Inside the black box: A theory of endogenous organizational change and economies of scale

Recent observations of firm organization along with the organizational histories of two major U.S. industries imply that the institutional structure of prediction is an endogenous variable whose value is chosen by the firm within an implicit optimization framework. That is, a firm's management chooses to alter its boundaries as an optimal response to a changing economic environment. Furthermore, the evolution of the industrial structure arising from these organizational changes may represent a potentially significant source of external economies and, therefore, an important contributing factor to aggregate productivity growth.; To address these issues, the author draws together three separate strands of economic literature: trade theory, industrial organization, and transaction cost, economics to build a theoretical model of firm behavior that differs significantly from that of traditional neoclassical theory; indeed, one could view this model as operationalizing Coase's (1937) theory of the firm. The model serves three primary purposes.; It highlights the highly restrictive organizational assumptions imposed implicitly upon firm behavior by users of traditional constant returns to scale production functions. Using basic principles of trade theory, it shows that internal economies of scale arise naturally as a consequence of expanding intrafirm trade and specialization within the firm's boundaries. Furthermore, these scale economies are attenuated, at any given time, by the firm's administrative capabilities--making this organizational structure perfectly compatible with a competitive market structure.; The model also demonstrates how the firm's choice of vertical boundaries represents an additional margin of substitution along which firms can minimize costs. Costs are broadened to include not only direct production costs, but also the costs associated with the internal coordination of production activities and the transaction costs incurred through interfirm contractual arrangements. It is the presence of interfirm trade and specialization that establishes a link between organizational change and external economies of scale.; Specifically, firms respond to aggregate economic growth by adopting an increasingly specialized structure that leads to higher organizational productivity and, consequently, lower average costs of producing a given quantity of final output. Therefore, a true microeconomic mechanism is responsible for this type of external economy and that mechanism is endogenous organizational change.