357

Organizational Forms and Measurement Costs

by

YORAM BARZEL

Under caveat emptor, buyers effect their measurements prior to exchange. Longterm relations and contracts allow buyers to measure commodities at consumption. Buyers use subjective measurements in long-term relations. Contractual guarantees shift enforcement to the state, but require objective, veriable measurements. Most exchange agreements combine the two forms and benet from the comparative advantage that each provides. Vertical integration reduces excessive measurement because employees gain little from manipulating commodities and information about them. The capture of quasi rent from specialized assets is just a manifestation of difcult-to-measure entities. The notion of measurement cost is more general and more operational than that of specic assets. (JEL: D 82, D 83, L 14)

1 Introduction Exchange is a most basic economic activity. To exchange commodities, individuals require information both about the commodities makeup and about the terms under which they are exchanged. Yet the literature does not explicitly address how such information is provided or obtained.1 Bringing the question of information to the fore, as I do here, facilitates the recognition of problems that otherwise would be likely to elude us. As one addresses information issues, a number of questions arise. Is it to be expected that only one of the parties to a transaction will collect the information and then share it with the other? Alternatively, will both collect it? Or will a third party collect the information and then provide it to the transactors? Commodities, as a rule, have numerous attributes, and their levels often vary across specimens. Will information be gathered on every unit, or on a sample of units? Will it be gathered on all of the attributes of a multiattribute commodity? What is the maximizing level of accuracy of the information to be collected? When will the information be produced? Under what terms would it be transferred from one transactor to the other? I attempt to answer some of these questions in this paper. The cost of information in the perfectly competitive Walrasian world is zero. Because exchanging parties know precisely the attribute levels and prices of all
1

DEMSETZ [1988] is a major exception. I will return to his paper below.

Journal of Institutional and Theoretical Economics JITE 161 (2005), 357373 2005 Mohr Siebeck ISSN 0932-4569

358

Yoram Barzel

JITE 161

commodities, the problems posed above are trivial. Symmetry of information is costlessly attained, and asymmetry of information is of no concern. Costless information implies that everyone knows what he and others actually own, and, as Walras explicitly assumes, rights are well dened. Also perfectly clear is what has to be enforced. Enforcement, therefore, is also costless, and, more to the point, disputes are absent. The Coase theorem applies, and all exchange is Paretooptimal. In the model I adopt here, not only is information costly to produce, but difculties arise in transmitting it. I argue that as circumstances change, people will form different kinds of agreements and different kinds of organizations to resolve the problems that underlie the questions posed above. In sections 2 and 3 of the paper I attempt to determine what exchange parties that operate independently can accomplish by the use of different forms of agreement. Underlying that discussion is the assumption that the exchange information is useful to the two transactors only. The information, however, may also be valuable to third parties. In sections 46 of the paper I focus on the transmission of information by independent transactors across vertical and horizontal production stages. I argue that integration is useful for overcoming the difculties associated with such transmission. I also show how my view relates to the capture of the quasi rent of specialized assets. I present the conclusions in section 7.

2 Property Rights over Assets and over Asset Information The property-rights framework is most useful for the study of the production and transmission of information. Property rights, as I use the term, are economic rights over a good, and they indicate the ability to enjoy the good directly or indirectly through exchange.2 With no information about a commodity, the makeup of the commodity and its value constitute black boxes. Information is a key to these black boxes; it endows ownership with meaning.3 The property-rights framework thus induces us to ask two additional questions. First, how is the ownership over exchanged commodities and over the information used to exchange them established? Second, how is it divided between transactors? Information is costly to produce, and maximizing transactors acquire only partial information on the commodities they exchange. Errors, then, are inevitable, and so are disputes. Since the information is incomplete, individuals rights are not
2 Legal rights are rights over an asset that the state recognizes as belonging to a particular person. The state spends resources to help enforce such rights and thus enhances the persons economic rights. Both legal rights and economic rights are forward-looking concepts. 3 If you are not aware of the oil eld under your land, you do not possess the economic rights over it. Indeed, another person who discovers that there is oil there may be able to buy the land at its non-oil value.

(2005)

Organizational Forms and Measurement Costs

359

clearly delineated. Errors open the door to the expenditure of resources to capture wealth, because in their presence, among other things, people can pass off their poor performance as a result of random error. The costs of transacting, as I dene them, are the costs of effecting transfers and of protecting against them.4 Due to these costs, deadweight losses (relative to the unattainable Pareto optimum) will be present in market exchange. One of the forms they take is the duplication of information.5 Individuals, however, will choose to organize activities in the least dissipating modes available to them.

