The Theory of the Firm tries to answer this question, alongside others such as: Why do firms exist (instead of just having purely market forces dominate the transactions)? Why are firms the size that they are?
It begins with an idea proposed by economist Ronald Coase, who sets out the transactional cost theory: human actors incur a cost in communication and negotiation every time we make a transaction. For example, if market forces were to dominate the allocation of human employment, then we would have to negotiate and renegotiate contracts for every action that we undertake (fetching coffee, filing a report, serving a customer)- wasting our time on negotiation and not actually producing value.
Firms exist when pre-negotiated rules (year -long contractual agreements) reduce the transactional costs below that of having to constantly renegotiate them on the market. At the same time, though, the same constraints create an upper limit on the size of the firm. As the firm gets bigger, and handles diverse interactions, the very act of monitoring and managing employees creates inefficiencies. Eventually the firm gets so large that it is actually inefficient to manage more people.
During this process, another interesting challenge arises – how to best align the middle managers’ personal interests for profit and promotion alongside the entire firm’s interest for profit. Wikipedia describes this problem as:
… that managers’ interests are best served by maximising sales after achieving a minimum level of profit which satisfies shareholders.) More recently this has developed into ‘principal–agent’ analysis (e.g. Spence and Zeckhauser and Ross (1973) on problems of contracting with asymmetric information) which models a widely applicable case where a principal (a shareholder or firm for example) cannot costlessly infer how an agent (a manager or supplier, say) is behaving.
Fundamental to both problems is information. Information about the right price to price a good in the market (necessary for the Efficient Market Hypothesis that basically says the market equilibrium price is the right price for any product because Supply and Demand are perfectly aligned at that point), information about the performance of your middle-managers and other employees,mis–information and imperfect information that leads to perverse incentives like the Moral Hazard Problem.
Philip Rosedale, asked the interesting question: what happens when technology lowers the cost of transaction, and also accelerates (or even incentives) the proliferation of information. With our new-found ability to collect, record and analyze hordes of information, we might be able to solve the transactional cost bottleneck to human collective organization, through policies of radical openess (i.e. sharing of information).
What are some concrete ways we can put this into practice?
Well, suppose that you can create a list of all the tasks that you need to do to accomplish a project, post it for the world to see, and ask people to do a task, and then tell you how much they expect for their fees. The caveat is that that record is open for the world to see, so if you were to charge an exorbitant amount for your work, then everyone else knows you are a scam artist, and so your incentives to cheat are regulated by social reputation.
This idea gave birth to their first product: Worklist.net- (page 19 of this slidedeck: http://www.slideshare.net/CoffeePower/philip-rosedale-first-steps-to-starting-a-tech-startup-13412918), creating their website in 11 months from 63 contributors and $229,000.
Next, Philip wanted to address the perverse incentives of middle managers – so he created another information transfer tool – letting his employees decide who should get the end-of-the-year bonuses:
“Using a simple piece of software built in-house, Linden Lab divided the total bonus money and handed out an equal share to each employee. Employees then anonymously gave it away to anyone in the company they pleased, keeping none for themselves. It could all go to their best buddy, they could spread it evenly around the company’s couple hundred employees, or any allocation in between – whatever they decided. Job done.
“It takes away all the stress and negativity from the evaluation process around management,” Rosedale says. “At Linden Lab, you could complain about me and the senior managers in the company, you could complain about our strategic skills but you couldn’t complain about what you were getting paid.”
But the results of the Rewarder process weren’t irrational, according to Rosedale. In fact, at Linden Lab, he found the allocation arrived at by the Rewarder process actually closely resembled management’s previous evaluations of various employees’ performance. “All the superstar performers that managers would have identified in the management-led process will still be in the top ten percent,” says Rosedale.
“If you have a bunch of people all making different assessments, it’s not that they’re not biased. They all are,” he explains……But what’s incredible cool is, if you let everybody in the company impose their own bias on the situation but you give them all an equal amount of money, all the biases cancel each other out and the only coherent signal that remains is: I want the company to be around.”
The best part is that aside from all these indicators of more efficient success, he also gets the ultimate thing he’s looking for:
In addition, Rosedale cites one more benefit of the process – transparency.
“If you know your peers are going to judge you each quarter freely and give money to you, you’ll probably work at being more transparent,” he says, citing the fact that a randomly selected employee at Linden Lab was generally better able to explain what other randomly selected colleagues’ were working on than you’d expect at a similarly sized company. To support the transparency generated by the Rewarder, an internal Twitter-like tool called The Love Machine (which Rosedale says is very similar to Rypple) allowed employees to easily and publicly keep each other up to date and share their appreciation for co-workers’ efforts.
Isn’t that amazing?
These experiments show that there are some things the crowd is really good at, and that given the correct incentives to share information, will react accordingly. With this in mind, how will you shape your own culture, and encourage sharing of information.