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Firm Boundaries and Agency Issues

Firm boundaries are defined by informational and organizational constraints, which limit the span of control of management. A firm can work with outside contractors so long as management can monitor and measure their work. But when opacity of information imposes constraints on monitoring, firms must expand their span of control and envelope the workers into employee status within the firms’ boundaries. On the other hand, management will hit the hard wall constraint of limited time and mental bandwidth if the firm boundaries are ever increasing. Synchronizing activities of large numbers of dispersed employees could create an unsolvable logistical puzzle. Therefore, firms will equilibrate at some intermediate size, determined by the industry and the economic environment.1

Whenever an agent is interjected between the owner, or principal of an economic enterprise, and its outcome, a problem arises, commonly called the agency problem. In particular, if the nodes with information are not the nodes making the decisions, there are going to be non-optimal transactions. Another way to look at this is ifthe node, the principal, with the information, resources and authority, delegates decision-making power to his agent, we have a situation where the agent may take a sub-optimal decision because (i) he may not share the same incentives as the principal, who provides the resources and (ii) he may not have the complete information set held by the principal. There will then be conflicts of interest between the two sets of parties, and more importantly, between all the other sets of parties through which the resources and decisions are delegated along the way.

This gulfbetween management and employees adds complications to the explicit contract which maps worker effort to its outcome. It will, therefore, often need to be supplemented by implicit contracts to overcome monitoring and informational constraints. For example, in addition to wages and work hours, there is an agreement, based on shared expectations, about goals and objectives of the firm. Postulating every eventuality is impossible and hence this shared broader objective incorporates the implicit expectations about worker engagement. Larger firm size increases the complexity of these contracts. The principal may not observe the actions by the agent, yet these actions have enormous implications for the outcome. Sub-optimal production and output decisions (e.g., shirking) can be mitigated by the presence of an intermediary who monitors the actions of the agent to ensure maximum productivity. Disintermediation, as well as production on a smaller scale, can eliminate this agency problem.2

There are two separate developments, both powered by digital technology: contraction of firm boundaries and elimination of intermediaries. Shrinking boundaries is evidenced by the fact that small businesses account for over 50 % of all mature firms in the US economy, according to data from the US Census Bureau [28]. Disintermediation is suggested by the changing organizational structure of firms: we are witnessing the restructuring of the production establishment due to the very nature of workers in firms like Airbnb and Uber. Driver-partners, as they are called at Uber, for example, are not employees but independent contractors; so Uber is considered a small firm in employee size. The focus has shifted from hours worked to quality of output. Work done outside the firm’s boundaries cannot be monitored and checked for work hours inputted, it can only be judged by output. Hence, the contractual terms between labor and management, the question of control over quality of the product or service and its price, are fundamental to the granular structure of production.

A classic example of this trend toward granularity, and synchronization of principal and agent agendas, is from the music industry. The artist Taylor Swift, as principal, bypassed the intermediating function provided by established record labels and aligned with an independent record label, Big Machine. She had the power to force the world’s largest company to change strategy when Apple, as her agent, had to reintroduce royalties in June 2015, for artists whose songs were played during the transition phase as the firm introduced its new app, Apple Music. Apple was rolling out its subscription streaming music service, a free Internet radio station and a platform that allowed artists to upload new songs and videos. During this initial phase, these artists would not earn any royalties, reducing earnings of new artists. This policy was reversed when, in a Tumblr post entitled “To Apple, Love Taylor,” Swift concluded with:

We don’t ask you for free iPhones. Please don’t ask us to provide you with

our music with no compensation. [29]

Swift increased the pressure on Apple by also threatening to withhold her latest album 1989 from Apple’s streaming music service.

With no intermediaries, the institutional setting within which buyers and sellers interact becomes increasingly significant. The distinctive feature of this network economy is a cooperative institutional framework, rather than a competitive one. For example, in response to Taylor Swift’s post, Eddie Cue, one of Apple’s senior executives personally called her to assure the reinstatement of royalties. Importantly, he tweeted an informal message, “We hear you @taylorswift13 and indie artists. Love, Apple” [29]. Cooperation can be interpreted as collaboration or joint- participation so we have market participants collaborating on the terms of transactions.

In order to understand the process whereby intermediaries are eliminated and the supply chain restructured, we need to examine the role played by these market participants. For that we turn to the model of multi-sided markets.

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