3 The Organization of Exchange Consider the information sellers and buyers need. Sellers need information about the commodities they produce and sell, as well as about the inputs required for their commodities. When acting as producers, buyers need some of the same information so they can further transform the commodities they buy. As ultimate consumers, buyers need the information as input for producing utility. Measurement is a particular form of information. Certain measurements are routinely effected in the process of carrying out production, and various measurements, including some that are also needed for production, are obtained in the course of consumption. The former tend to be objective and veriable, and thus likely to be used in contracts. Measurements undertaken in consumption are likely to be subjective, and thus useful only in self-enforced agreements. Exchange may be governed by a variety of forms of enforcement. Most fundamental is the use of long-term relations, as all the other forms are embedded within it. These other forms are those associated with caveat emptor and auctions, with contractual relations that the state enforces, and with transfers effected within organizations. Each form differs from the others in its informational requirements, sometimes radically so.6 In caveat emptor transactions, information is collected up front. In long-term relations and in contractual relations, sellers offer buyers assurances that the merchandise meets some quality standards, reducing buyers need to measure the merchandise when transacting for it. I discuss caveat emptor, long-term relations, and contractual relations in this section, and within-organization exchange in the next.

4 The costs of transacting as dened here include such things as the losses from not effecting exchanges as a result of the high cost of agreeing on terms. 5 DEMSETZ [1988] focuses primarily on the cost of producing information. He largely ignores the question of how ownership over information is maintained, and the nature of the difculties of exchanging it. 6 Factors that contribute to the differences include the cost of measuring the various commodity attributes, the cost of forming long-term relations, the quality of contract enforcement by the state, and the length of the chain of individuals through which the information passes.

360 3.1 Caveat Emptor and Auctions

Yoram Barzel

JITE 161

Caveat emptor transactions, while not very important in practice, are the simplest form of transacting. Parties will engage in caveat emptor exchange only when they maintain no long-term relations with each other. Therefore, they require a third party to enforce their exchange. The enforcers role is conned to the prevention of theft and of fraud; the rest is up to the exchange parties. The seller must measure his wares in sufcient detail to avoid grossly underpricing them, and the buyer must measure the merchandise to avoid being grossly overcharged. The buyer converts an asymmetric situation into a (more) symmetric one. However, he duplicates already available measurements. Further, his measurement efforts will be wasted if he decides not to buy. Buyers eventually measure the merchandise while using it, but by then the transaction cannot be undone. Measurement is costly, and the parties are expected to economize on these costs. First, they will only sample commodity specimens and their attributes. Second, the actual measurements will be subject to error. The parties, then, face a trade-off between the amount they spend on measurement and the chance of getting burned, and they expect to get burned occasionally. Auctions share many of the main features of caveat emptor transactions. It may appear that in auctions sellers just sit back and wait for the highest bid. However, when only one bidder shows up, he will bid at most the minimum price set by the seller. Sellers, then, must conduct research to determine the optimizing minimum prices. They must also alert would-be buyers that the auction is worth attending. Buyers who attend have to decide how much to bid. So here too effort is duplicated. 3.2 Long-Term Relations The use of long-term relations to enforce exchange induces a radical change, compared to caveat emptor, in the measurements that the parties effect and in their timing. Under long-term relations, the seller makes explicit or implicit promises about the levels of certain attributes of his commodity. Taking advantage of these promises, buyers refrain from measuring the commodity at purchase time. Instead, they measure it when it is least costly to do so, often as part of the act of consumption. That measurement, however, tends to be subjective. Dissatised consumers can punish the seller by withholding future purchases, but they seldom expect to get their money back. As moral hazard would not benet them, it will be absent.7 I will return to the moral-hazard issue when discussing transactions enforced by multiple enforcers. To perform their function, long-term relations, usually accompanied by brand names, must be sufciently valuable to induce buyers to risk paying for merchandise that they do not inspect. The more the seller could gain by breaking his promise, the stronger the long-term relations must be, and the greater is the investment made in
7 Buyers threat to extort by terminating the long-term relations does not seem credible.

(2005)

