be efficient or effective to survive. The more an organization lasts, the more efficient and effective it will have to be to continue surviving. Does Barnard's maxim hold about national or regional economies? It seems to me that it does to a very significant degree.

In the long run, only the resourceful organizations will survive. The wasteful ones are most likely to disappear, and disappear they will quite quickly.

Effectiveness vs. Efficiency--Why Organizations Persist?

I originally wrote this entry on September 13, 2004, and published it on blogs.sun.com.

I've written about Chester Barnard before. His 1938 book, The Functions of the Executive (Harvard University Press), remains one of the most important business and institutional economics classics. It has been reprinted some 30 times since its initial publication.

Here's what Barnard says about the persistence of organizations.

The persistence of cooperation depends upon two conditions: (a) its effectiveness; and (b) its efficiency. Effectiveness relates to the accomplishment of the cooperative purpose, which is social and non-personal in character. Efficiency relates to the satisfaction of individual motives, and is personal in character. The test of effectiveness is the accomplishment of a common purpose or purposes; effectiveness can be measured. The test of efficiency is the eliciting of sufficient individual wills to cooperate.

As Barnard seems to imply, efficiency is harder to measure than effectiveness. Let's give an exmaple.

Say, 10 people get together to push a large spherical rock up a hill. Effectiveness of their organized activity can be determined by seeing whether the rock makes it to the top. The efficiency of their activity will depend on their optimal expenditure of energy for pushing the rock up the hill. How do we know who's pushing more, or less, optimally? A measurement of effort which does not poison cooperative relatioships is quite hard. The only way people are motivated to do what they are doing is if they are satisfied with the results as it relates to them personally. As Barnard has noted, the survival of an organization not only depends on the environment or context of its activity but also on factors "which relate to the creation or distribution of satisfactions among individuals" since such satisfactions will determine motivation and efficiency of the cooperative activity.

When Industries Explode into Revolutions

I have always wondered how technical (not scientific) revolutions come about and join with market forces to create a bonanza of activity in a particular industry.

We have seen it happen with Java in the Software and Internet industries.

Now, we are witnessing similar processes in other industries.

Take the case of flat panel displays. This is a case where consumer demand, technology, globalization and bold planning are meeting to create fantastic industrial giants.

Here are some interesting facts from a recent Wall Street Journal article by Evan Ramstad.

• 
  AU Optronics Corp. is the third largest producer of flat-panel, LCD screens after Samsung Electronics Co. and LG Philips LCD of South Korea. AU is pouring $2.3 billion in a factory to be built in Taiwan. To shorten the construction time for the factory by 40 days, they paid $500,000 to have a 210-ton machine delivered from its manufacturer in a Soviet-built, six-engine Antonov 225 plane. It was the only plane large enough to carry the machine to its destination. The machine was built in Germany by Applied Films Corp., a U.S. firm that specializes in glass and metal coatings.
  
• 
  Revenues in flat-panels is going to increase to $60 billion this year, 40% above last year.
  
• 
  Ordinary TVs cost manufacturers less than $5 / sq. inch of screen size. LCD's cost $20 to $30 / sq. inch of screen size. Plasma screens cost around $20 / sq. inch.
  
• 
  Most of the research and development for flat panel screens is now being done in the Asian countries where the manufacturers are based: Korea, Taiwan, China and Japan.
  
• 
  Here's a couple of very interesting paragraphs from the WSJ story:
  

The company [AU] has built each of its five latest plants faster than the previous one. It's now pushing its contractors to the limit: AU's new factory has 2.4 million square feet of clean room, where manufacturing takes place, compared with 500,000 square feet at Intel Corp.'s largest chip-manufacturing plant. Handed a deadline of just seven months, general contractor Fu Tsu Construction Co. began construction late last year even before the plant's architects were done. "When we are still working on the first floor, they are still designing the second floor," says Lin Chih-sheng, a Fu Tsu director.

Fu Tsu lined up three sources of steel because the project consumed 140,000 tons of it. That's nearly twice as much of it as Taipei 101, the world's tallest skyscraper that opened last year in the capital city. The plant and other flat-screen facilities being built in Taiwan began consuming so much concrete that a sand shortage arose.

Now, there's an industry exploding into a revolution ! ! !

To Share or Not to Share (II)

I originally wrote this entry on August 27, 2004, and published it on blogs.sun.com.

The vastly prolific Judge Richard Posner's musings regarding a recent court decision on file-sharing ("In the Wake of Grokster") has led to a torrent of great commentary by his readers.

