Category Archives: Specialization and Trade Economics Intro

Specialization, Bilateral Monopoly, and Firms

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A bilateral monopoly is when there is one buyer and one seller.

When the first IBM PC was introduced, there was one buyer for Microsoft’s operating system (DOS) and one seller. However, IBM allowed other companies to make “clones,” with the result that the hardware became a commodity and the software became worth a fortune.

We rarely observe bilateral monopolies between two firms, because each firm has such a strong incentive to try to create competition on the other side of the bilateral monopoly. Thus, I would argue that bilateral monopoly is more likely to wind up within a firm than across two firms.

Specific human capital, meaning skills that are valuable only in the context of a particular industry or a particular organization, gives rise to bilateral monopoly. An employee who is familiar with the procedures, culture, and systems that are peculiar to one firm is more valuable to the firm than another employee. For the employee, the firm is now a better fit than some other firm.

In the economy as a whole, specialization tends to produce a lot of specific human capital. Thus, many economic relationships have to take bilateral monopoly into account. You can think of these sorts of bilateral monopolies as repeated games, in which cooperating means sharing the rents from specific human capital, and defecting means either trying to appropriate all of the rents or ending the relationship.

Typical contract features that try to deal with these repeated games include increases in pay and benefits tied to length of service, including pension vesting or additional weeks of vacation. Some firms offer training or tuition reimbursement with a requirement that the worker continue with the firm for a period of time afterward.

I think that most of these sorts of contractual features could be reproduced across the boundaries of firms. That is, if I want you to invest in human capital specific to my firm, I can design a contract that induces you to remain in a long-term relationship.

However, there is another type of inducement that is almost inherently within the firm. That is the inducement provided by promotion from within. If you know that internal candidates have an advantage when a high-level position opens up, that gives you an incentive to invest in specific human capital within that firm.

In fact, I believe it is the case that organizations that promote almost entirely from within have very loyal middle managers. The cost is that such organizations can be culturally rigid and stagnant. Conversely, firms that frequently fill high-level positions from outside and/or engage in mergers and acquisitions can be more flexible and dynamic, but at a cost of low morale and high turnover at lower levels of management.

Specialization, Externality, and Firms

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Suppose that a production process is divided into tasks. Think of Adam Smith’s example of a pin factory, or think of a software application developed by many people.

It is unlikely that this process will be coordinated by decentralized market prices. Separately, each worker’s contribution to the process is not marketable. It is the final product that can be sold. In a sense, there is a “production externality,” in that the finished product is worth something, even though the individual worker’s output is worth nothing by itself. The task of Coasian bargaining among the workers to come up with a way to allocate this externality is onerous, so it is handled by a manager in the context of a firm.

Social Science, Dogma, and Steven Pinker

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Why am I re-reading The Blank Slate? First, because on first reading I marked it as one of the all-time great non-fiction books. Second, because I am thinking about possible parallels between the psychology of B.F. Skinner and the economics of Paul Samuelson. Some remarks:

1. Both Skinner and Samuelson dominated their fields around 1960. For those of you who do not know, Skinner’s view was that all behavior is learned, through the process of reward and punishment. We do what is rewarded and avoid what is punished.

2. Both took a very mechanistic view of, respectively, human behavior and the economy. We should not be surprised to see intellectuals in the aftermath of World War II seeing the world in terms of simple machines. What won that war? T-34 tanks. B-17 bombers. LCA’s that carried soldiers to the beaches held by Germans or Japanese. Relatively simple machines, built in enormous numbers, by countries whose economies were under considerable central control. Neither Skinner nor Samuelson would have thought in terms of personal computers or the Internet as metaphors.

3. Psychology eventually escaped the clutches of Skinner’s restricted research paradigm. Economics succumbed to Samuelson’s.

4. Pinker’s goal in the book is to dispel the dogma that human beings are shaped entirely by environmental factors, especially arbitrary social circumstances, and that social scientists have the power to re-shape society to achieve any desired outcome. On p. 19, he writes,

In behaviorism [Skinner’s psychology], an infant’s talents and abilities didn’t matter because there was no such thing as a talent or an ability. . .To a behaviorist, the only legitimate topic for psychology is overt behavior and how it is controlled by the present and past environment.

According to what I see as the central dogma of (progressive) social science, individual characteristics and choices bear little or no responsibility for differences in life outcomes. Instead, people who are successful owe their achievements to being born into power and privilege. People who are unsuccessful owe their deprivation to being born into poverty and discrimination. These outcomes are entirely changeable, through the application of social science.

Of course, this dogma is still prevalent. President Obama and many academics appear to be wedded to it.

5. I am starting to think about doing a work with the tentative title: Specialization and Trade: A Re-Introduction to Economics. The idea will be to shift focus from the issues of scarcity and choice that are now considered absolutely central in economics textbooks. Although these are certainly important, I want to argue that the central social phenomenon is specialization. In some respects, my goal is like Pinker’s. I want to emphasize the weaknesses in the simple, mechanistic views Samuelsonian economics, particularly Keynesianism, and instead offer a way of thinking of the economy that owes more to computational metaphors. Consider these sentences from Pinker (p. 31, p. 39, p. 40):

The mental world can be grounded in the physical world by the concepts of information, computation, and feedback.

The mind is a complex system composed of many interacting parts.

It is now simply misguided to ask whether humans are flexible or programmed, whether behavior is universal or varies across cultures, whether acts are learned or innate, whether we are essentially good or essentially evil. Humans behave flexibly because they are programmed: their minds are packed with combinatorial software that can generate an unlimited set of thoughts and behavior.

After listing a set of physical brain differences that are associated with different mental capacities and behavioral traits, Pinker writes (p. 44-45),

These gross features of the brain are almost certainly not sculpted by information coming in from the senses, which implies that differences in intelligence, scientific genius, sexual orientation, and impulsive violence are not entirely learned. . .There is much we don’t understand about how the brain is laid out in development, but we know that it is not indefinitely malleable by experience.

Similarly, I want to point out that economic outcomes are not indefinitely malleable by fiscal, monetary policy, and policies intended to correct market failures.