Organizational Forms and Measurement Costs

361

them. Thus, for instance, the investment is expected to be relatively modest when buyers effect long streams of small purchases. The buyer operating under long-term relations enforcement saves the cost of measuring at purchase time as caveat emptor buyers do. This is signicant for attributes that are especially costly to measure at transaction time relative to measuring them later. For example, the commoditys durability and shelf life are usually expensive to measure at purchase time, whereas they are often measured cheaply with use. I predict that durability or shelf life would not be a signicant attribute of commodities traded under caveat emptor or in auctions. 3.3 Enforcement by Contract The state, as a rule, does not participate in the contractual process, but it enforces contractual exchange stipulations.8 It obtains its information about the contract when a dispute erupts. To be effective, then, contract stipulations must be objectively measurable and veriable. Verication appears to constitute unavoidable duplication. As with long-term enforcement, however, the guaranteed can effect the verication while he uses the commodity rather than when it changes hands. Attributes that are easy to measure and to verify are likely to be contracted for. The lower the cost of measuring commodity attributes, then, the more attractive is exchanging them by contract. On the other hand, the information required to guarantee that something is beautiful or delicious is more ephemeral, and so is its standing in court. Such difcult-to-measure attributes, however, may be stipulated in long-term exchange agreements. 3.4 Agreements with Multiple Enforcers In BARZEL [2002] I argue that, as a rule, to enforce their agreements, parties take advantage of more than one enforcer. Each form of enforcement enforces the components of the agreement for which it has a comparative advantage. Moreover, caveat emptor aside, a contractual relation constitutes only part of an agreement and is always supplemented by long-term relations. Long-term relations require investment in the relationship; contract enforcement requires the existence of a state and of a rule of law. We expect highly valued attributes that are relatively easy to measure to be guaranteed by contract. On the other hand, we expect valuable but costly-to-measure attributes to be placed in the long-term relation component of the agreement.9 The simultaneous use of long-term and contractual enforcement can exploit the fact that long-term relations are free of moral hazard, and at the same time can use contracts to reduce the needed level of reputational capital. Consider the guarantee of
8 Here I follow legal scholarship, where the term contract applies only to what the state enforces. McNeil, for instance, states that contracts must be legally binding. 9 Some attributes are inspected at the time of exchange (i.e., they are subject to caveat emptor). This component, however, is not germane to the argument here.

362

Yoram Barzel

JITE 161

the longevity of appliances. Typically, sellers guarantee appliances longevity partly by contract and partly by long-term relations. The contractual guarantee covers the early portion of the life of an appliance, when the moral-hazard problem is not serious. Long-term relations back the guarantee beyond that point. The seller does not have to compensate its buyers beyond the contractual guarantee period. Buyers, then, cannot gain from moral hazard, and thus will not punish the seller for their own carelessness. 4 Within-Organization Exchange Thus far I have considered what independent exchange parties stand to gain from using different forms of agreement. Some of the information generated within transactions, however, is valuable to third parties. Vertical and horizontal integration may prove useful for transmitting the information while avoiding the capture expenditures that independent transactors would have effected. 4.1 The Employment Relationship In general, to be effective, rewards must be tied to performance. Nevertheless, employees are rewarded largely by xed wages; they are residual claimants to their operation only to a moderate degree. Whereas employees are not induced to exert themselves, neither are they induced to exploit some of the capture opportunities that would entice independent workers. An upstream producer who produces a highly variable and difcult-to-measure product would fear that allowing his buyers to pick and choose would harm him. Whereas we expect independent workers exertion level to be optimal, we expect their effort in picking and choosing to be excessive. This is not a signicant problem in vertically integrated operations (BARZEL [1982]). The reason is that, in such operations, the products producer and its user are employees in the same rm, and the employer tells employees both what to produce and to whom they are to transmit their output.10 The employer is more concerned with employees average level of performance, which is relatively cheap to measure, than with each employees variance in performance, which is relatively expensive to measure.11 Following the employers instructions, the employed producer is thus induced to produce specimens of both higher average quality and higher variability than those he would produce as an independent operator. In turn, the downstream producer, also an employee, will gain less from actions such as picking and choosing than he would if he were an independent worker. The problems of producing low-quality output and of the potential dispute in transmitting it largely disappear under integration. The employer, of course, has
10 In the next section I connect, and compare, the approach here with that based on the capture of specic assets quasi rent. 11 Thanks to Timothy Dittmer for this observation.

(2005)