In their commentary, Luka, Ernest Miller and Matthew Saroff have made interesting technical points to demonstrate the serious challenges police crackdown faces as a prevention tool, and I certainly agree with Luka's critique of the ideal-world equilibrium analysis offered by James McDonnell.

McDonnell claims that if file-sharing could be stamped out, the no-file-sharing world would be possible to maintain through minimal enforcement because such a world would be one of the equilibrium worlds (that he postulates). Luka notes how the diversity and growth of file-sharing alternatives make such ideal-world analysis less than satisfactory. He gives Orkut as one of the non-trivial examples.

Referring to unsuccessful prohibition attempts in history, Raoul and Doug Munger focus on the limits of enforcement in general. ("The RIAA has only sued 4000 people out of 60,000,000," writes Raoul. "It's a joke.")

In his original blog, Judge Posner has used the "expected utility" approach of the economists to analyze the ancillary effects of a recent DoJ crackdown on a file-sharing network. (I'm coining the phrase "expected utility" for explanatory purposes.) The "expected utility" approach says, basically, that economically rational agents will look at the probabilities of outcomes (will I get punished or not if I file share) and multiply these probabilities with the value of each outcome (the pain of getting arrested vs. the gain of thousands of more free songs) and determine the "expected" utility of some action.

On the limits of such "expected utility" analysis, see Richard Thaler's The Winner's Curse: Paradoxes and Anomalies of Economic Life, Chapter 6 (Princeton University Press, 1992). The point Thaler makes is that people do not always see decisions according to the "expected utility" approach. (I will say more on this in a separate log.)

. . . Thanks to honorable Judge Richard Posner for having started the dialog on Grokster. As a bystander, I thoroughly enjoyed the conversation as it unfolded.

Note:
Earlier, I'd given a quick review of reports on the Grokster case and pointed to the DoJ crackdown on a file-sharing network that followed, almost immediately.

Housing Market, Interest and Exchange Rates

I originally wrote this entry on August 26, 2004, and published it on blogs.sun.com.

Shreedhar has written regarding his surprise at the unfathomable Bay Area housing market. He has noted wages and population moving in a direction that will lead to lower prices. Things are a bit more complicated, as research has shown.

Housing prices are determined by a number of factors, including wages, population growth (as Shreedhar has noted implicitly), interest rates, inventory, "production" (new houses), etc. When interest rates are low, housing market will move faster; when production or inventory is high, prices will be lower.

Historic prices, however, need to rise somewhat to provide an incentive for buying the house and also to help avoid defaults. If prices fall too sharply and too much, borrowers will go into default. This is not good for the borrowers. It's also not good for the banks or other creditors. At the moment, loans on houses form the largest volume of "fixed-income" debt paper (i.e. bonds) out there. So, on its own, any illiquidity in housing debt (bond) markets may have more influence on interest rates in the U.S. than government treasuries.

If bonds on loans become cheap, i.e. once default rises, interest rates will rise, too. However, high interest rates are not good for a sputtering economy because they make money too "slow" to come by. The only saving grace, I've read, is for the U.S. dollar to devalue even further against other currencies.

This could be good for companies such as Sun because of its large revenue footprint abroad, but it also may mean inflation if the U.S. becomes increasing more dependent on imports of basic goods. Any devaluation steps need to be taken very gradually.

Dying Culture

I originally wrote this entry on August 23, 2004, and published it on blogs.sun.com.

Richard Posner, the honorable guest at Lessig Blog, has written a short piece about the Eldred decision. He is correct that Lawrence Lessig has "from time to time" self-flagellated about losing the Eldred decision at the Supreme Court. (See chapter 13 and 14 of Lessig's Free Culture.)

Frankly, I don't see anything dishonorable in feeling shame. Particularly when something happens on your watch, and Eldred did happen on Lessig's watch, shame is a noble feeling. It may have been better not to argue the case at all, as Lessig notes himself in his most recent book. So, I applaud Lessig for flagellating himself on this, at least for a while. In any case, he has now recorded his feelings in his book and can move on to more interesting stuff.

Now, let's stick to the actual issue Posner has mentioned.

First, I don't think anyone would argue with Posner when it comes to the importance of propertization as an incentive to the owner to conserve and nurture his or her property. In fact, it has been argued by many economists, including Nobel Economics Laureate Douglass North that secure propertization is essential to economic progress. (See here.) This has been well established by him and other economists who have written since the Second World War. (North has also made some other interesting, general points about the role of technology in economic development.)

