The nature of the (illegal) firm

My University of Chicago colleague Ronald Coase died recently—too soon at the age of 102. He had just published a book on the subject of Chinese economic development. I regret never having had the chance to meet him.

He’s most widely remembered for his deceptively-simple “Coase theorem.” When property rights are unambiguous, information is freely available, and the costs of bargaining and contracting are low, private parties can negotiate efficient solutions to externality problems without further need of government intervention.

If, for examples, Austin’s factory emits water pollution that stains the shirts being cleaned downstream in Aaron’s laundromat, the two firms can work this out. Maybe the most efficient solution is for Austin to install an exhaust filter. Or maybe it’s cheaper for Aaron to buy different washing machines or to move. As long as Austin and Aaron can easily bargain, they’ll do whatever maximizes their total surplus. If the filter is cheapest, Austin will install it. Property rights matter, but only in determining who will pay. If Aaron has a clear legal right to clean water, Austin will buy the filter. If Austin has a clear legal right to emit this pollution, Aaron will pay for the filter instead. Coase’s 1960 analysis of such problems arguably provided the starting-point for the discipline of law and economics.

Coase’s lesser-known 1937 paper “The Nature of the Firm” is more directly useful for my work. Here Coase noted another deceptively simple paradox of the modern market economy. We teach our Econ 101 students that the price mechanism allows a decentralized, miraculously efficient allocation of activities and resources. Under the proper conditions, anyway, the invisible hand is genuinely powerful with no need of further central planning.

Yet we somehow have these organizations called “firms,” whose internal processes more closely resemble command economies than they do the textbook price-driven competitive economy. Just today, Walmart’s publicity materials compare living-wage legislation to state socialism. Yet its managers operate an internal command economy to allocate hundreds of billions of dollars in capital while coordinating the efforts of more than two million employees.

I don’t offer this as a criticism. It’s just an interesting puzzle. Why would a firm become that large? Why not larger? Walmart buys Vlasic pickles and plastic toys from China. Why doesn’t it open its own pickle and toy factories, dispense with the suppliers, and manufacture these items in-house?

These are the kinds of questions that fascinated Coase. These have obvious parallels in healthcare. Why don’t the Harvard teaching hospitals or the Mayo Clinic exploit their quality reputations to become Walmart-size organizations across the country? When is it wise (or unwise) for an academic medical center to buy up local medical practices? And so on.

One might ask similar questions of illegal organizations such as drug cartels or terrorist organizations. Consider one trivial example:

Drug-selling organizations transfer wads of cash from New York, Moscow, London, and Paris to source countries. Couriers smuggle cash using specially-constructed high-top sneakers with hidden compartments crammed with 500-Euro notes. A normal firm wouldn’t need to launder its money. And if a normal firm somehow required a special shoe, it could simply contract with Nike or New Balance to build its specialized gear. Drug cartels can’t hire these things out. They must do this work in-house, inexpertly and at higher cost.

I could tell rather similar stories for bookkeeping, security services, and more. Replicated a thousand times over, such examples exemplify one dynamic that leads clandestine industries to be inefficient. Obviously, there are others; this is one.

Criminal entrepreneurs, operating in the shadows, weigh the risks, costs, and benefits of moving the boundaries of their organizations. My friend and colleage Peter Reuter is one of the nation’s leading experts on drug-selling organizations. He notes that these entrepreneurs balance a different set of risks from those faced by their legal counterparts. Sometimes they are inefficiently large, as when they keep in-house sensitive tasks that legal businesses could easily farm out to others.

More often, these organizations are too small. RAND researchers estimate that the (untaxed) price of marijuana might drop by as much as 80% if these products could be openly manufactured at industrial scale using the most efficient methods. Reuter notes one striking feature of illicit drug markets: their extreme lack of vertical integration. From the Traffik-depicted Afghan poppy grower to Avon Barksdale on the streets of Baltimore, heroin may pass through ten separate organizations.

Why is that? The first issue is obvious. The larger the organization, the more people are in some position to rat-out the criminal entrepreneur. It’s profitable to expand the organization only to the point where decreased coordination costs are offset by the marginal increase in enforcement risk. Police interactions matter, too. Integrating across markets might require coordinating the corruption of several different law enforcement agencies.

Coase might have something to say about terrorism, too.

After 9/11, I had lunch with some friends from engineering school. They casually reeled off a succession of plausible atrocities a moderately-skilled group of fifteen terrorists could perpetrate in major American cities. The physicist Richard Garwin published a similar frightening piece in the New York Review of Books.

Almost none of these frightening possibilities have been realized. It’s surprisingly easy to generate clever ideas for mass murder. It’s surprisingly hard to coordinate the efforts of more than a handful of people to perpetrate these atrocities while evading the hostile gaze of military and law enforcement agencies.

The recent debate over NSA snooping includes claims and counterclaims regarding the efficacy of our spying in thwarting identifiable plots. These are interesting questions; this debate is also massively incomplete. The most important impacts of our counterterrorism efforts are less direct.

Seventy-six years ago, Ronald Coase noted that the invention of the telephone was essential for the development of geographically-dispersed massive organizations. When we snatch away the use of that telephone, when we force Al Qaeda to deploy inefficient couriers and to deploy huge efforts guarding against covert operations, we degrade their organizational capacity to do us harm.

Such strategies can bring unexpected consequences. Al Qaeda may respond by fragmenting into decentralized franchises that are more difficult to address. In big-city America, law enforcement has achieved unprecedented success in decapitating or weakening hierarchical criminal organizations. You really can’t be a celebrity criminal anymore. Law enforcement is too capable when faced with a direct challenge like that. What these organizations leave behind is a much more fragmented set of cliques and crews who are, at times, more violent than the more cohesive criminal organizations they have replaced.

This seems paradoxical, but it’s not. Criminal organizations seek profit, not mayhem as an end in itself. A key challenge of violence-oriented law enforcement is not (merely) to wipe out or suppress these organizations, but to ensure that criminal entrepreneurs pursue business models that are less violent and less harmful to their communities.

The seriousness of many police departments in pursuing violence-oriented approaches seem quite helpful in reducing urban violence. As they pursue these strategies, Coase’s classic insights regarding the boundaries and functions of modern firms may prove surprisingly helpful.


Hidden information below


Email Address*