The Evolution of Organization/Firms, pt 1

Chandler: Main advantage to administrative coordination is that it enabled existing labor/capital resources to be utilized more intensively through better control over the flow of goods through the supply chain. This became strong enough to overcome the informational and monitoring advantages of the price system/market, once a number of innovations took place, including organizational innovations..

Description of American Industry, 1840

Fewer than 100, probably fewer than 50, employed at least 250 people. Of those that did, almost all were textile firms on the east coast at which it was economical for workers to avail themselves of a common energy source (waterwheel) to drive their spinners and looms.

Firms consisted of an owner/manager, who personally supervised all workers, or who received reports from a single supervisor. There were no manager/supervisors who reported to other manager/supervisors.

In many cases, firms were families -- sons working for fathers. Similarly, when owners hired apprentices, they were treated like family, often living with them.

Owners themselves were able easily supervise or monitor a large part of the economic activity within the firm. They were personally responsible for and informed about purchasing decisions, demand conditions, product quality, all aspects of production. It was all under one small roof.

This was generally true of firms involved in production and distribution and those involved with commercial activities such as insurance, exporting, importing, and lending.

Firms may have looked very much like the classical firm, with the market monitoring each monitor.

Transactions were of the form of many impersonal interactions across firm boundaries. Market relationships.

There was a high degree of specialization in the market. Firms concentrated on one single task. Production of a single good. Wholesaling/distributing, when volume warranted (cotton) of a single good. Small scale retailing. Fragmented supply chains mediated by the market.

Why weren't firms larger? Transportation costs were extremely high, owing to poor roads, slowness of canals. Limited size of markets, and therefore size of firms. Limited economies of scale and scope in production (traditional tools and simple machines) and distribution (canal boats and wagons). Why did markets coordinate such a high percentage of economic activity? The main advantage, according to Chandler, of administrative coordination is that it may permit the firm to better utilize existing resources (or utilize them more intensively) by maintaining constant flow of goods in the pipeline. There were limited opportunities for this at the time, because of high transportation costs and limited economies of scale.

Why? Firm size was so small that owners were personally involved with transactions and operations. Less need for internally-generated data. Furthermore, there were relatively few accounts to keep track of, and traditional accounting systems did this well enough.

Organizational Innovation and its Complements

Between 1840 and 1880, there were several broad technological developments.

These other developments/inventions were complementary to the development of administrative hierarchies for several reasons.

This is particularly true of the new production techniques and machines. Suddenly, individuals could be far more productive with this new capital equipment.

Production economies of scale would not have been any good if transportation costs were still prohibitive. The development of railroads enabled fewer, larger firms could supply an area cheaper than many small firms.

Energy and transportation was now less connected to the weather. This allowed firms to better plan production schedules, marketing, etc. Decreased uncertainty meant increased throughput.

There were complementary to the administrative coordination for the following reasons.

First, economies of scale meant that there was suddenly a value to mass producing goods within a large firm. One large firm was more efficient than two small ones, if all were used at optimal capacity. There was more administration simply because production processes were larger.

Second, and more importantly, economies of scale meant that producing more intensively had huge gains, because you were way out at the end of the curve. Not using this capacity meant that your average cost of production was quite a bit higher. Integrating forward (into retailing or wholesaling) guaranteed you the ability to consistently market high levels of production. Integrating backward (buying out your suppliers, particularly for key inputs) guaranteed you sources of supply. This enabled the firm to use its capacity optimally.

However, administrative coordination was not automatically superior to the market. After all, markets tend to be informationally efficient, and monitor effort well. Invention had to occur -- developments in organizational technology -- before administrative coordination became actually superior. Individuals had to invent means through which to coordinate economic activity efficiently. Existing (as of 1940) organizations were simply not developed enough to outperform the market, even after these other developments.

Railroads: The First Organizational Hierarchies in America

Not only was the development of railroads important in organizational development because of the innovational complementarity between organization and transportation, but the first important organizational innovations were within the railroads themselves.

The first US railroads were built in the 1830s, and very quickly replaced existing forms of shipping freight (canals and teamsters). Railroads were, by 1850, by far the largest businesses in America. Even the smaller railroad lines were larger than the largest textile firms. Major railroads contained $10-20 million in capital; the biggest textile firms were only just over $1 million.

Problem was how to manage the economic activity within the railroad so that use of capital was efficient, and transportation was safe. Creation of adminstrative procedures, job definitions, hierarchies, business practices to effect this. Since no hierarchies had previously existed to this scale, they had to be invented. Organizational innovation.

Scope of supervision on railroad lines was about 30-50 miles, which could be covered by about 50 men. These men had to accomplish the following tasks: maintain the trackbed, maintain the cars, schedule carriage of goods, collect revenues and monitor accounts, maintain schedules. Superintendent of railroad had assistants in charge of each of these activities, who in turn monitored workers. Often the superintendent himself monitored workers directly. Small-scale business. This was the length of early railroads.

