Employment patterns, business organisation change - I

Preference is given to small owner-managed business if transaction costs are low

LONDON: The famous Coase Theorem implies that individuals will organise themselves into businesses if transaction costs of conducting an independent business are higher than such costs when they happen to be working for an organised business, ie, firm.

Transaction costs include information costs, documentation and contract costs and costs associated with enforcement of contracts. Thus, if a carpenter finds it difficult to connect himself to his customers, does not know how to document transactions and finds it difficult to recover compensation from the customers, he would prefer to work for a firm or company that buys his services for a fixed wage.

If the transaction costs are negligible, the person will be indifferent to going independent or joining an organisation.

Given the incidence of transaction costs, the choice is between a large business and a small owner-managed business. It is interesting to note that the transaction costs are either negligible or irrelevant in technical services offered by skilled but uneducated or less educated people in Pakistan.

Owing to very large populations and big clusters of people in cities, finding customers is not difficult in a number of trades like plumbing, electric works, tailoring, automobile repair and grocery business.

A different story

The story is different when the behaviour and choice of educated people is studied. Those with a plain vanilla university degree prefer to work for organised businesses, but those possessing portable skills like accountancy, designing and IT management exhibit preference for independent work.

Therefore, in a low transaction cost environment, from small car wash businesses in Islamabad to large industrial activities in Gujranwala, the preference is for small owner-managed businesses.

A car wash business located at a petrol station in I-8 sector of Islamabad presents a typical form of business. Any car going for what is known as “comprehensive service” will receive services from several vendors.

Car wash is done by one vendor and tyre work (inflation, wheel alignment, etc) is done by a separate vendor on the same location. There are a couple of guys who would offer their services for engine oil change. The customer buys engine oil directly from the petrol station. If any electric work is needed, an electrician will be there. The customer prefers to negotiate with all the vendors individually.

This holds true for other businesses as well. Car body work presents a similar picture. Any auto repair area will have a number of related but independent small businesses.

In many cases, these different vendors will share the same premises – normally a small shop. Why do they not join hands to build a joint business? There are several factors that explain this lack of organisation.

Lack of entrepreneurial skills

It is observed that while a lot of individuals have excellent technical expertise, they, however, lack entrepreneurial skills. While offering specific services is a technical skill, managing a business is a completely different ball game. Complexity of entrepreneurship increases with the rise in size and scope of the business and most of those who otherwise have excellent expertise in one field find it difficult to cope with the complexity.

Moral hazard

This is another major factor that hinders growth of employment in small businesses and their evolution into bigger businesses. Joining hands to offer a complete package of services requires transparency in inputs and their pricing. Small vendors somehow start shirking when their services are bundled and priced together.

Dearth of capital

Small businesses lack capital to expand their operations. Business organisation requires additional administrative resources in addition to technical skills. These include accountancy and finance, marketing and advertisement, and general support services like office administration. All these require additional capital to run a business on a sustainable basis.

Unsophisticated customers

In Pakistan, a large number of customers are not sophisticated and many of those are not willing to pay for quality. They rather prefer to shop around even if that means spending a lot of time on gathering information. They prefer getting different services from different vendors even if the price differential is marginal.

In the process they end up spending a lot of time, which although increases transaction costs but as they are not financial costs customers tend to discount them.

Free rider

This is another factor hindering the size of the firm. A very large number of shopkeepers in markets rather prefer to rent out a small pitch to other businesses in front of their premises or inside them but would not like to internalise them simply because they prefer rent-seeking rather than actually doing the business and earning profits.

This is why we find a toy shop owner renting a pitch in front of its shop to another one who would sell second hand garments, in exchange for a daily, weekly or monthly rent. Although the toy shop owner can actually earn more by running the garments business himself, he rather prefers to seek rent from another.

The writer is an economist and a PhD from Cambridge University

Published in The Express Tribune, September 1^st, 2014.

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