The Firm and the Division of Labor
Economists since Adam Smith have understood the enormous potential for productivity due to the division of labor. Overall productivity increases dramatically by splitting a job into several separate tasks performed by different people, each focused on their specific task. Ricardo further developed this understanding and showed that even in situations where one person outperforms another in every one of these tasks, both are still better off each focusing on the task for which they have a comparative advantage.
A surgeon who is also tremendously adept at preparing for and assisting during surgery is therefore better off — and actually does society a service — when hiring a nurse. This is true even if the nurse is worse at both performing surgeries and assisting during such procedures, simply because by focusing on the relatively more productive task (in this case to perform surgery), the surgeon produces greater overall value — even though some of the profits pay the nurse. The result is that the physician earns more, the nurse gets a job and earns a wage, and the rest of society gains access to both more medical expertise and more doctors' appointments and treatment.
But it is equally true that this increased focus on more narrowly defined tasks creates a mutual dependence between the surgeon and the nurse. The surgeon can only operate on this many patients if the nurse assists during surgery. Likewise, the nurse cannot offer the service of assisting were there no one with surgical skills to perform the operation. Therefore, in order to provide the market with surgery efficiently it is necessary to have both a surgeon and a nurse — and they need to cooperate in the production process. This is the reason Ludwig von Mises emphasized the division of labor as social cooperation and argued that every civilized society is based on the prosperity as well as the mutual dependence caused by the division of labor.
Mises was right. The enormously complex network of products and services — not to mention the collaborative skills that are coordinated in order to produce them — shows that we are all quite dependent on others for our prosperity and wealth. But note that this state of dependence is necessary only if we find desirable the prosperity that comes with it. Everybody should have the right to renounce this market order and refrain from partaking in the division of labor, even if it ultimately means that those who choose to do so also have to opt out of everything that makes our lives comfortable and convenient.
In fact, everybody has to make this fundamental choice: we can either engage in the social division of labor and contribute to our own and society's overall prosperity, or turn our backs on civilization and live the nasty, brutish, and short life that awaits all "noble savages" that do not partake in social cooperation through the division of labor.
The Dependencies of Indirect Production
Eugen von Böhm-Bawerk showed how society, at least the parts that choose division of labor instead of barbarism, consistently develop more roundabout and productive production processes that consist of ever more stages and involve (are dependent on) more people. The roundaboutness or "length" of a production process denotes the number of tasks it includes, where each task is continuously more narrowly defined. The alternative to the division of labor is that the baker has a small field out back where he grows and harvests his wheat, has a mill where he grinds it into flour, and a self-built oven to bake the bread. A longer or more indirect production method, which Böhm-Bawerk talks about, amounts to a farmer specializing in the production of wheat, a miller to grind the wheat, and a baker to produce the dough and bake bread in an oven made by someone specializing in oven making.
In other words, the production process is "longer" because it includes farmers, millers, bakers, and oven makers. And they are all dependent on each other to find outlets for the products of their labor. But it is equally a matter of having access to the ingredients or inputs necessary in each productive task: the miller is dependent on the baker purchasing the flour but is also dependent on the farmer to produce the wheat to mill. In the same way, the baker is dependent on both the flour produced by the miller and the oven maker's oven to produce the bread that is sold to consumers.
The latter is what directs the whole production process. Everybody involved in the production of bread (or any other product or service) — directly or indirectly — is dependent on consumers' valuation of it. If it cannot be produced cheaply enough, nobody in the chain of productive tasks can sell their intermediate products. The whole economy aims to do this single thing: to produce goods that satisfy the needs and wants of consumers.
But if this is the case — and if division of labor makes the market more efficient (productive) in satisfying consumer wants — why don't we experience an even more intense division of labor? Why don't we see the baker's job divided into numerous separate tasks? With what we know about the division of labor, we should see more productive production processes where different people mix ingredients, work the dough, form loaves, bake, take the bread out of the oven, let cool, etc.
The limitation to the intensity of the division of labor lies in the extent of the market. In order to support increased division of labor, greater volume is needed — and workers must be provided with sufficient incentives to take part in such "extreme" specialization. Likewise, the mutual dependence that arises between the baker and the miller limits the possible divisions of labor.
It is simply impossible to offer the service of "forming loaves" out of dough in the existing market. The market for such a service is literally nonexistent, because this task is an obvious part of the baker's job in the current structure of the market. The market therefore provides resistance to actors' overutilization of specialization through the division of labor. On the one hand, anyone in the current market structure choosing to grow and harvest his own wheat, then mill it into flour, then make bread and deliver it to consumers will suffer relative inefficiency and will not stand the market test. On the other hand, one cannot specialize to such an extent that the task carried out is incompatible with existing tasks carried out by market actors. There has to already exist both producers of inputs for and users of the output of the task for which one wishes to specialize.
In the case of the person wishing to specialize in "forming loaves," there must already exist those working the dough who are willing to sell it before forming it into loaves (input) — and those working with putting the already-formed loaves in the oven to bake. In a market where the baker commonly carries out all of these tasks there is no entrepreneurial opportunity to specialize in offering this particular service.
