Distributed knowledge and the organization of economic activity

Abstract

This paper develops a simple simulation model to study the relation between the nature of knowledge and the architecture of economic systems. The market and the firm are different mechanisms for coordinating economic activity in a system where knowledge is widely dispersed. While the market solves coordination problems by decentralizing decision-making, the firm solves coordination problems by centralizing knowledge. The market incurs the cost of finding potential exchange partners and agreeing on terms of trade, while the firm incurs the cost of centralizing dispersed knowledge. The market therefore has an advantage over the firm in coordinating activities in which knowledge is difficult to centralize. The nature of knowledge involved in an economic activity influences not only the choice of the institution through which it is coordinated but also the internal structure of the institution. More specifically, the more hierarchical the firm, the better it is at using changing knowledge, but the worse it is at using knowledge which is difficult to transfer from one individual to another. Therefore, the number of layers in the hierarchy of the firm is influenced by the rate at which knowledge changes relative to the difficulty associated with communicating it.

A Comparing the ideas developed in this paper with those in the literature on knowledge and information based theories of economic organization

Over the years, a wide variety of answers have been proposed to the question of why some activities are organized through markets and others through firms. Williamson (1971) and Alchian and Demsetz (1972), among others, argue that firms exist because markets fail in the presence of opportunistic behavior. This constituted significant progress over the earlier view that economic organization is determined by technology alone (Barnard 1938). Some scholars however found opportunistic behavior explanations to be unsatisfactory (Hart 1989). Coase (1988, p. 44) recalls that during his empirical work in the 1930s, he found himself more worried about opportunistic behavior than the businessmen who engaged in market contracts. This is not surprising. Markets have a variety of ways to solve problems associated with opportunistic behavior including reputation and social norms (Hill 1990; Ghoshal 2005). Furthermore, firms are not immune to moral harzard and adverse selection problems (Ghoshal and Moran 1996). As Coase (1988, p. 43) noted, opportunistic behavior does not necessarily make the market more costly than the firm and therefore may not explain the division of economic activities between the two institutions.

Knowledge-based theories and information-based theories of economic organization emerged in response to these critiques. The ideas proposed in this paper fall within this literature. One of the significant contributions of this paper is that we attempt to explain ‘the organization of the economy’ and ‘the internal structure of the firm’ using a unitary factor. Most knowledge and information based theories either explain the internal structure of the firm (Aoki 1986), or the division of economic activity between the firm and the market, but not both. Nickerson and Zenger (2004, p. 617) is one of the few papers which simultaneously studies the question of “boundary choice (i.e., internal versus external) and the choice among alternative internal approaches to organizing”. They however do not attempt to solve the problem from the point of view of coordinating dispersed knowledge. In what follows we compare the ideas developed in this paper to some of the most relevant papers on knowledge and information based theories of economic organization.

1.1 A.1 Knowledge-based theories

Some of the literature on knowledge-based theories of the economic organization grew out of Penrose (1959) and Cyert and March's (1963) work on economic organization. While the literature on firms as knowledge-entities is large, only a subset of the literature compares the costs of using the firm to the cost of using the market. In so far as we seek to understand the architecture of economic systems, comparing the costs of alternate arrangements of organizing economic activity is the crux of the matter. Among the theories which compare firms and markets, one set of theories compare firms and markets in producing knowledge (Langlois 1992; Kogut and Zander 1992; Langlois 2013), while another set compares the two mechanisms in coordinating knowledge (Grant 1996; Conner and Prahalad 1996). Naturally, the ideas developed in this paper belong to the second set of theories. This paper is unique among the second set in so far as it presents a formal model of the transmission of knowledge and its impact of economic organization.

Grant begins with Hayek’s claim that the basic economic problem is how to coordinate the plans of economic actors in a system where knowledge is widely distributed. Grant accepts the view that markets are efficient at using knowledge, but claims that this is not true for all kinds of knowledge. He argues that markets cannot integrate knowledge that is non-rival and tacit, and firms exist because markets fail to coordinate activities that involve the use of such knowledge. Conner and Prahalad argue that firms are better than markets at using knowledge because they allow individuals to use knowledge that they do not fully possess or fully understand. Grant and Conner and Prahalad differ from Hayek and Polanyi’s thesis that tacit knowledge is best used through distributed interactions rather than central control. In contrast to Grant and Conner and Prahalad, our setting closely aligns with Hayek and Polanyi’s thesis on the use of tacit knowledge.

It is worth noting some of the defining features of our argument which mark its boundaries and therefore distinguish it from other knowledge-based theories. First, the literature on knowledge-based theories of the firm uses the word ‘knowledge’ in many senses, including the ‘relations between individuals’. Following Hayek, we use the word knowledge to mean attributes possessed by individuals and not the relations between individuals. Second, knowledge has dimensions other than dynamism and tacitness. For instance, Tsoukas (1996) distinguishes between four kinds of knowledge: explicit knowledge held by individuals, explicit knowledge held by the firm, tacit knowledge held by individuals, and tacit knowledge held by the firm. We limit ourselves to two dimensions of knowledge held by individuals. Third, we do not study the ways in which tacit knowledge is codified and converted into more explicit knowledge, see Zack (1999), Haldin-Herrgard (2000), and Bhardwaj and Monin (2006) for such an analysis. We assume the nature of knowledge to be an exogenous variable that influences the nature of economic organization. The purpose of this assumption is to isolate and study the impact of knowledge on economic organization; it is not to deny the bi-directional relation between the nature of knowledge and economic organization. Fourth, we study the problems associated with centralizing knowledge from workers, we do not study the problems associated with passing instructions to workers. See Tullock (1997) and Simon (1965) for a discussion on costs and frictions associated with communication from managers to workers.

1.2 A.2 Information theoretic literature

The information theoretic literature studies firms and markets as alternate arrangements of processing information. Within this literature, our paper is closely related to Sah and Stiglitz (1988), Bolton and Farrell (1990), Radner (1992), and Stein (2002). Sah and Stiglitz (1988) study how centralized and decentralized systems aggregate errors in human decision making. Bolton and Farrell compare centralized and decentralized systems in solving coordination problems when information is private. They argue that decentralized systems produce lower-cost solutions but involve delay or duplication. Radner studies how the firm processes information to derive its optimal structure. Stein studies the dependence of internal structure of the firm on information. He argues that the performance of hierarchies improves with the ease of passing information, an insight largely consistent with our own.

While our study incorporates features of the afore noted studies, it differs from them in significant ways. Sah & Stiglitz model the market as a system in which one agent considers a project after it has been rejected by another agent. They do not allow for parallel decision-making in the market. Massively parallel interactions are however an essential feature the market (Axtell 2003). We model the market as a system in which agents make decisions in parallel without knowing what other agents do. Bolton & Farrell study the problem of entry in a decentralized system between two agents who do not know each other’s costs. They however do not allow the agents to communicate with each other. We believe the problem of communicating private knowledge plays an essential role in determining the architecture of an economic system. We allow agents in the market and the firm to communicate with each other. Radner studies how firms solve non-associative problems, which are problems whose parts can be solved independently of each other. We study how the market and the firm solve a coordination problem which by its very nature is associative. Furthermore, neither Radner nor Stein compare the market and the firm as alternative mechanisms for using different kinds of information. In short, we address a gap in the literature by studying parallel interactions between agents who communicate with each other in both the market and the firm.