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Market Failure and Uncertainty
In this essay I would like to argue that market failure is the reason for hierarchy. I will argue that market failure leads to uncertainty and that uncertainty leads to incomplete contracts. To explore the notion of incomplete contracts I have used the ideas of Milgrom and Roberts. They describe how incomplete contracts can lead to a "relational contract" or an "implicit contract. I will argue that relational contracts can lead to the formation of an organisation. Once an organisation is established it differs from other equally organisations by its social capital. This social capital, I will argue, leads again to uncertainty and again to incomplete contracts. To prove this I will use repeated game theory and the folk theorem. I believe that the uncertainty within an organisation leads to implicit contracts that capture the reputation of cooperation of the members of the organisation. In conclusion I will argue that this reputation of cooperation is corporate culture. In the first part of 'Managerial Dilemma' Miller argues that hierarchy, at least in theory, exists by the grace of market failure. Market failure is described by Miller (1992) as: "(...) market equilibria that fail to allocate resources efficiently" (p.17). Miller states that market failure is caused by market power, information asymmetries and (team) externalities. However if I take a closer look at these reasons for market failure I will argue that they can be the reason to form an organisation, but not nesecarily have to be. Market power by a small number of parties increases the amount of uncertainty about how these parties are planning to use this power in ongoing or future transactions when faced by unforeseen contingencies. Information asymmetry -when one party is deprived of vital information available to the other side- also raises the amount of uncertainty about how the other party is likely to react to unforeseen contingencies. The third reason for market failure (externalities) can also be seen as driver for uncertainty since transactions in the marketplace can have an impact on third parties. So far, I have argued that market failure leads to uncertainty. The general assumption presented in the lectures is that uncertainty leads to incomplete contracts and interdependency between the parties involved in a transaction. This takes me to the next step of my argument. This general assumption makes parties to design their contracts recognising that they cannot possibly be perfectly adapted to all possible future circumstances. Milgrom and Roberts (1992) describe how this can lead to a "relational contract" or an "implicit contract". A relational contract is defined as: "A contract that specifies only the general terms of a relationship and specifies mechanisms for decision making and dispute resolution"(p.602). An that are not legally enforceable but that the parties consider to be binding on one another's conduct" (p.599). An employment contract is a good example of a relational contract, because it delegates authority to the employer to direct the employees actions rather than describing precisely the work that has to be done in every contingency. In this stage of my argument I would like to take the notion of relational contracts further. If an exchange in the market is more costly than the same exchange in an organisational structure, due to the degree of uncertainty caused by market failure, one of the parties can decide to add the relation to its organisation structure. Especially if we assume that based on rationality a contract will occur within whatever infrastructure minimises its costs. This notion combined with the fact that most people dislike having their incomes dependent on random factors and are therefore "risk averse". I argue that uncertainty caused by market failure can lead to relational contracts such as an employment contract and therefore can lead to the formation of an organisation. I put emphasis on the word can because if the parties concerned in the transaction are all "risk neutral" and there are no wealth effects it is more likely that the same uncertainty will lead to the building of trust between the parties by means of implicit contracts in order to prevent that one of the parties behaves "opportunistic" (e.g. monopolises the contracts residual). Later on I will return to the notion of implicit contracts when I discuss the role they play in social capital. Until this point I have argued that market failure leads to uncertainty and that that uncertainty can lead to relational contracts and therefore can lead to the formation of an organisation. Now I would like to argue that once an organisation is formed uncertainty within the organisation can lead to implicit contracts. Furthermore I would like to argue that these implicit contracts can lead to social capital and therefore can lead to a cooperative corporate culture. How can two organisation that have the same capital, human capital, technology, operating environment and the same incentive system differ in performance? In the lectures we argued that in the absence of non-standard utilities, one answer can be that they differ in "social capital". In class we defined social capital as follows: "B has the extent that she has either pre-existing or can generate at 'low costs' relationships