2.3 and a lower-case x for what should be an upper-case X in equation 2.7. Appendix 3A, Mathematical Analy- sis for Managers, which does need to be accurate, has an equals sign rather than a minus sign in the formula on p. 139 for the quotient property of logarithmic functions. The two diagrams on p. 140 and p. 142 need the Y symbol rotated clockwise through 90”. Perhaps it would have also been a good idea to provide further references so that mathematical awakenings could be pursued in more depth. Among other errors, I noted a wrong cross-reference on p. 662 to Chapter 5 which should be Chapter 7 on Demand Analysis. There is a mistake on p. 355 in the numerator of the formula from the Durbin-Watson statistic for which, by the way, there are no tables in the Appendix. Yet overall, it would be churlish to continue to be pernickety when so much has been achieved in these 779 pages. It is more constructive to note that all is brought to an end by a useful index which uses boldface entries to indicate key glossary terms, italic page numbers to refer to Manage- rial Applications examples and [CS] to indicate a Case Study.

Finally, may I make two suggestions for the next European edition which will probably be assembled before the end of this century? We have to face up to the fact that managerial economics texts are approach- ing, if not equalling, the size of normal economics textbooks with which they are already competing. It is very difficult to talk about management without labour, so one should grasp this particular thistle and incor- porate a chapter on labour economics. Even though this is a specialist subject in itself, surely one could include aspects of employment and unemployment, in- dustrial relations, investment in human capital and even human resource management in a single chapter.

Second, I would have liked to see a concluding chapter which develops material that uses many of the concepts covered in the book. An industry like the airline indus- try or computer software itself could be selected to show how important market structure is and how the forecasting of demand and the optimization of supply take place. Be it all a tall but not an impossible order for the next European edition. As for this edition, it carries the banner forward and puts the opposition to flight, starting in Silicon Glen!

REFERENCES

Centre for Computing in Economics (1993). Catalogue of Economic Software, Centre for Computing in Economics, Bristol.

P. R. Ferguson, G. F. Ferguson and P. Rothschild (1993). Business Economics, London: Macmillan.

M. Hirschey and J. L. Pappas (1993). Managerial Economics (7th edition), London: The Dryden Press.

A. Marshall (1922). Principles of Economics (8th edi- tion), London: Macmillan & Co.

W. D. Reekie and J. N. Crook (1995). Managerial Economics: A European T a t (4th Edition), Heme1 Hempstead: Prentice Hall International.

J. Sloman (1995). WinEkon: a revolution in teaching economics. Economic Journal, 105, September, 1327- 46.

JOHN MARK King’s College, London

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THE ECONOMICS OF THE BUSINESS FIRM: SEVEN CRITICAL COMMENTARIES by Dem- setz, H., Cambridge: Cambridge University Press, 1995, 179 pp., $39.95.

With the possible exceptions of Armen Alchian and Ronald Coase, no one has contributed more than Harold Demsetz to the development of the modern theory of the firm. His insights into the role played by business organizations in capturing the synergistic benefits of team production while simultaneously coping with the incentives of team members to shirk helped launch a whole literature on the advantages and disadvantages of alternative ownership struc- tures and property-rights regimes. The weaknesses he identified in the theory of monopolistic competi- tion and the market-concentration doctrine likewise contributed to the revolution in thinking in industrial organization that began a little more than two decades ago, and which, to paraphrase Yale Brozen, is now complete in the academic journals. So it was with great anticipation that I began reading Zhe Economics of the Business Firm, a collection of seven

new essays that were first presented as lectures at Uppsala and Lund Universities in Sweden, a meeting of the Mont Pelerin Society in Prague, and the Center for the Study of the Economy and State at the University of Chicago.

I was not disappointed. This set of commentaries offers a number of fresh perspectives - and pro- vides some important new empirical evidence - on basic questions concerning the definition and exis- tence of the economic institution called the firm. As such, the book promises to serve usefully as a supple- mentary (and in some cases the main) text in man- agerial economics and industrial organization courses; it should also have pride of place on the shelf of every professional economist who teaches or does research in areas related to the theory of the firm.

