The Times, They’re A-Changing: The Firm Edition

People ‘job-hop’ much more these days. Where it was very unusual for people to change jobs at one point of time, this slowly but surely changed over time. And today, we live in a world where not only is job hopping common, an increasingly large number of people are choosing to not work formally with a firm at all, but rather as free-lancers instead. Including yours truly!

What is the economic explanation for this? That is, if you look around and see that attrition is rampant, and that people up and quit their jobs, you might want to ask yourself this: what are the economic factors that explain this phenomena?

A first-pass answer is, of course, the pandemic. But the pandemic is the proximate cause, or in the language of the economist, an exogenous shock. The question that we need to ask is a narrower one: what changed in the economy that allowed people to respond to this exogenous shock by walking away from their jobs? Think of it this way – did the pandemic a century ago also result in increased attrition and folks deciding to be freelancers? While I’m not familiar with labor markets of a century ago, I feel reasonably safe in saying that the answer is almost definitely no.

So while the desire to quit (or freelance) may be because of the pandemic, the ability to do so must be because of other factors. What might these factors be?

To answer this question, we first need to understand what caused firms to exist in the first place.

One morning, an economist went to buy a shirt. The one he chose was a marvel of global production. It was made in Malaysia using German machines. The cloth was woven from Indian cotton grown from seeds developed in America. The collar lining came from Brazil; the artificial fibre from Portugal. Millions of shirts of every size and colour are sold every day, writes Paul Seabright, the shirt-buying economist, in his 2004 book, “The Company of Strangers”. No authority is in charge. The firms that make up the many links in the chain that supplied his shirt had merely obeyed market prices.
Throwing light on the magic of market co-ordination was a mainstay of the “classical” economics of the late-18th and 19th centuries. Then, in 1937, a paper published by Ronald Coase, a British economist, pointed out a glaring omission. The standard model of economics did not fit with what goes on within companies. When an employee switches from one division to another, for instance, he does not do so in response to higher wages, but because he is ordered to. The question posed by Coase was profound, if awkward for economics: why are some activities directed by market forces and others by firms?

So: why are some activities directed by market forces, and others by firms? Because being able to participate in market based activities is an expensive process in terms of money and time without having access to a firm. Consider my own example: I earn a living these days by teaching courses in economics and statistics, and do some consulting work on the side. But teaching courses in economics and statistics is something I do for the customers of firms called colleges.

Students – and this might come as a surprise to some people in academia – are the customers of firms called colleges. They are not aware of my existence before they enroll in these colleges (for the most part). And I am unaware of these students before I walk into my first class. It is the firm – the college – that does the job of getting ‘my’ customers to sit in class. Me? I rock up to the class and start yapping.

And while both the students and I would greatly prefer that we deal with each other directly, without the middleman’s meddling (attendance! examinations! certificates!), that realization only strikes us much later on in the semester. At the start of the college year, the costs involved in terms of the students getting together and figuring out who to hire to teach them economics are very high in terms of time, money and coordination efforts.

It is the same for the teacher too, of course. How do I know, without knowing of the student’s very existence, that this is the bunch of students I want to teach? It’s easier for both the students and the teacher in question to outsource this job to the firm – the college. An economist would say that we (the students and I) are reducing our transactions costs, or our search costs. Plus, the students might quite entirely reasonably point out that what the market values isn’t so much the fact that they’ve learnt economics, but the fact that the college has certified that the student has indeed learnt economics. And a certification to this effect from a college will always carry more weight than any certificate that an individual can issue. Colleges know this fact, by the way, and will of course do everything in their power to maintain this status quo.

So as far as I am concerned, and as far as students are concerned, it makes sense to enter into the kind of transaction we do, via the medium of a firm called the college.The college might prefer to hire me because it is much cheaper for the firm to pay me my hourly rate, and be done with me as soon as this transaction is over. There’s no need to pay me for the hours I sit in office, there is no need to make contributions into my Provident Fund, there is no need to pay out gratuity – outsourcing is cheaper. The higher the supply of people willing to work as visiting faculty, the more the temptation for the college to run a course by using visiting faculty only. It might make for a poorer on-campus experience, having more visiting faculty, but that’s a whole other story.

But are transaction costs going down over time? Did students realize that you could too learn at home during the pandemic? Did teachers realize that they could talk to their students using blogs, or YouTube videos, or podcasts or even Instagram reels? Did firms realize that the certificates issued by colleges – especially during the pandemic – are on the basis of examinations so horribly farcical that they effectively mean nothing? Might all these drive down transaction costs? If so, how? With what consequences for teachers, students and colleges?

Does all this make sense to you if you are (or recently have been) a student? And if yes, now ask yourself a broader question. How should you then think about all firms and all of their employees and all of their customers post the pandemic? Have transaction costs come down post the pandemic? If so, due to what reasons? With what consequences?

To understand this, you might wish to read this thread, which I will talk about in greater details in Monday’s blogpost: