The Past Speaks

Dick Langlois, an economist at the University of Connecticut, recently posted something about the Vanishing Hand on the Organizations and Markets blog.  His term Vanishing Hand is a reference to both Adam Smith’s famous theory of the invisible hand and Alfred Chandler’s term the visible hand.

In his 1776 book, Smith had viewed the economy as involving a vast number of small and autonomous firms linked together by markets. This paradigm corresponded to the reality of that era, for the most part.  With the exception of a few chartered trading monopolies such as the Hudson’s Bay Company, the companies of the 18th century were small concerns, typically occupying only a single address, and using the simplest type of corporate structures (sole proprietorship or a partnership).  As the business historian Alfred Chandler demonstrated in his 1977 masterpiece, The Visible Hand: The Managerial Revolution in American Business, the 19th century saw the rise of large corporations that were radically different: they were active in many geographical locations (think of a railway),  were vertically integrated, they had many owners (shareholders), and were managed by a complex hierarchy of managers.  Large firms exist, as Ronald Coase showed many years ago, because they help to reduce some of the transaction costs that are part of the market economy.

The development of  large Chandlerian  corporations, which was prompted by a mixture of legal and technological changes, led to the displacement of the free market by corporate bureaucracy as the most important coordinating mechanism in the economy. Chandler called the managers of these firms the Visible Hand, a play on Smith’s terms.

Since 1977, advanced economies such as the United States have moved away from the model described by Chandler. In fact, Chandler published just a very peak of the model of economic organization discussed in his book. In the last 30 years, corporate bureaucracies have become less important as a coordinating mechanism in the economy and markets are more important.

Many of the big, vertically-integrated firms have been broken up via outsourcing– rather than make all of their upstream components themselves, they have decided to start buying those components in the market. That’s what Langlois means by the term Vanishing Hand.

As Langlois wrote:

One of my longest-running interests has been the relationship between economic change, including technological change, and the boundaries of the firm. In broad strokes, my story is this: when markets are thin and market-supporting institutions weak, technological change, especially systemic change, leads to increased vertical integration, since in such an environment centralized ownership and control may reduce “dynamic” transaction costs; but when markets are thick and market-supporting institutions well developed, technological change leads to vertical disintegration, since in that environment the benefits of specialization and the division of labor outweigh the (now relatively smaller) transaction costs of contracting. This latter scenario is what I called the Vanishing Hand.

The most commonly accepted theory for the vertically-integrated corporation has diminished in importance in the last 30 years relates to technology.  This is certainly what Langlois argues. In his recent blog post, Langlois points to some recent research that appears to support his belief that it is technological change that is driving this process. Langlois is talking about a working paper by Ann Bartel, Saul Lach, and Nachum Sicherman, called “Technological Change and the Make-or-Buy Decision.” Their research was based on a dataset of Spanish firms from 1990 to 2002.

Here is a summary of their paper:

A central decision faced by firms is whether to make intermediate components internally or to buy them from specialized producers. We argue that firms producing products for which rapid technological change is characteristic will benefit from outsourcing to avoid the risk of not recouping their sunk cost investments when new production technologies appear. This risk is exacerbated when firms produce for low volume internal use, and is mitigated for those firms which sell to larger markets. Hence, products characterized by higher rates of technological change will be more likely to be produced by mass specialized firms to which other firms outsource production. Using a 1990-2002 panel data set on Spanish firms and an exogenous proxy for technological change, we provide causal evidence that technological change increases the likelihood of outsourcing.

You can read an ungated version of the paper here. It  shows that the authors studied a wide range of industries, from electronic components, where the measured rate of technological change was fast, to furniture, where the measured rate was slow.

Using patent filings as a way of measuring the amount of technological change in an industry, these authors found that Spanish firms in industries which were experiencing rapid economic change tend to outsource more ceteris paribus than firms operating in industries where the products didn’t change much in this period.

I’m pretty sympathetic to the idea that technological change is the main driver of the vanishing hand. It seems plausible to me.  It is now much easier to engage with the market than it was in 1977, thanks to the internet. You can go online and read customers’ reviews of firms you are considering outsourcing to.  It is relatively difficult to steal from a standardized shipping container, which makes firms more likely to outsource to a distant supplier. However, I don’t think that the research Langlois cites in his blog post does much to support the theory that the move away from the industrial structure discussed by Chandler is driven by technologies that have lowered transaction costs.

First, patent filings are not a reliable gauge of technological innovation in an industry,  company, or country. For instance, there are many firms that specialize in filing totally bogus patent claims so they can then sue the makers of products. The growth of TFP in an industry would be a better measure of the rate of technological progress.

Second, the Spanish industry-level data  is basically about the products made by companies in various industries.  The companies are grouped into industries by what they make. It doesn’t really examine the changing use of technology to coordinate the production of these products, which would be more relevant, in my view.  The technology involved in producing furniture probably hasn’t changed much in the last few decades.  The technology to make portable music players has changed rapidly, as transistor radios gave way to Walkmen and then Ipods. However, the technologies used to market these products and to purchase inputs have changed dramatically: you can buy and sell stuff on eBay, etc. Some firms that sell very traditional products, e.g., wine, have been very innovative at using technologies to change how they deal with customers and suppliers.  For instance, some wineries now use websites to sell directly to consumers, bypassing the middleman.