The Driver of Market Specialization
The question then is how the market evolves toward consistently higher levels of specialization and more roundabout ("longer") production processes. Remember that we are not talking about increased efficiency in terms of methods or execution here but the splitting up of a task into several separate tasks. Such change cannot be brought about through small, continuous steps in a certain direction, but splitting one task into many is a decisive leap toward a different way of producing goods or services to satisfy consumer wants. And every such leap needs a market base to be feasible and to the advantage of everyone. How are market actors induced to take such leaps forward?
This problem has not been analyzed in detail in economic theory. Rather, economists have assumed that the increased division of labor in the market comes about quite automatically — and that this process accelerates. But how? No single actor in the market has incentives to make such a change as to specialize in a previously unknown narrow task, because doing so necessarily means suffering enormous losses until there exist actors who perform compatible services prior to and after the specific task in the overall production process.
There have been certain attempts to explain this situation using transaction-cost reasoning. Due to high transaction costs in the market, the extent of the market available to each actor is limited; consequently, the continuous increase of the division of labor is hindered. But this type of reasoning does not answer how or why the market is characterized by constantly higher degrees of division of labor; it only labels yet another contributing factor to the self-regulating and seemingly stable specialization level in the market.
In reality, however, the market is not only characterized by increasing division of labor — but increasingly so! Production processes become ever more roundabout and indirect — and at an increasing speed; to then focus on what hinders the adoption of increasing divisions of labor hardly explains the overall trend.
Obviously, one would expect to find an explanation in the driving force of the market: the entrepreneur. But this is problematic, because specializing in "forming loaves" is by definition an entrepreneurial act, yet market incentives directly counteract pursuing such opportunities (as we saw above). It is equally problematic for an entrepreneur wishing to indulge in "loaf forming" to first attempt to bring about a market structure where such services are traded — and it would completely undermine the profit motive (if not completely wipe out the possibility of profits), the very purpose of the entrepreneur's actions. Working to change the whole market structure in order to create a market for "loaf forming" would be costly and have few benefits.
A solution may be found if we look at the bigger picture, however. Overly specialized production processes can be coordinated in the market even if the individual tasks are incompatible with the market structure if they are integrated. An entrepreneur who imagines a new structure of production, where for instance the baker's job is split into multiple tasks as above, can contract with several bakers to each specialize in single tasks.
If these employed bakers are brought together to carry out and jointly work out the details of cospecializing these tasks, as well as coordinate their actions in an efficient manner, then the entrepreneur and bakers can avoid incompatibility: there are no such limits to the specific process (chain of tasks) as are in the market, because all necessary parts in the mutual dependence of tasks are created simultaneously. In other words, the entrepreneur can create and put together not-yet-existing competencies in a production structure that also does not yet exist, where each task is highly specialized and overall production therefore highly productive. What used to be a baker's job is, on this island of specialization created by the entrepreneur, transformed into several highly efficient tasks.
The Role and Function of Firms in the Market
But the question remains, How can this new, roundabout production process be brought about? The answer is that the limit to the division of labor, the "extent of the market," can be sidestepped through the economic function offered by the firm. According to this view, the firm provides a means for the entrepreneur to further exploit the market's vast wealth-creating powers — and thereby make all involved better off (including consumers). At the same time, existing interdependencies are dissolved as other entrepreneurs follow the money and attempt to mimic the successful production processes, thereby increasing volume and, eventually, creating a labor market for those who have specialized within the firm.
The self-reinforcing limits of the market structure that existed prior to the firm are thereby mercilessly done away with, and existing production processes are replaced with successful (profitable) longer and more indirect processes.
This structural renewal process constitutes a leap toward greater specialization, longer and more indirect production, new capital constellations, new and additional mutual dependencies, and enhanced social cooperation — resulting in greatly increased productivity and, consequently, prosperity.
This important role of the firm in the market process has not previously been identified in the literature. Instead of being a way of organizing (coordinating) production where transaction-cost theory says it is too costly, the firm here becomes a progressive tool for the entrepreneur to completely reshape the market — in spite of its limitations — by establishing new forms of production. The firm therefore takes a very central and extremely important role in the functioning of the market, while offering an explanation for how the market can constantly be improved, streamlined, and become more specialized, despite the limitations to such development in the existing market structure.
There are several important implications of this view of the firm. Stigler's (1951) thesis that factors are first developed within firms and then markets are created for trading those factors (rather than vice versa) is confirmed. And theoretically, it makes embracing a changing or dynamic view of the market necessary — static models and general equilibrium theories appear irrelevant with the firm as the entrepreneur's tool and specialization catalyst: the entrepreneur is awarded a central role and the market structure is continuously pushed toward greater productivity through the establishment of new firms. This theory also offers explanations to the driving force behind and the reasons for outsourcing as a natural component of the market process.
But the practical and political implications seem potentially of even greater significance for the state and our view of society. As the firm is shown to play such a central and important role for the development of overall social prosperity, any legal or arbitrary effect by regulation on the business environment may very well mean huge welfare losses as the successes and development of firms are hindered.
One must ask, however, why the firm has not already been given greater attention in economic research, and why there have been no serious attempts to discover and explain its role in a larger market contest. As I have mentioned in a previous article, Adam Smith discussed the division of labor within the firm — and so did Karl Marx. And in the 1920s, several economists attempted to explain the existence and function of firms in the market through focusing on the division of labor. But it seems the neoclassical revolution severely undermined these theories before they matured — and the Coasean transaction-cost theory, despite its lack of ability to explain many of the phenomena mentioned above, put an unfortunate end to all such attempts.