Second, Posner is right when it comes to a relativistic interpretation of the "for limited Times" term in the Progress Clause of the Constitution. However, Lessig has also realized that fact. In his book, he has noted that insisting on a reasonable interpretation of "for Limited Times" in his arguments was not a winning strategy before the Court. Lessig says that he should have argued from the "Free Culture" point of view. In other words, he should have said that extending limited terms is harmful to basic freedoms in our culture. However, I think even that argument has some flaws in it. First of all, no culture is truly free. We all live with and are rooted in our pasts. If any institution in the U.S. government knows that fact well, it should be the Supreme Court. So, emphasis on "free," instead of on "roots" might not always work with the Court.

Last but not least, copyright term extension beyond a certain point, as Lessig has analyzed so skillfully, promotes the death of culture much more efficiently than it stifles free culture. (That is why I think Lessig should have chosen a different title for his book but it could have become too dramatic. I don't know?)

Death of culture through repeated copyright extensions going well beyond three or four generations happens in several essential ways.

• Only "cultural" products for which current economic value can be extracted are protected and nurtured into prosperity.
  
  
• With continuing copyright term extension, many pieces of potentially valuable cultural works that are not currently and commercially active remain silent and could be lost to history because it costs more to clarify their copyright status than can be earned by making them available to public, either directly or through "mixing" in other cultural products.
  
  
• Continuing copyright term extensions also prevent active mixing of the past into the future. If copyrights are allowed to be extended beyond a certain point, going for more than three or four generations as the case may be, it becomes increasingly more problematic to do such cross-generational mixing of cultures beyond what is made available through commercially active culture. That's the true loss.
  
  

Oil prices at the pump (in Iran)

I originally wrote this entry on August 17, 2004 and published it on blogs.sun.com.

The price, listed on this gasoline pump, is in Iranian Rials. In July 2004, when this picture was taken on the road from Isfahan to Saveh, 8600 Rials could be exchanged for about $1. The total price, seen in this picture, is for 5.07 liters. That's about 1 + 1/4 of gals for less than 50 cents.

As you can see, in Iran gasoline is priced sharply under the world markets. The social and economic reasons are subtle. In very brief terms, this is primarily a way for the government to subsidize the national economy. Other oil derivatives which require higher-level processing are traded at world market prices and are normally produced by companies listed on the Tehran Stock Exchange.

Why we cooperate and adopt group purposes?

I originally wrote this entry on August 11, 2004 and published it on blogs.sun.com.

Chester Barnard provides the following summary answer to this question:

Among the most important limiting factors in the situation of each individual are his own biological limitations. The most effective method of overcoming these limitations has been that of cooperation. This requires the adoption of a group, or non-personal, purpose. The situation with reference to such a purpose is composed of innumerable factors, which must be discriminated as limiting and non-limiting factors. The Functions of the Executive

Individuals in Organizations

I originally wrote this entry on August 10, 2004 and published it on blogs.sun.com.

Chester Barnard provides the following account of the "individual" in organizations:

The individual human being possesses a limited power of choice. At the same time he is a resultant of, and is narrowly limited by, the factors of the total situation. He has motives, arrives at purposes, and wills to accomplish them. His method is to select a particular factor or set of factors in the total situation and to change the situation by operations on these factors. These are, from the viewpoint of purpose, the limiting factors; and are the strategic points of attack. The Functions of the Executive (1938)

Barnard starts by noting our limited power of choice. Earlier in his book he amplifies on this theme connecting choice to context (i.e. "factors of the total situation") one is acting in. The structure of action is then decomposed into motives, purposes and will. In terms of actual practice of acting, he notes that individuals usually select a factor or a set of factors in the "total situation" to affect. For example, say you don't like your career path. It could be because of where you are, what you're doing, who you're reporting to, the goals or the team. One can change one or a set of these factors. Which actual factor is selected depends on one's total situation. Next Barnard discusses purpose. Purpose determines one's goal. From the point of view of one's goals, some factors may be limiting. Those factors are exactly the ones that will be selected for change.

That's a brief summary of Barnard's views on "individual" actors in an orgniazation.

In the next post, I'll summarize his views on what moves individuals in an organization to adopt group purposes.

The Functions of the Executive: Chester Barnard and the Theory of Organization

I originally wrote this entry on August 10, 2004 and published it on blogs.sun.com.