Organizational Forms and Measurement Costs

363

to supervise employees to ensure that they exert themselves and produce the right kind of output. This employment relation has the additional advantage of making the quality of output easier to verify. The literature has often classied instances into those that are veriable versus those that are not. I suggest that a variety of actions that do not appear to be veriable can nevertheless be veried. As a rule, independent producers are not keen on sharing the measurements they generate. Such producers may deliberately make the information difcult to observe and verify. The information may become more readily veriable under other organizational arrangements, especially when its producers are employees.12 Coase aptly characterizes wage employment as a masterservant relationship. An employee cedes to the employer the right to instruct him in how and where to carry out his duties. Among other things, employers control the workspace of their employees. Employers, then, can position employees so that they become easier to observe, and so that the employer can verify whether or not the employee is making the desired effort. If the employer also employs the output recipient, he can verify that the uncontaminated information is transmitted to that recipient for whom it is useful. This factor too, then, is a force towards vertical integration. 4.2 Expanding the Scope of Vertical Integration In this section I consider two puzzling sets of observations. First, in large markets, some tasks that could have been subdivided into narrower, more specialized tasks are not so subdivided. Instead, a number of less-specialized workers perform the same less-specialized task. Second, consumers purchase many commodities in not quite nished form and then perform the nishing tasks at home. I suggest that, although they are not usually viewed as such, both of these are cases of incomplete specializing. In both cases, a higher degree of specializing would be attained under vertical integration. 4.2.1 The Extent of the Market: A Necessary but Not a Sufcient Condition for Specializing One of Adam SMITH s [1776/1976, p. 21] most celebrated pronouncements is that the division of labor is limited by the extent of the market. Smiths view implies that, if a worker performs more than one production stage, it follows that he must be operating in a small market, while in a large market tasks cannot be subdivided further than they already are. I contend that the extent of the market is a necessary but not a sufcient condition for full specializing.
Consider ofce workers. It is relatively easy to measure what they produce and how if they have to work in an open ofce or behind a glass partition. On the other hand, it is difcult to determine what they are doing if they work behind a wall, and even more so if they work on their own premises.
12

364

Yoram Barzel

JITE 161

The degree of specializing that we commonly observe seldom fully exploits the specializing opportunities markets actually afford.13 Measurement cost considerations may clarify the concept of production stages and of the degree of specialization and explain why the extent of the market is not a sufcient condition for full specializing. In his pin-making illustration, Smith takes two items as common knowledge: that when specializing is at its high level the market is indeed large; and that specialized pin makers are self-employed. I assume that these are factually correct. Smith observed that in a large market the metal for pin making is rst drawn by one specialist, then straightened by a second specialist, then cut by a third one, and so forth (p. 8). It is plausible, however, that pin production can be subdivided beyond the stages Smith describes. More highly specialized workers could perform each of the more narrowly drawn stages. Why did Smith not observe in large markets several subspecialists subdividing each task among them? I hypothesize that such extra production stages are unlikely to be performed by self-employed workers because the product of the new interior workers would be difcult to delineate and thus subject to capture. Were more specializing to take place, it would be expensive for the recipient of the product to determine what he was paying for. Each new upstream producer could shirk in the quality of the product he was to deliver, and each downstream producer would spend an excessive amount of time checking the supplied product and choosing the best specimens. The value of the transactions between the providers of the products and their recipients would then be partly dissipated. I rather expect each actual task to have a reasonably well-dened starting and ending state. In the absence of such (relatively) clear delineation, developing markets for the intermediate products is very costly.14 If observed tasks are indeed divisible, then that which constitutes an actual production stage in a large market is not constant. Rather, it will cover less territory as a result of any of the following: Measuring and delineating constituent parts becomes easier; the value of the product increases; or organizing vertically integrated rms becomes cheaper. These, in turn, may be induced by changes in measurement technology, changes in production methods due to changes in input costs, increases in product price, or a fall in the cost of policing employees. Under such conditions I expect more production stages to emerge and the degree of specializing to increase, both among independent workers and within rms. Another implication here is with respect to vertical integration. Until the nineteenth century, rms were small, workers were largely self-employed, and the actual
13 The Seattle Metro Yellow Pages list about 1000 dentists who seem not to be specialized further within dentistry. The extent of the market is such that each of these could have specialized, say, in just one tooth rather than treat all thirty-two. That would still leave more than thirty specialists per tooth. Note that treating one tooth may easily spill over to neighboring teeth. 14 S CHLICHT [1998, pp. 247254] argues that coordination problems may lead to incomplete specializing.

(2005)

Organizational Forms and Measurement Costs

365

degree of vertical integration was modest. Early in the nineteenth century, vertical integration became common. I venture that the difference resulted, in part, from a fall in the cost of preventing employees theft. It is implied that the tasks that were performed in Smiths time by self-employed workers would have been subdivided and performed by employed workers within vertically integrated rms during the nineteenth century and beyond. 4.2.2 Market Specializing and Home Production The second puzzle also concerns incomplete specializing. Why are some goods sold in not fully nished form, requiring consumers to nish them at home even though nishing is not their primary specialty? One example is the home assembly of items. Another is the home laundering of clothing that shrinks after being washed and dried, and thus in general will not t well as purchased. Sometimes, specialists provide assembly and preshrinking services; at other times, buyers have to fend for themselves. As with pin making, I hypothesize that, when it is easier to measure the not fully nished product (or services) than the more nished product, the product will tend to be sold in not fully nished form. We expect that the more highly buyers value their time, the more likely they are to buy the product in its nished form. More signicantly here, we also expect that, as it becomes cheaper to measure the nished commodities, more of them will be sold in nished form.15 4.3 Transmitting Information across Transactors As already stated, guarantees relieve buyers from measuring what they contemplate purchasing prior to the transaction. The advantage of guaranteeing is blunted, however, when additional links in the production process separate the guarantor from the guaranteed. I argue that vertically integrated rms, the focus here, are well suited to transmit information when intermediate operations separate the guarantor from the guaranteed. I commence by discussing a situation where the effect of the separation is modest, as seems to be the case with garments guarantees. A consumer dissatised with a garment will return it to the retailer. For all he is concerned, the retailer is responsible for the performance of the garment. The retailer, however, is likely to demand a refund from the wholesaler, who in turn may get the manufacturer to pay him back. When these links function smoothly, it transpires that it is the manufacturer who has actually guaranteed the garment to the consumer, while neutral intermediaries have catalyzed the transaction. This is a case where the intermediaries do not gain from inducing claims over and above those that conIncome-tax considerations also induce consumers to engage in do-it-yourself activities, including the nishing of goods. Self-employed workers, however, can claim some such purchases (say of work clothes) as business expenses. For the latter type of activity, the prediction in the text is free of the caveat.
15