Longer lines meant the following:

One possible solution: many small railroads, each about 30-50 miles. Transaction costs, however, when railroads interconnect (imagine problems of switching planes every time you have to make a connection...). Might have to transfer goods to other cars. Even if car-sharing system was worked out, have to switch engines. Shipper would have separate agreements with different railroads. It would be more difficult for railroads to shift resources (labor, capital) across lines.

First administrative solution:

More divisions. Have separate superintendents for each part of the road.


Solved the monitoring problem, but... Superintendents lacked information to coordinate train scheduling, particularly because there were no telegraphs at the time. Train accidents.

Organizational invention:

Central headquarters to monitor and manage the divisional superintendents. Functional supervisors at headquarters, who in turn reported to the general superintendent. These functional supervisors were the very first "middle managers".

Potential Problems:

Upper level managers did not have direct contact with what was going on. Hierarchies place information requirements that markets do not.

Employees at lower levels could make arrangements on their own to coordinate activities. This may reduce the cost of that particular arrangement but increase the cost to the firm as a whole. (For example, they might agree to allow a train to leave a station early.)

Coordination problems among functional departments. Does scheduling know when the maintenance department will work on certain parts of the track? Does car maintenance people know when a particularly large customer is scheduled to make a big shipment?


Very sophisticated reporting requirements. Each manager filled out daily reports to his supervisors. This information supported the decisions they made during the day. This info was also consolidated into monthly reports that permitted managers to better allocate resources.

Clear lines of authority. Individuals only responded to immediate supervisors. So as not to disrupt overall goals of railroad, divisional managers could not make arrangements on their own. Occasionally this was inefficient, but lend itself in general to better coordination.

Strict schedules for conductor. Clear goals, with detailed instructions and procedures to follow if the train broke down or fell behind schedule. Very, very difficult to change schedules. Everyone in the organization could anticipate exactly what conductors would do in each situation.

These basic innovations were adopted throughout the railroad industry, and held even as lines expanded. The basic principle of functional organization/ line and staff /hierarchies remained even as railroads got larger and larger and more and more complex.

The Evolution of Organization/Firms, part 2

Description of American Industry, circa 1890

There were many large firms.

The speed with which industry structure changed was remarkable. Whereas before 1840, there were probably fewer than ten non-textile firms in the entire country that employed 250 people, by the late 1870s, big business, had become an important and controversial public policy issue. Concern was with both the railroads and other large industrial firms. Congress passed laws intended not only to limit railroads' market power, but the market power of firms in other lines of business as well.

Large firms used new, sophisticated organizational forms which helped managers coordinate economic activity.

There existed layers of middle managers who supervised production, served as information conduits. Line and staff organizational form, divided functionally.

Integrated supply chains. Coordination to take advantage of economies of speed, guarantee constant flow of product.

Manufacturers often integrated "downstream" into wholesaling, and sometimes upstream into supplying key raw materials.

Mass production. many industries, most prominently capital-intensive ones. These directly utilized new industrial inventions (machines) and processes, and indirectly benefited from inventions that reduced the cost of and increased the reliability of energy and innovations in organizational structure.

Large firms developed sophisticated accounting methods to provide overview of firm/divisional performance. Financial, cost, capital accounting procedures developed, standardized.

Transportation infrastructure, particularly railroad systems, were much more sophisticated. Railroads connected almost all communities above a given size.

Improved coal mining techniques and generators resulted in cheaper, more reliable energy sources. (Steam engines, coal burning furnaces, etc.)

For the first time, internally-generated data was being used by firms to help improve their performance.

What happened? Set of complementary innovations.

1. Production innovations. New machines, processes. Steam engine.

2. Transportation innovations. Railroad.

3. Communication innovations. Telegraph.

4. Financial innovations. Option contracts, financial markets (to finance railroads). Accounting systems.

5. Organizational innovations. Development of line and staff. Hierarchies. U-form. Lines of authority/communication.

These innovations were complements because innovation in one of these dimensions raised the returns at arose from innovations in others.

For example...

Production/transportation complementarity. Coming of the railroads raised the returns from invention of new machines and processes which permitted mass production, because it allowed the achievement of benefits from increased scale economies. Production advances raised the returns from the railroad system because it the production processes needed faster replenishment of inputs.

Organizational innovation was complementary to these because production/transportation advances made returns from better adminstrative coordination greater. Whereas previously, there were relatively small costs from poor management -- for example, operating at the wrong scale, it was now extremely important to operate at the right scale continuously. The invention of these new organizational forms raised the returns from production advances because it meant that achievement of scale economies was not limited by the scope of supervision of an individual manager.

Railroad made invention of instantaneous communication particularly valuable. Telegraph made returns from railroad system particularly high because it allowed achievement of potential to coordinate economic activity both within the railroad (making the railroad more efficient) and outside it (making other economic activity more efficient). Better communication permitted the more intense use of resources.

