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Technical Information and Industrial
Structure
KENNETH J. ARROW
(Department of Economics, Stanford University, Stanford, CA 94305-5015, USA)

This paper attempts to relate the role of information in production to the organization
of industry, particularly the organization into firms and the competitive behavior of
these firms. Its emphasis is technical information or the knowledge needed to produce
goods. Information is an economic good but it has many characteristics which differen-
tiate it from the goods usually modeled in economics. In particular, it is surprising to
find how poorly current theories apply to the situation of high fixed costs which arises
when information acquisition becomes a major part of a firm's activity. The paper
concludes by conjecturing an increasing tension between legal relations and fundamen-
tal economic determinants. In addition, unresolved problems in the economic theory of
pricing and competition arise in an economy in which .information is important for
both cost and utility, producing conditions of competition between firms that are con-
ducted under large fixed costs. Standard paradigms for modeling this competition are
inadequate since they postulate a market price in the sense that buyers can buy at their
pleasure at a fixed price. The role of information requires a new approach to the theory
of oligopoly.

I
N 1. Introduction
js
| This paper is a very preliminary attempt at outlining the interrelationship
between two of the basic concepts of economic analysis, the role of informa-
| tion in production and the organization of industry, particularly the organ-
£ ization into firms and the competitive behavior of these firms. The paper
builds on an earlier study in this area (1994); I intend to develop these ideas,
both theoretically and empirically, in research over the next two years.
| The information I will concentrate on is technical information, that is the
J knowledge needed to produce goods. More precisely, it defines the probabil-
» ity distribution of inputs, outputs and product quality. Changing informa-
J tion can take the forms of improved processes or new products (including
3 © Oxford University Press 1996

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 Technical Information and the Industrial Structure

new qualities of existing products). There are, of course, other kinds of infor-
mation relevant to the economy, especially marketing information, i.e.

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information about demand conditions. Much of this can be treated analo-
gously to technical information; some cannot.
Information is an economic good, in the sense that it is costly and valu-
able; but it has many characteristics which differentiate it from the goods
usually modeled in economics, e.g. in competitive equilibrium theory or in
its modifications to take account of imperfect competition and monopoly. It
is also true that technical information is in ordinary economic analysis a
defining characteristic of a firm. Neither of these concepts is novel, but the
treatment of neither is fully satisfactory, and their interrelations need much
more exploration. In particular, it is surprising to find how poorly current
theories apply to the situation of high fixed costs which arises when informa-
tion acquisition becomes a major part of a firm's activity.

2. Characteristics of Information as an Economic Commodity

Economic analysis in the last 30 years has been devoted in good measure to
the analysis of the strategic implications of asymmetric information among
economic agents. Asymmetric information arises because one party cannot
obtain freely (or at all) information available to another. This work has been
of the greatest importance. It has explained the existence of many institu-
tions which find no place in standard theory. In particular, the interactions
among economic agents take many forms of which the market is only one.
Especially important in this context is the study of the internal organization
of the firm and the substitution between inter-firm and intra-firm transac-
tions, a study brought to the attention of economists by Ronald Coase
(1937) and given rich content and explanatory power by Oliver Williamson
(1985) in his classic work.
The literature, especially the formal literature, in this field has largely
traced the effects of a given information structure. An agent, for example, is
assumed to observe a random variable, while the principal knows only the
distribution of that variable. Not enough weight has been given to the
possibility that information can be and is daily altered by economic
decisions. A firm can buy information in one way or another or it can expend
resources in research and development to wrest the information from nature.
It is the treatment of information as a variable and its implications for
economic behavior that needs further analysis. The current literature on
asymmetric information certainly stresses the scarcity of information and
this insight must be maintained.
The study of information as a choice variable has been given much more
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weight by disciplines other than economics, especially mathematical statis-