366

Yoram Barzel

JITE 161

sumers would make. The producer, then, does not fear that the intermediaries will take a ride on his guarantee to consumers. This scenario seems to apply to most intermediation by wholesalers and retailers. However, it does not apply to the general case; intermediate producers are often able to take a ride on the guarantee at the guarantors expense. This, for instance, seems to be the case when the intermediaries are producers or shippers who alter the product that the upstream producer ships downstream. I proceed with an illustration of intermediation by shippers. B, an upstream seller, buys fresh vegetables from farmers. Using two successive independent shippers, C and D, B ships the produce downstream to supermarket E. Obviously the freshness of produce is highly valued. To economize on the cost of inspection, E would like B to guarantee the produce. Below is a not implausible scenario in which B would not be willing to guarantee his produce. Suppose that the following cost conditions hold. First, freshness is easy to inspect when B prepares the vegetables for shipment, as well as when they are unpacked at the supermarket. Second, when the most economical packaging method is used, inspecting the vegetables while in transit is expensive. Third, shippers costs are lower when they skimp on maintaining freshness. Suppose that B were to use the low-cost packaging method and guarantee the produce to E. C and D, then, would skimp on maintaining freshness, each blaming the other for the loss of freshness. Freshness would not be adequately maintained, and B would have to compensate E for the low quality of the produce. Trade might be conducted instead by a sequence of caveat emptor transactions. Since freshness is directly remunerated here, it is likely to be taken care of. To make inspection easier, the more transparent and highertotal-cost packaging method will be used. This arrangement, besides requiring the more costly packaging, entails three caveat emptor transactions, where each successive buyer enters the transaction only after evaluating the freshness of the produce. The repeated measurements that caveat emptor transactions entail may be avoided by the use of vertical integration. Suppose now that C and D merge and C+D agrees to be held responsible for the freshness of the produce that it handles. Since C+D will become the residual claimant to the degree of freshness, it will use the optimal shipping method. C+D can deliver because it employs the producers for wages, and will simply instruct them to take the steps necessary to maintain freshness. As stated, wage employees gain little from producing low-quality products, or, in this case, altering the guaranteed attribute. The merger of C and D allows B to leapfrog both and contractually guarantee freshness to E.16 Even though C and Ds merger increases the level of integration, the noncontractual component of the operations is actually lowered.
16 Freshness, then, is broken into two components: one that C+D takes charge of, and one that B takes charge of. The error in measuring these must be moderate for the arrangement to work.

(2005)