Demsetz’s provocative first commentary, entitled ‘The Firm of Theory: Its Definition and Existence’, focuses on clarifying what is meant by ‘the firm’. He begins by pointing out that explaining why the firm exists has very little to do with explaining how it is organized. Demsetz then goes on to summarize -

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and to reject - both Frank Knight’s and Ronald Coase’s explanations for why the firm emerges as an economic entity. Knight, on the one hand, who ‘sees in the firm advantages of redistributing risk between owner-managers and employees’, is guilty of ‘reject- ing risk as a source of profit and substituting an unpredictable source of profit [uncertainty] for it’ (p. 3), in the process failing to recognize that wages and prices will adjust to reflect the actual distribution of risk. Coase’s theory, on the other hand, which identi- fies ‘reduction in coordination cost achieved through managed coordination’ (p. 4; emphasis in original) as the key to explaining why the firm arises to super- sede the decentralized and interdependent coordi- nating structure provided by the market, is, in Dem- setz’s view, a sufficient but not necessary explanation (p. 6). This is because ‘management does not depend on the existence of complex organization’ (p. 7): Even Robinson Crusoe had to manage his own time, deciding how much of it to allocate to gathering coconuts and how much to ensuring adequate sup- plies of fresh water. Moreover, in contrast to Coase’s view, firms are not substitutes for markets because market ‘prices do not coordinate, they supply infor- mation’ on which economic agents act (p. 9).

To Demsetz, specialized ‘production for others’ is the firm’s defining characteristic: ‘firms exist because producing for others, as compared to self-sufficiency, is efficient; this efficiency is due to economies of scale, to specialized activiq, and to the premlence of low, not high, transaction costs’ (p. 11; emphasis in original). This definition supplies a rationale for profit-maxi- mizing behavior on the part of the firm’s owner-manager while also admitting the possibility that the profits of the firm are not at a maximum because the owner-manager finds it cheaper to con- sume some of them inside the enterprise rather than within his or her household. As conceived by Dem- setz, the firm fits much more comfortably into the framework of neoclassical theory than has been ar- gued by some contributors to the modern literature. Adam Smith would have found more to like here than will Oliver Williamson.

Indeed, in his second commentary on ‘Agency and Nonagency Explanations of the Firm’s Organization’, Demsetz, like Ronald Coase before him, raises doubts about the proposition that transaction-specific assets (and the opportunistic behavior to which they may give rise) is the key to understanding either the existence or organization of the firm. Vertical inte- gration, which would be plentiful even in an economy where everyone behaves honorably, is explained not by opportunism but by the ‘demand for continuity’ in production operations. Assembly lines are not di- vided into two separate parts, not so much because the owner of each part would thereby be vulnerable to being held up, but simply because it would be too ‘costly in time and effort to link the output of one part of the assembly line into the second part, break- ing continuity of operations’ (p. 21).

The second commentary also extends agency the- ory in new directions in order to analyze some issues

related to the separation of ownership from control in the modern corporation. In particular, Demsetz models the trade-offs between efficiency wages and direct monitoring as alternative means by which ra- tional investors can hold managerial shirking to its cost-effective minimum. At the same time, Demsetz recognizes that in order to reduce the firm-specific risk they bear, investors will prefer to own smaller shares of larger firms. Because diffuse ownership is a rational investment strategy and owners benefit from ‘the expertise and full-time attendance of professio- nal’ managers, ‘a positive amount of management entrenchment is desirable’ (p. 29).

These ideas are elaborated in the third commen- tary, whose main theme is the productive role played by wealth in the control of business organizations. Enterprise control requires concentrated ownership, but concentrated ownership increases each owner’s exposure to firm-specific risk. Because only the very wealthiest individuals and large institutional in- vestors are able to purchase controlling ownership stakes in large firms while simultaneously diversify- ing their investment portfolios so as to reduce firm- specific risk to acceptable levels, it follows that there exists an optimal degree of inequality in an economy’s distribution of wealth: ‘Extreme inequality and ex- treme equality in wealth distribution both reduce the degree to which effective control can be maintained’ (p. 45; emphasis in original). This observation is then used to explore cross-country differences in the structure of corporate ownership (the five largest shareholders own one-fourth of the equity of the typical Fortune 500 firm, whereas the fraction is much larger in Japan and most European countries); the challenges faced by the former Soviet Union and its satellites in making the transition from socialism to capitalism; the adverse effects of the Glass-Stea- gall Act’s separation of investment and commercial banking; and insider trading’s function as compensa- tion to large investors who would otherwise receive no return for bearing firm-specific risk.

