Technology and the Vanishing Hand

21 05 2012

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.



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The Military-Industrial Complex and the American Miracle

12 05 2011

Just over fifty years ago, on 17 January 1961, outgoing President Dwight Eisenhower’s speech of  in which he used the phrase “military-industrial complex” in his farewell speech to the American people.

Until the latest of our world conflicts, the United States had no armaments industry. American makers of plowshares could, with time and as required, make swords as well. But now we can no longer risk emergency improvisation of national defense; we have been compelled to create a permanent armaments industry of vast proportions. Added to this, three and a half million men and women are directly engaged in the defense establishment. We annually spend on military security more than the net income of all United States corporations.

This conjunction of an immense military establishment and a large arms industry is new in the American experience. The total influence — economic, political, even spiritual — is felt in every city, every State house, every office of the Federal government. We recognize the imperative need for this development. Yet we must not fail to comprehend its grave implications. Our toil, resources and livelihood are all involved; so is the very structure of our society.

In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the militaryindustrial complex. The potential for the disastrous rise of misplaced power exists and will persist.

The phrase military-industrial complex quickly entered the political lexicon, replacing the earlier phrase “merchants of death”, which had been used in the 1920s to describe the armament manufacturers who, allegedly, got rich off of the First World War.

The 50th anniversary of the speech occasioned a number of blog posts  (see here, here, and here) and a new book by journalist James Ledbetter.

  Business historians have also contributed to the debate on whether Eisenhower’s warning to Americans is still relevant. The Spring 2011 number of the business history journal Enterprise & Society was a special issue on “the military-industrial complex.”  The speech itself is available as a video here and as a transcript here. The National Archives also has a video discussing the writing of the speech. The Eisenhower Institute held a commemorative event, which can be seen on video. For more details, see here.

This graph, which shows American defence  spending as percentage of GDP from 1940 to the present,  helps to put Eisenhower’s speech into its immediate politico-economic context.

An even more interesting graph is this one, which shows US military spending a percentage of GDP from starting in 1800.

With the exception of the Civil War period, US defence spending rarely rose over 2% of GDP until the First World War. It was certainly around 2% in the 1890s, when Eisenhower was growing up.

In his classic 1956 book The Civilian and the Military: A History of the American Antimilitarist Tradition, historian Arthur A. Ekirch Jr. argued that one of the things that defined America for much of its history was the anti-militarism of its people and their suspicion of standing armies. For most of its history, the United States spent a relatively low percentage of national income on its military– much lower than Prussia, France, and most European countries, even Britain, which had its own quite strong anti-militarist tradition. Indeed, the desire to escape the burdens that European armies placed on their taxpayers, was, along with their quest for cheap land and cheap food, one of the reasons so many Europeans migrated to the New World.

The anti-militarism and “isolationism” of the American people also helps to explain what some business and economic historians call the “American miracle” – the ability of the United States and its businesses to overtake Europe as the economic leader of the world in the late nineteenth and early twentieth centuries. In the early 19th century, Britain was the world’s undisputed technological and economic leader. Despite its first-mover advantages, Britain and other European countries were overtaken by the United States for reasons that continue to be debated by economic historians. By 1945, the Americans’ relative economic power reached an all-time high: Europe was shattered and nearly starving while Americans were prosperous and well-fed. By 1945, the citizens of the United States and other countries of English-speaking settlement were the luckiest inhabitants of the planet.

In the decades since 1945, the gap between the levels of well-being in America and Europe has narrowed.  By the 1960s,  the gap in living standards had narrowed to the point that there was no longer an economic incentive for Western Europeans (and Japanese people) to migrate to the United States. European (and later Japanese) companies also began to compete successfully with American firms.  Today, average incomes in a few European countries now exceed that in the United States.  People in NW Europe, at least, enjoy something resembling an American standard of living. In terms of ownership of consumer durables such as computers and flat screen TVs, Americans and Europeans are on roughly the same level.  Average annual incomes in France are lower than in the United States, but this is because French people (and most Europeans) work fewer hours.  In previous generations, Americans were larger and healthier than Europeans: during WWII, Britons observed that visiting American servicemen were tall, well-fed, and had great teeth. Today, the exact opposite is true: Western Europeans born in the last few decades are taller than Americans of European ancestry born in the same period.

New research has shown some unexpected disparities between statures of Americans and Europeans, indicating that recent social changes and diet are major influences on adult height. For British men, too, are outstripping their transatlantic rivals. At the time of the American Revolution, the average US male was two inches taller than his British counterpart. Today he is almost half an inch shorter.  Read more here.

Americans also have shorter life expectancies and higher infant mortality.


The reasons for these divergences and convergences in measurable living standards continue to be debated by historians. American business historians such as Alfred Chandler have argued that the basic reason for the “American miracle” was that American corporations developed superior forms of internal organization in the late 19th-century. This explanation probably has some truth in it, since the post-1945 convergence in between European and US living standards was accompanied by the adoption of American business methods by many European firms.  Other people have argued that the US was able to overtake Europe because it had a better patent system that encouraged more inventions. The list of possible explanations for the American miracle and then post-1945 convergence is potentially long. But one thing that needs to be part of any explanation is warfare, militarism, and the percentage of national incomes  consumed by the armed forces of various nations.

As the great and brilliant historian Leslie Hannah observed in an article in the 1990s on the American miracle, militarism and the avoidance of militarism need to be part of any explanatory framework:

It seems obtuse, however, to seek the reasons for these standings [i.e., of countries in national economic league tables] in the traditional subject matter of business history. The five laggards [i.e., UK, France, Germany, Italy, and Japan]  spent much of the first half of the twentieth century killing one another, invading one another’s countries, and destroying one another’s cities, industry, and infrastructure. Such human tendencies to collective mayhem in North America were more constrained: those parts south of Canada entered “world” wars reluctantly, late, and usually only after extreme provocation. Even then the United States’s mobilization usually increased rather than compromised its organizational  and capabilities, unlike the case in the other industrial powers. Moreover, the absurd imperial conceits of all the other five — and no doubt some other factors — contrived to perpetuate their problems into peacetime, creating inflationary and protectionist policy idiocies that further compromised their capacity to converge on U.S. productivity standards.

Now look at this graph, which dates from 2002. One notes that within NATO, the United States is the third most profligate spender on its military, coming just behind Greece and Turkey, two countries in which defence expenditures are influenced by ancient ethnic and religious rivalries.  The other OECD countries have held their defence spending below 2% of GDP, the figure that the United States held to in the period when it was catching up with Europe. Europe’s successful demilitarization in recent decades is discussed by historian James J. Sheehan in a recent book called Where Have All the Soldiers Gone?.

One of the tragic things about the 0ver-militarization of the United States in recent decades is that it has involved wasting vast amounts of human, economic, and political capital that might otherwise have been kept in reserve in case the United States really needs to fight a major war of self-defence at some point in the future.

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References:

Leslie Hannah, “The American Miracle, 1875-1950, and After: A View in the European Mirror,” Business and Economic History 24 (1995): 197-220.


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