Organizational Forms and Measurement Costs

367

Which production stages will integration encompass? Were integration to confer benets only, it would presumably encompass all stages. But it is expensive to turn independent, prot-oriented operations into more bureaucratic organizations.17 The benets from integration, then, have to exceed this cost.18 Suppose that an operation consists of k stages. If the difcult-to-verify information from stage 1 is useful to stage k , the operator of stage 1 is expected to guarantee his product to the stage-k operator. The integration will then encompass stages that lie between 2 and k 1.19 We expect that only the stages that otherwise offer signicant benets from taking a ride on the guarantee will be included in the vertically integrated rm. A producer of an interior stage who would not gain from exploiting the guarantee is expected to operate independently as an outside contractor; i.e., to engage in outsourcing to the vertically integrated organization. For instance, suppose that k is a nal consumer and k 1 is a retailer. If the retailer gains little from taking a ride on the guarantee, he will not be included in the integrated operation, and the integration will encompass at most stages 2 to k 2. It is instructive to think about the potential for reverse engineering in this context. Reverse engineering may be applied at any juncture in the vertical process. If, when performed at the i th stage, the process does not yield signicant new information compared with one performed at the (i 1)th stage, then keeping the two within the same organization confers only a modest advantage. The above analysis yields a number of implications. We expect (1) vertical integration to increase with the number of vertical steps in production (the reason is that the larger the number of production steps, the greater the opportunities for taking a ride on guarantees), (2) production to become more specialized when the cost of organizing vertical relations falls, and (3) production to become more integrated when the gains from specializing increase. 5 Capture of Quasi Rent I have just argued that forming vertically integrated organizations is useful when the cost of measuring intermediate commodities is high. How does this argument relate to WILLIAMSON s [1975] and to KLEIN, CRAWFORD, AND ALCHIANs [1978] leading theory that vertical integration serves to prevent the capture of specialized assets quasi rent? In my view, the two models do not differ fundamentally from each other. The capture-of-quasi-rent model, however, suffers from two shortcomings. First, it is too restrictive in what it deems subject to capture. Second, it tends to
17 The notion that integration sacrices the incentive for prot is a possible answer to SCHLICHTs [1998, p. 255] query Instead of asking Why Firms? the difcult question to answer is Why Markets? 18 This reason, I think, conforms to COASEs [1937] rationale of the limits on rm size. 19 ARROW [1975] seems to have been the rst to suggest that vertical integration is a method for transmitting information. However, he does not consider the case where the production of information consumes resources.

368

Yoram Barzel

JITE 161

overlook methods besides vertical integration that may reduce the deadweight loss from capture. To belabor the obvious, assets generate higher income in their specialized use than they could generate elsewhere. This differential is prone to capture. Quasi rents, however, are not conned to what are usually tagged as specialized assets. For example, as a rule, employees value to their employers exceeds their wage. At the same time, their reservation wage tends to be less than their actual wage. Correspondingly, we often observe wage increases in response to outside offers, and we also observe that employees choose to stay on even when, for some reason, their wages are reduced. The discrepancy between the maximum employers would pay and the reservation wage constitutes capturable quasi rent. As another example, once shoppers enter a store, they are earning quasi rent for not having to travel to the store; thus the practice of bait and switch. The existence of capture opportunities implies that (economic) property rights are not well delineated. When measurement is costless, writing and enforcing complete contracts is trivial, and ownership is well dened. Neither specialized assets quasi rents nor anything else will then be captured. Measurement, however, is costly and subject to error, so transactors are not certain how they will fare in their exchanges; their economic rights are not well dened. Capture opportunities exist everywhere, and transactors will spend resources to capture what they can. This behavior characterizes any dispute, as disputes consist of the competition between parties to capture the difference in their valuation (or quasi rent) of the disputed entity. Maximizing individuals attempt to reduce the resource expenditures associated with capture. Vertical integration is one such action. Standardizing idiosyncratic assets is another method for avoiding disputes. Standardization reduces quasi rents and, with that, the incentive for capture. The benets that standards generate, however, must be weighed against the cost of the infrastructure for their implementation and the loss from reduced variety.20 The use of long-term relations is still another method for sidestepping quasi-rent capture. Long-term relations seem to be especially effective when transactors deal directly with each other, because forming such relations is then relatively easy. Thus, vendors acquire a reputation for refraining from bait and switch, employees for faithfulness, and employers for fairness. Finally, rms may acquire a reputation for not engaging in capturing the quasi rent. Consider the relationship between the owners of a small-town newspaper and a printing plant. As an alternative to vertical integration, one or both might merge with a chain having a reputation for honoring its agreements. I have just argued that the notion of specic assets is less general than that of measurement costs. The former is also less operational.21 The easier it is to
Standardizing is a step toward perfect competition, and away from noncooperative (and perhaps repeated) games. See BARZEL [2004]. 21 The literature debates the question whether asset specicity can be handled by contract or whether it requires vertical integration. It seems, though, that the answer should not be in the form of all or none. Rather, the greater the specicity of an asset, the greater the advantage of vertical integration. Similarly, DEMSETZs [1988, p. 154]
20

(2005)

Organizational Forms and Measurement Costs

369

measure and verify contract stipulations, the more readily can contracts be enforced. It is predicted that as the costs of measurement and of verication decline, transactors will use contracts more often and engage in vertical integration less often.22 This proposition is unlikely to emerge from the concept of specialized assets.