from 'others' whereby B can draw (with high probability) upon an insecure commitment of resources from others (i.e. in the absence of collateral at zero interest rate)." A will invest in the social capital of B only if she believes there exists high probability that B will discharge the debt at an appropriate time and in a self-enforcing manner. In other words A must not feel uncertain about B returning her 'help'. This brings me back to the first notion that unforeseen contingencies can influence transactions. Earlier I have showed that uncertainty can lead to incomplete contracts and that these incomplete contracts can lead to hierarchical transactions. However, I will argue here that it will lead to implicit contracts because I believe that the existence and the level of social capital within the firm depends on the reputation of cooperation of the individuals within an organisation. Cooperation will be defined as occurring when individuals in a social dilemma select alternatives that are not rewarded by the formal incentive system but that result in Pareto efficient outcomes (Miller 1992). The other party will only select these alternatives if it believes that it will be reciprocated. Kreps (1984) argues that the source of this faith is the "reputation" of the other party. In order to get a clear picture about reputation, Kreps uses repeated game theory and the folk theorem. Repeated game theory can best be approached from a one-sided version of the Prisoners' dilemma game; the trust game (see figure 1). If this game is played only once and noncooperative both of the parties have a dominant strategy to not trust. The Nash equilibrium will therefore be a $0 pay-out to both A and B. From an economical point of view this is a Pareto inefficient outcome. A Pareto efficient outcome can be achieved by a "tit-for-tat" strategy in repeated prisoner's dilemma games. A tit-for-tat multiperiod strategy is defined as playing the cooperative (dominated) alternative in the first play of the game and thereafter mimicking the other player's previous choice. In other words the trust-honour arrangement allows for the possibility of self-enforcing if the game is repeated with sufficiently high probability. Unfortunately, even when the game is repeated with sufficiently high probability a Pareto efficient outcome is not inevitable. The folk theorem states that in any repeated Prisoners' dilemma game, there are an infinite number of outcomes that are sustainable as long-run equilibria by rational, self-interested actors. Imagine for instance what will happen if B states that he will violate A's trust once every three times the game is played. And furthermore, if A ever retaliates by not trusting B, player B will be less likely to trust A again. A's dominant strategy will still be trusting B all of the times, as long as B does not violate A's trust more than once every three times. This is just one example of the wide range of equilibria of a repeated Prisoner's dilemma. Even in a repeated game the player's have an incentive to specify and enforce the terms of the transaction and therefore allow the transaction cost to "eat" some of the residual gained by the transaction. This is where reputation comes in. Reputation means that the trusted party will honour that trust because not honouring it would preclude or substantially limit opportunities to engage in future valuable transactions. To make this point clear I will use the social capital example that I used earlier. Say that A invests in the social capital of B and B does not reciprocate. If this noncooperation of B is observable A will never invest in the social capital of B anymore, and furthermore she will refuse to reciprocate B's future investments in her social capital. This observable failure to reciprocate reduces B's social capital to zero. If we take this "bilateral reciprocity" up to a corporate level we can speak of "generalised reciprocity". This means that B depends on several A's to build up his social capital. This generalised reciprocity is much more efficient because it reduces the chance that any A is not available at the moment that B needs her help. On the other hand, the shift towards generalised reciprocity exacerbates "free-riding" problems as B will attempt not to reciprocate all A's and as A's will attempt not to reciprocate B. I have argued that the existence and the level of social capital within the firm depends on the reputations of cooperation of the individuals within the organisation or, in other words, the implicit contracts. And I have argued that the social capital is more efficient when it exists out of generalised reciprocity. Furthermore I have showed with the use of repeated game theory that there is a possibility that individual behaviour in a coordination game is rationally constrained by social conventions and norms. The viability of this convention depends on the level of generalised reciprocity (Miller 1992). I believe, to conclude my argument, that corporate culture is a mechanism of generalised reciprocity. This takes me back to Miller when he states: "The term 'corporate culture' denotes these mutually reinforcing expectations in a firm. A 'cooperative' corporate culture is one in which each player expects all others to cooperate and to enforce the norm of cooperation."(p.207)


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