tics, communications engineering and decision theory. The studies have

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tended to emphasize particular cases, for, indeed, information tends to
become amorphous in the general case. To take the most elementary point,
there is no general way of defining units for information. What is true in the
statistical and communications perspectives is that information is a signal,
that is, an observed random variable, which may be of no economic interest
itself but which is not independent of unobserved variables which affect
benefits or costs. This definition does not easily lend itself to measurement
in general. In some specific models, particular measures seem to play a lead-
ing role. The well-known Shannon measure of information emerges in
several models, sometimes as a cost measure, sometimes as a benefit measure.
An alternative approach starts with Bayesian normal sampling; it tends to
use as its preferred measure of information the precision of a distribution,
defined as the reciprocal of the variance. These approaches are actually
useful, but only on very limited problems. Nevertheless, they give some
purchase on the analysis of information as a choice variable.
Economic theory has been less forthcoming in this respect. Mainstream
economics from Ricardo through Arrow and Debreu has made virtually no
explicit reference to information. There are some important exceptions, and
they point to the significant relation between information and increasing
returns to scale. Adam Smith had several arguments for the superior
efficiency obtained by division of labor; some of them refer to the acquisi-
tion of skills, a form of information, by dint of practice. Similarly, Alfred
Marshall also alludes to the acquisition and transmission of information as
among the causes of a downward-sloping industry supply function.
The reason for this wariness has to do, I would conjecture, with the
analytic difficulties which would follow introducing information as an
economic variable. Competitive equilibrium is still the central paradigm of
economics, and it is viable only if production possibilities are convex sets,
that is, do not display increasing returns. This point was first made by A.A.
Cournot in 1838. No one read Cournot for many years, but a brief passage
shows that John Stuart Mill gave the same argument 10 years later. Marshall
sought to reconcile competition with increasing returns, whether due to
information or to other causes, by introducing the even more striking
doctrine of externalities. Important and even basic as this notion is, it does
not in fact adequately resolve the difficulty.
Let us turn more specifically to the special properties of information,
including among others those that give to increasing returns. Increasing
returns can occur for other reasons than information. But with information,
constant returns are impossible. Two tons of steel can be used as an input to
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produce more than one ton of steel in a given productive activity. But
repeating a given piece of information adds nothing. On the other hand, the

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same piece of information can be used over and over again, by the same or
a different producer. This means both that the way information enters
the production function is different than the way other goods do and that
property rights to information take on a different form. These remarks are
obvious enough, but their implications are not.
To elaborate the point, the usual logic of the price system depends on
constant returns. For conventional inputs, the buyer can buy more or less at
a given price (or at least close to it if there are elements of monopoly). But
information is different. Technical information needed for production is
used once and for all. The same information is used regardless of the scale of
production. Hence, there is an extreme form of increasing returns.
Much of the recent literature on imperfect competition assumes a fixed
cost of production with constant marginal costs. The fixed cost can be
identified with the cost of technical information. This can be modeled by
assuming that technical information is an on-off variable; either the firm
acquires it (at some cost) or it does not. In the latter case, the firm does not
produce. But the models derived from statistical or communications theory
make information a variable with many values, in the limit a continuous
variable. It is in fact usually true that there is better or worse information
and that better information can be acquired at a higher price. 'Better' here
may have several different connotations: more reliable information, produc-
tion of a given product at lower cost, or ability to produce a higher-quality
product. This generalization is very important in applications. It does not,
however, contradict the general proposition that the need for information in
production leads to increasing returns.
As already indicated, there is a second implication to the ability to use
information without destroying it for further use. Once obtained, it can be
used by others, even though the original owner still possesses it. It is this
fact which makes it difficult to make information into property. It is usually
much cheaper (not usually, however, free) to reproduce information than to
produce it. The argument lends into the general area of intellectual property
rights. Two social innovations, patents and copyrights, are designed to
create artificial scarcities where none exists naturally, in order to create
incentives for the acquisition of information. They have well-known
problems in creating inefficiencies.
Further, they offer only a partial protection. There are many paths by
which knowledge is diffused, (i) The interfirm mobility of technical person-
nel is one. To what extent is knowledge acquired by an individual employee
in the course of development at one firm the property of that firm and to
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what extent is it the property of the employee? This question points up the
feet that knowledge to a large extent is inherent in individuals, (ii) The

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appearance of a product on the market automatically conveys information;
if nothing else, the information that the product can be produced. The
existence of the product is a signal that the product can be produced. The
probability of success in a development is, after all, the product of the prob-
ability that success is possible by the conditional probability that the firm
will achieve success given that it is possible. If the first probability becomes
1, then the expected return from the development project must rise, (iii)
There is, of course, the diffusion that academics are most accustomed to,
that through written materials. The motives for written dissemination
include royalties, pride and scientific reproduction, (iv) Finally, but very
importantly, there is diffusion by informal interpersonal contacts. Indeed,
the usual explanation for economies of spatial agglomeration in high tech-
nology industries is precisely this factor, since informal contact even in the
era of modern communication is facilitated by propinquity.
The ability of information to move cheaply among individuals and firms
has analogues which one class of property, so-called fugitive resources. Flowing
water and underground liquid resources (oil or water) cannot easily be made
into property. How does one identify ownership, short of labeling each
molecule? With the development of environmental concerns, we recognize
that air too is a fugitive resource. It is for this reason that water has always
been recognized as creating a special property problem and has been
governed by special laws and judicial decisions.