Returning to some of the points first raised in the opening chapter, Demsetz’s fourth commentary, ‘Profit Maximization and Rational Behavior’, dissects in detail the attacks on the neoclassical assumption of profit-maximizing behavior launched in the 1930s by Adolf Berle and Gardiner Means, and in the 1970s by Harvey Leibenstein. (John Kenneth Gal- braith, Thorstein Veblen, Frank Knight, Herbert Simon, and Gary Becker, in particular, and experi- mental economists in general, are alloted their shares of criticism in the fourth commentary as well.) The positive implications of on-the-job consumption are explored within the framework set by Dermsetz’s definition of the firm, which allows owners’ decisions to personally consume some of the firm’s resources by purchasing amenities or by producing unrecorded outputs to be reflected in lower measured profitabil- ity, but requires managers and employees to pay for consumption on the job through lower wages.

The next two commentaries provide new empirical evidence on the usefulness of accounting data for

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drawing inferences about economic profitability and on the explanatory power of tournament theories of managerial compensation. In ‘The Use and Abuse of Accounting Data’, Demsetz responds to the Fisher and McGowan attack on accounting-measured profit rates by, first, appealing to the market’s continuing acceptance of such data and, second, by admitting that while Fisher and McGowan’s demonstration of the defects in accounting data is convincing, the conclusions drawn from it are not. Demsetz then proceeds to report evidence of strong, positive corre- lations between annual accounting rates of return for 489 manufacturing firms and their end-of-year stock prices over the years 1962 through 1981. He also shows that these correlations are less robust when firms employ more inputs, like capital goods, advertising and R&D, that accountants have more difficulty valuing. Both of these findings are consis- tent with a less unforgiving attitude toward account- ing data that recognizes its flaws, but also ac- knowledges that it can provide meaningful answers when the right questions are asked.

In ‘Management Compensation and Tournament Theory’, Demsetz investigates the theory and evi- dence relating to an idea advanced by Lazear and Rosen that the structure of managerial compensa- tion in the modern American corporation can be thought of as a series of prizes in a rank-order tournament that rewards relative rather than abso- lute performance. High CEO pay is explained in this model not by the productivity of the incumbent office holder but rather on the basis of the incentives it provides for managers at lower ranks to work harder than justified by their current compensation in ex- pectation of increasing their chances of promotion to the top rung on the corporate ladder. No empirical support for the tournament model is found. Based on a cross-sectional analysis of managerial pay in 100 manufacturing corporations averaged over the years 1978 through 1984, Demsetz consistently finds that variations in various measures of managerial produc- tivity and performance (log of firm size, mean annual stock market rate of return, and CEO tenure) ex- plain more of the variation in compensation than variables devised to test the predictions of the tour- nament model (ratios of CEO compensation to ju- nior management compensation at each of four lev- els below the top of the organizational chart).

Demsetz devotes his seventh and final commentary to antitrust. He provides a wide-ranging critique of the antitrust treatment of a host of business prac- tices, including horizontal price fixing, horizontal mergers, predatory pricing, and so-called vertical re- straints of trade (resale price maintenance and exclu- sive territories). He rehearses the facts in a number of leading cases on these issues and finds them wanting. Despite prefacing his summary evaluation of US competition policy with a cogent review of the meaning of competition that emphasizes the subtle and difficult trade-offs facing policy makers - ‘it is impossible to increase the intensity of competition in the pursuit of one desirable objective without thereby reducing the intensity of competition in the pursuit of other desirable objectives’ (p. 143) - Demsetz nevertheless ends with a very Borkian defense of Section 1 of the Sherman Act: ‘[I]f our choice is between no prohibition of [horizontal] price agree- ments and a blanket prohibition, the blanket prohibi- tion seems preferable to me’ (p. 158).

Anyone who knows my own work knows that Dem- setz and I part company here. While I agree with virtually all of his criticisms of antitrust policy, he fails to draw the obvious conclusion. If the antitrust enforcers are either unable or unwilling to get in right in all other areas, why should they be allowed to prevent firms from attempting to agree on price when it is in their - and consumers’ - interest to do so? When it comes to government, not everything that is, is necessarily efficient.

This policy quibble aside, I recommend The Economics of the Business Finn highly. While reading the book, I constantly found myself remarking men- tally at the profusion of insights, not to mention the possible dissertation topics, Harold Demsetz has served up here to the profession. The Economics of the Business Firm is sure to reinforce his reputation as one of the leading industrial organization economists of our time.

WILLIAM F. SHUGHART I1 Depament of Economics and Finance

Uniuersity of Mississippi Uniuersity, MS 38677, USA