One way to understand what happened is that, during the mid-late 1800s, there were many complementary innovations. These innovations were mutually reinforcing in the sense that, in some circumstances, when applied together, they permitted the achievement of previously unattainable efficiencies. One set of extremely important inventions during this time was organizational. This is often not stressed in history courses. Organizational innovations -- hierarchies, business procedures, routines, etc. -- permitted the achievement of returns from other innovations (railroads, steam engine, machines) to a degree that otherwise would not otherwise have been obtained.

Organizational innovations were particularly important in capital-intensive industries. Iron, steel, aluminum. Salt, sugar, oil, prepared foods (soup). Small machines and tools.

Why? Because the innovations in production technology created the possibility of large economies of scale from mass production. For example, from new, continuous-process machines. Think of a canning machine for soup. Think of how one would can soup without such a machine...

Relatedly, some capital intensive industries were able to achieve new economies of scope (as opposed to scale) from these new innovations. For example, dyeing machines (producing more than one dye keeps the machine running), cereal (using the same machines to create flakes and toast them).

Industries that were more labor-intensive (clothes and furniture, for example) did not suddenly have this potential.

It suddenly became very important to keep the machine running. There were considerable benefits from using capital very intensively. This required:

Relying on price mechanism meant that 1 and 3 were extremely difficult to achieve. First, difficult to write contracts with suppliers that guaranteed shipments at a given time and place. Furthermore, it was more difficult to foresee when potential logistical problems were going to arise with enough time to secure alternative sources of supply. These contracting and information problems were smaller when firms vertically integrated. Analogously for downstream integration.

This does not mean that firms necessarily supplied all of their inputs, or even all of a certain key input. For example, auto companies often supplied only a fraction of key parts. But this was enough to guarantee continuous supply of these inputs.

Example: Duke and American Tobacco Co.

Before 1885, tobacco companies bought almost all of their tobacco from distributors (tobacco brokers) and depended on wholesalers to distribute their output and advertisers to market their products.

At the time, their business was mostly not in cigarettes. Cigarettes were made with simple machines for which continuous production was not important. Sunk costs low.

Machine invented which rolled large numbers of cigarettes in continuous production. Huge economies of scale available for firms using this machine, but required continuous supply of tobacco leaves, and large, consistent sales.

American Tobacco, under James Duke, does the following.

Salesmen visited individual wholesalers and large retailers, and were more effective than those handling other products as well in promoting American Tobacco's product. The sales bureaus also coordinated advertising within local regions.

The striking thing is that most managerial effort and talent went into the functions of sales and procurement, not direct production.

ATC was able to use this organizational structure to its advantage in supplying other tobacco products (snuff, plug, smoking tobacco) for which there were large scale economies from continuous production. However, it did not prove to be advantageous in the cigar market, for which production scale economies did not exist.

Chandler argues that this pattern is common to many industries in which economies of scale and scope became suddenly available. (Because of complementary technological innovations...) Companies that followed this pattern included Coca Cola and Wrigley's gum.

Three types of investments

Chandler: To benefit from the cost advantages of these new production technologies, entrepreneurs had to make three sets of interrelated investments.

[These investments are complements in adoption.]

Investments in the technology itself. Large production facilities that enabled him to capture production scale/scope economies.

Investments in a marketing and distribution network. To keep sales volume up. Inform consumer/retailers about the product (advertising) and sometimes how to use it, monitor retailers' effort in selling the product.

Investments in management. Organizational structure and managerial ability. This coordinated the flow of goods through the production process and supply chain in a way that permitted the achievement of scale/scope economies. Management important in all phases.

Middle managers in charge of coordinating day-to-day production/flows. Making sure the inputs are at the right place at the right time. Making sure the production process runs smoothly. Coordinating the process through which the outputs move off the line and into the distribution network. Managing distribution to individual stores. Monitoring local demand conditions and reporting to upper level management.

Upper level managers in charge of planning, securing input supplies, planning new products/market expansion, corporate strategy, etc.

One Perspective:

Firms actions during this time can be best understood not as motivated for market power, and not in response to contracting problems, but rather as ways of achieving economies of scale/scope through complementary investments. Non-contracting efficiency explanation.

Why Was There A First-Mover Advantage?

Interesting empirical fact: firms that were the first to make these three-pronged investments tended to continue to have high market shares for many years. Some (such as ATC, Coca-Cola, and Wrigley's) remain to this day. Why was there an advantage from going first?

Probably did not have to do with mastering production. Machines were straightforward to operate.

Learning by doing in management. The first-movers had an advantage because they had learned to coordinate flows better. So anyone moving second not only had to enter on a large scale (in order to achieve the necessary economies), but had to face a competitor with lower costs.

But these initial managers have long since died. Why do first movers' advantages persist even after those with the knowledge leave the firm?

Institutional knowledge embodied in routines, business practices, hierarchies of the firm. Evolutionary theory of the firm (Nelson/Winter) conjectures that the nature of the firm is defined not by its contractual arrangements, but rather by these routines, business practices, etc. that persist even as individuals come and go...