Why firms?

Interesting that Munger leaves out one of the core principles of Lean Manufacturing, that employees accumulate knowledge in the process of working, and that knowledge can be used by smart firms to drive improvements in the business. When all work is contracted out, that opportunity vanishes.

Excellent post and entirely consistent with my own observations on outsourcing. Thre points:

1) The issue of (high) transaction costs makes it imperative to outsource large chunks of work or the costs go through the roof

2) Information Gap and Monopoly Power

One additional issue that crops is one of information gap - it is almost impossible, especially in non-repetitive, knowledge based work to define the 'value' of a new activity that the vendor is going to perform. As more and more knowledge transfers to the vendor, the vendor pretty soon has monopoly power in pricing. In contrast, with its own employees, performance reviews and ability to reward employees, the firm retains some ability to manage pricing by ensuring employees are efficient.

3) The point Nordsieck makes essentially about innovation is very valid and it is very difficult to ensure contracts are written that motivate the vendor to continue to be more efficient.

From my viewpoint down on the street, I think Mr. Munger over thought himself, or as the Brits say, "to clever by half".

Regardless of all his mental gyrations it still comes down to price driving all the decisions in the firm. it that wasn't true then there would be no competition, no winners, and no losers.

Firms do not work in a vacumm as Mr. Munger's essay seem to suggest. Firms produce a good or service which is then sold for a price. All decisions in a firm must be directed to maximizing that price if there is to be maximum profit.

For instance here Mr. Munger says, "The worker in a firm doesn't look to price, but rather asks his boss, "What will I do in the plant today?"; and by what ultimate standard does the boss reply? Price in the marketplace of what the plant produces.

It has to be. How long would a boss last if he did not have basic awareness enough to direct his employees to maximize profits? And, my friends, there are no profits if there is no price.