6 Horizontal Integration 6.1 Introduction In vertical relations, information is usually desired for the product to which it is tied. The number of individuals seeking each piece of such information tends to be small.23 On the other hand, the number of individuals seeking horizontal information is often large. Such information, sometimes sought for its own sake, is not as tied to products as is the information used in vertical relations. Consider a commodity produced for the market by numerous producers. Due in part to random variations, each buyer or seller obtains information that is useful both for him and for others and is not identical to what others get. Each, then, could benet from receiving and aggregating the information that the others collect. Obviously, the amount of resources used is lowest when such aggregation is performed only once. The information needed to set commodity prices is such a case. Organized exchanges for trading stocks and futures commodities aggregate information to form prices by compiling the buy and sell orders. Their fees consist of the buysell differential. The quantities individuals and organizations trade in these markets are usually too small to signicantly affect market price, so they do not then gain from withholding or altering their information. The problem of collecting the information changes radically when the number of traders is small, and in such cases various methods are available for dealing with it. One is to impose restrictions such as the suppression of information (BARZEL [1977] and BARZEL, HABIB, AND JOHNSEN [2005]). Alternatively, rather than operate independently, individuals may form horizontally integrated organizations and transmit and conserve information within them. I analyze this problem using two extensive illustrations hotel reservations and navigation on the Mississippi.
inquiry why markets exist if rm-like organizations reduce the cost of opportunism more than does the market becomes unnecessary if one recognizes that these too are matters of degree rather than being absolute. 22 In the literature comparing contracting and vertical integration, it is often forgotten that rent capture can be averted only if integration takes place before investment in the specialized assets. 23 Information about standardized commodities is often useful to many. This is an important exception to the statement in the text.

370 6.1.1 Hotel Reservations

Yoram Barzel

JITE 161

Consider individually owned hotels in a town. Reservation systems provide owners with information for planning the use of their facilities and deciding what prices to charge. As reservations are updated, each owner can use the information to revise his demand estimate. Owners, however, could improve their estimates by combining their information with the information other owners acquire. Owners might attempt to buy the information from each other, but for two reasons arranging such transactions is difcult. First, buyers who resell the information are preempting the seller from selling it to others. Preventing such resale could be avoided if both buyers and sellers would commit to exclusivity, but this is difcult to enforce. It may seem that the price the seller could charge a buyer who can resell the information would be commensurate with the sum of its values to the buyer and to his own customers. The initial problem, however, will recur, as the buyers clients are likely to undercut him. He would not, then, pay much for the information to begin with. Second, sellers may gain from manipulating the information. Since the information is difcult to guarantee, buyers will be wary of using it. Guaranteeing is problematic because it is difcult to tie the information sellers provide to observable data. Buyers could require access to the sellers accounting system for an audit. Such an arrangement, however, does not seem practical. Instead of obtaining the information via a direct agreement between hotel owners, it may be obtained indirectly a trade association or a government agency might collect and aggregate information from all hotels. But inducing owners to supply accurate and timely information is difcult. In addition, owners may be reluctant to share certain classes of information with their competitors. Horizontal integration may overcome these problems. If two hotels merge and share their reservation information, each will now have more information. As in the case of the vertical integration, employees of the same employer will produce the information. Their incentive and ability to conceal and debase it is mostly absent. The more alike the merged hotels are i.e., the better substitutes they are the larger their gain from the merger, as the information each has is a close match to the information the other desires. This is also the information they would be reluctant to share were they independent. 6.1.2 Pilots Union on the Mississippi24 In The Pilots Monopoly chapter in Life on the Mississippi, Mark TWAIN [1883/ 1996] vividly describes how Mississippi steamboat pilots exchanged information about navigating the ever-changing river. Pilots had to refresh their knowledge with every trip up and down the river. Information on the new conditions each encountered was of great value to those about to reach these locations. Independently operating pilots, however, had little incentive to share their information with others.
24

Thanks to Levis Kochin for bringing Twains colorful description to my atten-

tion.

(2005)

Organizational Forms and Measurement Costs

371

Just before the Civil War, some experienced pilots formed the Pilots Benevolent Association, charging members fees equal to 10% of their wages. Pilots exchanged information by written reports they deposited in secure spots along the way and in their main halls in St. Louis and New Orleans, which were accessible to association members. They occasionally also exchanged information directly as they passed each other in their steamships. However, it was a rigid rule of the association that its members should never, under any circumstances whatever, give information about the channel to any outsider (p. 182). Sharing information among members and keeping it away from outsiders had dramatic effects. [T]he pilot who had formerly been obliged to put up with seeing a shoal place once or possibly twice a month, had a hundred sharp eyes to watch it for him, now, and bushels of intelligent brains to tell him how to run it (p. 185). Now ... outsiders began to ground steamboats, sink them, ... whereas accidents seemed to keep entirely away from association men (p. 186). That difference did not go unnoticed; ... one black day every captain ... was formally ordered to immediately discharge his outsiders and take the association pilots in their stead. And who issued the order? ... It came from the power behind the throne that was greater than the throne itself. It was the underwriters! (p. 187). As one would expect, the union exploited its new power to the hilt, raising wages and collecting a large sum in back pay from outsiders who now wished to join. The union did not last long, however. First, the Civil War reduced the demand for steamboat service. Second, the railroads were emerging, resulting in a switch to mostly tugboat-pulled freight on the river. Finally, the treasurer of the St. Louis association put his hand into the till and walked off with every single dollar of the ample fund (p. 192). One implication of the informational model described here is that a separate union would form for every segment of the river navigated by its own pilots. Twains data support this implication. He contends that the success of the St. Louis and New Orleans association had now bred tolerably thriving branches in a dozen neighboring steamboat trades (p. 184). Had the unions primary objective been to extract monopoly rent, it should have merged with all the other branches. That they remained independent supports the notion that these unions primary purpose was the collection and protection of information. 6.1.3 Comparing the Pilot Associations with Merged Hotels The gain from information sharing was reciprocal both for hotel owners and for pilots: the information each pilot and each hotel gathered was useful, respectively, to the others. Consider, however, the scope of the organizations. The scope of each pilots associations consisted of a segment of the river in which pilots specialized. The scope for hotel mergers is much less clear. The usefulness of one hotels information to another depends on, among other things, the distance between them, the nature of their clientele (business or nonbusiness), and the quality of their services.

