So in our last lesson, we raised this issue about the transaction cost between different players within a market, and how that might drive you to diversify and be players in two adjacent markets. Consider the following as a counter, the movie industry. In fact, every movie that is filmed, most movies that are filmed, tend to be an organization that is formed just for the production of that movie. And, in essence, all the players within that movie production are independent contractors. So for example, the actors, the directors, the writers, even the gaffers and the keys. They tend to be contractual subcontractors to the movie production process as opposed to, let's say, employees. Let me give you another example. The construction industry. In the construction industry, it's not uncommon to see a general contractor who may or not be just one or two individuals who then sub-contract all the other work out to other organizational entities, be it electricians, the plumbers, the roofers, and all the different players that are needed to go build a house. So, this type of market exchange raises a really interesting question to economists, which is why do firms exist in the first place? Why is it not possible that all economic activity simply be organized through the markets of individuals who are having market exchanges through contracts, and that this whole notion of a corporation and a large organization that has multiple employees, simply needed exists. This is a branch of economics that's often referred to as the theory of the firm. And while this question might seem somewhat esoteric, it actually is a critical one for thinking through why firms might diversify and ultimately where the scope of the firm might lie. So at the heart of this idea of the theory of the firm is that all economic activity is ultimately a serious of transactions between independent economic actors. Think again of our general contractor contracting with subcontractors and the like to ultimately build a house. The key insight from the theory of the firm is that ownership, this notion of an organization, ultimately imparts what we call residual rights of control. So let's take a little deeper dive into what do we mean by this idea of residual rights of control. Residual rights of control is the idea that the owner of a set of assets has the ability to choose the course of action when there might be some disagreement or some unforeseen contingency arise. So consider our electrician subcontractor to a general contractor. If that electrician's tools break, maybe it's a screwdriver or the like, that electrician is now responsible for replacing that screwdriver and has the discretion to choose which screwdriver they're going to buy, and where they're gonna buy it, and how much they'll pay for it. Alternatively, if the general contractor was an organization where all of these other players were employees of that general contractor. Then that ownership gives them the residual rights of control, and now that owner gets to decide where that asset comes from, where they get it, and how much they pay for it. So again, ownership of assets gives that person residual rights of control. This also can even apply to employment relationships. Where in employment relationships not everything is specified. So it gives the employer the ability to argue where you should be spending your time, your discretionary time within the organization. As opposed to a contractor relationships where that's typically specified in the contract. And the contractor has a lot of say about what they do. The hope is that between ownership, a gate creates common incentives and mechanisms for coordination. It hopefully minimizes some of these transaction costs we were mentioning, where you don't have to renegotiate your contract every time an unforeseen contingency arises. And ultimately what it does is it minimizes the risk and frictions of transacting through the market here. Again, ownership imparts residual rights of control, it gives you the ability to choose the course of action when those unforeseen contingencies arise. And hopefully, this ultimately minimizes frictions that might arise if you used a market exchange. So why do we have these risks and frictions within market exchanges? Well, there's a number of reasons. First, the potential for relationship-specific assets and hold-up. What we might just call opportunism. So I mentioned coal mines and coal processing plants, great example where there's the potential for that hold-up there. Maybe it's a distribution partner. The distribution partner, if it's really the only one you have available to you and you don't have other opportunities, they might be able to hold you up for a greater deal or a better deal at the end of the day. Once again, that might drive you to integrate with that bouncing partner. In some particular areas, it's very hard to separate effort and resources expended. Innovation is a good example. If you're going to contract with someone for innovation and you had a team of people doing this, how would you recognize each his individual efforts? How do we think about the resources expended? How do we even observe and reward the output that we're looking for here? Those types of activities then tend to lend themselves to being part of the organization where you have this ownership of residual rights of control. Another interesting example, is what's often refers to us, Arrow's paradox after Nobel Prize winner economist Kenneth Arrow. He observed that the only way to contract an information was to reveal that information. So you know the value that you're receiving from it. However, the seconds you reveal the information so one could value it, you've then just given away the information, and there's no right to pay for it. Where you see this very pronounced is in the market for entrepreneurial ventures. So you have entrepreneurial ventures out there trying to raise capital from venture capitalists. They want to share their ideas with the venture capitalists. However, there's a risk associated with that. By sharing their ideas completely, the venture capitalists could actually take that information and go themselves and start that business. This is an essence Arrow's paradox again, while you want to be forward and reveal what you're doing so someone can value it, if you completely reveal it and all it is, is information then someone might in essence steal your idea. Again, in these types of creative and R and D situations, it might make sense to put it with an organization rather than try to contract for it. In some transactions, there is just simply private information, an economics term we often talk about adverse selection. This is the idea that the holder of information knows better than the person they're trying to transact with. So maybe its I'm trying to buy a used car. I don't know what happened to that used car, perhaps it was in an accident, perhaps it was flooded at some point, the owner of the used car might not be forthright and honest with me, and I don't know that beforehand. That creates a cost or a risk of a market transaction. Now what's interesting is there's been various players trying to solve that market information asymmetry, if you will. Players like CARFAX are coming in, and trying to give you the vehicle history. This is a way of reducing some of those transaction costs that you would have in a used vehicle sale. Finally, there's just simply uncertainty about future contingencies. Maybe the market is evolving quickly. You're looking to acquire a partner, but you're not sure if they're gonna be valuable moving into the future. These are some of the risks that might be created when you're trying to transact through the market again.
