Hierarchy as a reason for existence of firms - Efficiency derived there in

In the last blog, we discussed why an organization would be necessary when we already have the markets that are efficient. In today's blog we look at interesting reason why organizations have a hierarchy - stated differently this approach by Alchian-Demsetz approaches the reason for firm's existence to be measurement and metering the problems.

The measuring problem emerges when we talk about 'team production'; where the underlying motivation is the production gains that occurs through cooperation amongst the people when executing a complex task. There exists an incentive to cooperate. It is always a possibility that there could some Shirking amongst team members and when this happens the incentive to cooperate reduces. Shirking could range from cheating to merely giving less than one's efforts.

The team production in such a scenario makes it difficult to assess the contribution of individual member - the means to monitor or measure do not enable rewarding based on individual productivity. This imperfect connectivity to the reward system could potentially get the members to work less diligently. Measures like, splitting the income generated equally amongst the members doesn’t eliminate the incentive to shirk. (This view might not strictly hold in the J-Form organization we discussed earlier; this again would have to be understood in the context of the society)

Such a shirking behavior would potentially prevent a high-output individual to join the team; or if s/he joins the team, they may become shirkers too!

In such a scenario it would become essential to monitor the team. Monitoring each individual would reduce the likelihood of shirking. This introduces a hierarchy of sorts for the first time. This doesn’t completely eliminate the hierarchy and there might be a need to monitor this monitor and so on. A strong case for this monitoring hierarchy with reduced chances of shirking emerges when the monitor is given the right to negotiate contracts with all the team members,  monitor their productive efforts and (crucially) claim any residual value created by the team has received their expected compensation. The final level of this monitoring would rest at the stockholders of the company - who could gain from the firm's residual profit.