In my last semester at the Haas School of Business, I had the good fortunate of studying transaction cost economics (TCE) with the master: Oliver Williamson. He was a wonderful advisor, and although I had already read many of his essays, he guided my more extended readings and helped me gain a better understanding of the fundamental concepts of TCE. I started several ideas with him and finally settled on writing a paper that gave a transaction cost economics account of the bullwhip effect in supply chains. It was a fascinating exercise and learning experience. (Earlier on this weblog, I have written a brief account of the bullwhip effect, investigating it as a consequence of technological specialization and within the context of North's theories on the structual evolution of economic institutions.)

There was one book whose reading Williamson highly recommended to me: The Functions of the Executive by Chester Barnard. That book was first published in December of 1938. I have a copy of its 2002, 39th printing in my hands.

I've written about Chester Barnard and Oliver Williamson earlier, including a brief mention in a piece on Douglass North.

Today and possibly tomorrow, I'm going to extract a short summary of the first part of Barnard's book on The Functions of the Executive.

I think the material is important to anyone who works within a cooperative system, a business organization or any other kind of association.

Technology and Transaction Costs Economics

I originally wrote this entry on August 9, 2004 and published it on blogs.sun.com.

Douglass C. North, the Nobel Economics Laureate (1993), has applied transaction cost economics, an economic theory originally founded by Ronald H. Coase (the 1991 Nobel Economics Laureate) to develop a new theory of institutional economics.

In the last chapter of Structure and Change In Economic History, one of his earlier books on the economic history of institutions, North gives the following assessment of technology in economic history (pp. 206-207):

. . . the stock of technology determines the gains from specialization (via scale economies) and the costs of alternative forms of organization. The greater the gains from specialization, the more steps in the production process and the higher the transaction costs.

The jump from "the more steps in the production process" to "higher transaction costs" may be surprising for some but a review of the bullwhip effect in supply chain management should clarify the connection.

The bullwhip effect, i.e. demand and inventory uncertainty amplifications upstream of a supply chain was analyzed theoretically by Jay Forrester in his famous 1961 book, Industrial Dynamics. The bullwhip effect has also been studied by more recent investigators, such as Professor Hau Lee of Stanford University.

The expenditure necessary to handle increasing fluctuations upstream of a supply chain (either on larger inventories or on better supply chain coordination) represents transaction costs. Roughly speaking, transaction costs comprise the costs of remaining in business, the cost of making a deal or a transaction go through, the cost of holding a production organization together.

As Oliver Williamson, the noted transaction cost economics scholar, has shown, transactions can be characterized by the associated uncertainties, their frequency and the specific assets devoted to them. Each one of these characteristics determine some aspect of transaction costs. For example, transaction maintenance costs increase as specific assets increase. Human know-how specific to a particular contractual relatioship is an example of specific assets.

So, what is North saying again about technology?

He is saying that the stock of technology can lead to greater specialization, i.e. to more steps in the production process and hence to greater transaction costs.

The big question is then the degree to which these production steps will be organized by the market or within a hierarchy. This is the big strategy question that each economic entity needs to consider--for example, the question: "Shall I produce my own software or shall I buy it?"

Let's end with another quote from North's book:

The degree to which these various steps will be organized by market versus hierarchical organization will depend upon the alternative costs of measurement and enforcement. Since vertical integration into hierarchical organization means the substitution of factor markets for product markets, a key determinant will be the cost of the organizing factor, and in particular, labor markets.

Tehran Stock Exchange

I wrote this entry, originally, on July 11, 2004.

According to Iranian financial news reports I have read in the last few days, real estate grew by only 19% across Iran while stocks grew by more than 130% in 2003. It may be possible to confirm this by a look at the Tehran Stock Exchange although I have not tried it myself in any depth. Volume of exchange has grown by more than %250. More and more companies are being listed. CEO of the TSE recently called for listing of news media companies to give them greater vitality.

Chester Barnard

I wrote this entry, originally, on July 10, 2004.

I have started reading Chester Barnard's The Functions of the Executive.

It has been recommended by professor Oliver Williamson (Economics, Law School and School of Business at UC Berkeley) as an important work. Professor Williamson has reviewed Bernard's influence in Mechanisms of Governance.

The volume I have in my hand is published by the Harvard University Press, Cambridge, Massachusetts. It is the thirty-ninth printing (2002) of the book, originally published in 1938.

What sort of book is it that gets to have so many printings?

Apparently, Barnard never completed Harvard, but he wrote one of the most influential books there is when it comes to management, executive functions and organizational theory.