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Alchian and Demsetz. 1972. Production, information costs, and economic organization. American Economic Review 62 (December): 777-795.

In Brief

Coase argued that firms form to internalize the high transaction costs of constantly negotiating new contracts. By contrast, Alchian and Demsetz argue that information costs explain the rise of firms.

Main Argument

Firms will develop (Y) when two conditions obtain:

• X1: It is possible to increase production through team effort. Think of two men loading bulky cargo onto a truck. By working together, they can load the cargo in far less time than if they worked separately; the product of their efforts exceeds the sum of their individual contributions. When there is a team effort like this, you have information problems: it is hard to tell who is shirking.
• X2: It is possible to meter each input's (laborer's) marginal contribution, either by observation or specification of the inputs.

You will get a classical capitalist firm, which has these characteristics:

"The essence of the classical firm is identified here as a contractual structure with: 1) joint input production [team efforts]; 2) several input owners [e.g. each laborer owns himself]; 3) one party who is common to all the contracts of the joint inputs [the employer/owner]; 4) who has rights to renegotiate any input's contract independently of contracts with other input owners [e.g. can hire, fire, etc. to reward inputs that contribute more]; 5) who holds the residual claim [i.e. gets the "residual" income; see below]; and 6) who has the right to sell his central contractual residual status [i.e. can sell the company]."

By "residual" income, the authors refer to the amount of additional income that the team will earn by having somebody monitoring each input's marginal contribution. The employer has claim on this residual income [more or less].

In the Literature

In Fama's (1980) attempt to develop a theory of the firm that explains what happens when managers aren't owners (e.g. in a larger firm that is owned by stockholders), he reviews some earlier literature:

"The striking insight of Alchian and Dernsetz (1972) and Jensen and Meckling (1976) is in viewing the firm as a set of contracts among factors of production. In effect, the firm is viewed as a team whose members act from self-interest but realize that their destinies depend to some extent on the survival of the team in its competition with other teams." Fama criticizes Alchian and Demsetz, however, for failing to eliminate the entrepreneur from the picture; their theory still includes an employer who, like an entrepreneur, polices shirking because he collects the benefits of doing so.