372

Yoram Barzel

JITE 161

It is worth noting that the pilots association seems to have found it manageable to enforce information sharing and to exclude outsiders. Twain does not discuss the nature of the enforcement, but his description clearly implies that it was most successful. The pilots association imposed restrictions on its members and taxed them, but apart from the restrictions it did not tell them how to perform their jobs. In the case of hotels, an outright merger seems necessary to achieve such objectives. 7 Conclusions To exchange, a seller requires the same commodity information that the buyer wants. In caveat emptor transactions, buyers must effect their measurements prior to the exchange even if measurement is very costly at that time. Forming long-term relations as well as contracts allows buyers to measure the purchased commodities at consumption. In transactions enforced by long-term relations the measurements that buyers use tend to be subjective. To be effective, the enforcement of such transactions requires reputational investment. Contractual guarantees shift the enforcement burden to the state, but require objective and veriable measurements of the guaranteed attributes. Most exchange agreements combine the two forms in order to benet from the comparative advantage that each provides. Using this combination tends also to reduce signicantly the potential deadweight losses from moral hazard. Vertical integration reduces the cost of excessive measuring of commodities as they move downstream, because employed workers gain little from manipulating these commodities and the information about them. Vertical integration is especially attractive when upstream producers wish to guarantee their products across downstream transactors, who, when independent, would have gained from taking a ride on the guarantee. Long-term relations are difcult to implement in such a case, and operating within organizations seems effective in handling the transmission of the commodity without contamination at the intermediate steps. Horizontal integration accommodates benets from the assembly of information, which is difcult to arrange when the parties operate as independent transactors. Finally, the capture of quasi rent from specialized assets is just another manifestation of difcult-to-measure entities. The notion of measurement cost is more general than that of specic assets. It is also more operational.

References
ARROW , K. J. [1975], Vertical Integration and Communication, The Bell Journal of Economics, 6, 163173. BARZEL, Y. [1977], Some Fallacies in the Interpretation of Information Costs, Journal of Law and Economics, 20, 291307. [1982], Measurement Cost and the Organization of Markets, Journal of Law and Economics, 25, 2748. [2002], A Theory of the State, Cambridge University Press: Cambridge. [2004], Standards and the Form of Agreement, Economic Inquiry, 42, 113.

(2005)

Organizational Forms and Measurement Costs

373

, M. A. HABIB , AND D. B. JOHNSEN [2005], IPO Syndicates, Private Foreknowledge, and the Economics of Excess Search, Journal of Business, forthcoming. COASE, R. H. [1937], The Nature of the Firm, Economica, 4, 386405. DEMSETZ, H. [1988], The Theory of the Firm Revisited, pp. 144165 in: H. Demsetz (ed.), Ownership, Control, and the Firm, Basil Blackwell: New York. KLEIN, B., R. C. CRAWFORD, AND A. A. ALCHIAN [1978], Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, Journal of Law and Economics, 21, 297326. SCHLICHT, E. [1998], On Custom in the Economy, Clarendon Press: Oxford. SMITH, A. [1776/1976], An Inquiry into the Nature and Causes of the Wealth of Nations, The University of Chicago Press: Chicago. TWAIN, M. [1883/1996], Life on the Mississippi, Oxford University Press: New York, Oxford. WILLIAMSON, O. E. [1975], Markets and Hierarchies: Analysis and Antitrust Implications, Free Press: New York. Yoram Barzel Department of Economics College of Arts & Sciences University of Washington Box 353330, Savery 302 Seattle, WA 98195 USA E-mail: yoramb@u.washington.edu