3. Modeling Information in Firms

Despite the central role of the firm in both law and economic theory, there is
a vagueness about its definition which reflects a fundamental ambiguity.
Legally, incorporated firms are defined by the legal control and residual
claims of its owners, ordinarily identified with stockholders. But in a world
in which information is important, there is a question of what the owners
have claims to. In any case, as has long been understood, the management in
large limited liability public companies is only weakly responsive to the
stockholders. In fact, the management is more nearly the firm than the
stockholders, typically investors who trade their holdings with considerable
frequency and have no close relation to the firm. Management itself is by no
means a simple concept.
In economic theory, the firm is thought to be a locus of information, as
embodied in a production possibility set. But where is this information
located and in what sense is it characteristic of the firm itself, as opposed to
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its managers and other employees? No doubt some of the technical informa-
tion is embodied in written material and a database which might be

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regarded as owned by the firm like other property (although the low cost of
reproduction makes this analogy less than compelling). But much of the
most important information is embodied in individuals, not in reproducible
form. A specific item of software may be embodied in a program; but the
capability of creating similar kinds of software, far more valuable, is embod-
ied in individual minds. Much of the information that is most important is
tacit, to use the common phrase. Some scholars, such as Hayek, have perhaps
exaggerated the role of tacit as opposed to explicit information, but it is
nevertheless of great importance. Tacit information can still be transmitted,
but that is done by direct personal contacts. New workers learn partly from
older workers, as young scholars from professors, and perhaps partly from
sources outside the firm.
A firm then has an information base but it is typically distributed; not every-
one in the firm has every piece, and transmission, even within the firm, is
costly. As a result, we expect to see specialization of function to economize
on the transmission of information.
The distributed nature of information within the firm and the definition
of the firm by its information lead to some difficulties in the neoclassical
theory of the firm. In the latter, workers are not part of the firm; they are
inputs purchased on the market, like raw materials or capital goods. But in
fact they carry at least part of the information base which defines the firm,
even though they are not permanently attached to it. What then is the
knowledge that defines the firm?
It appears that the resolution of the issue has to do with the typical dura-
bility of the worker's relation with the firm. Mobility is not zero; indeed, to
explain the diffusion of technical knowledge, an essential aspect of economic
growth, it cannot be. However, mobility is also not infinitely rapid. The
expected decay of the firm's information base and the expected gain to other
firms due to mobility is moderate.
As a result, the information base of the firm is an asset, perhaps wasting
but at a finite rate. The firm, therefore, has a value as a going concern which
may considerably exceed the value of the firm's physical assets. The informa-
tion base embedded in workers, managers and technical personnel is an
important part of the market's valuation of a firm, though not property in
the usual sense.
The extreme case of this phenomenon is the valuation of computer soft-
ware firms, some of which are worth more than large industrial corporations.
Their physical assets are trivial and so is their marginal cost of production.
Their expenditures are for acquisition of information, but this information is
:
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held essentially in the minds of their employees. Why do not the forces of
competition draw away some of these employees and thereby erode profits?

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To the extent that the value of information to the firm is explained to
some extent by limited mobility, it must itself be explained. One answer is
Becket's concept oifirm-specifichuman capital, but this is itself a concept in
need of a rationalization. Its very existence is a critique of standard value
theory.
There is still another question raised by the distributed information base
of a firm: the need for internal coordination. Specialization leads to this need
in any case, but the matter is made more acute and more difficult to analyze
when there are differences of information within the firm. Consider, for
example, the choice of research and development projects. Since they require
resources, there is a need for choice at some central level, but the level of
financial control is apt to be less well-informed than the research and devel-
opment level.
The problem offinanceof new ventures also, of course, arises across firms.
A start-up firm requires venture capital; how are the capital-providers going
to be informed enough to make good choices? A whole industry has devel-
oped devoted to gathering the relevant information and transmitting it in
some form to potential investors. No good study on the information flows
implicit in venture capital seems to exist currently. The comparison of infor-
mation flows between internal and external financing remains to be under-
taken.

4. Implications and Applications of Information Considerations

Let me conclude with some conjectures about the future of industrial struc-
ture. Information overlaps from one firm to another, yet the firm has so
far seemed sharply defined in terms of legal ownership. I would forecast
an increasing tension between legal relations and fundamental economic
determinants. Information is the basis of production, production is carried
on in discrete legal entities, and yet information is a fugitive resource, with
limited property rights. Small symptoms of these tensions are already
appearing the legal and economic spheres. There is continual difficulty in
defining intellectual property; the US Courts and Congress have come up
with some strange definitions. Copyright law has been extended to software,
although the analogy with books is hardly compelling. There are emerging
problems with mobility of technical personnel; employers are trying to
put obstacles in the way of future employment which would in any way
use skills and knowledge acquired in their employ. These are still minor
matters, but I would surmise that we are just beginning to face the contra-
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dictions between the systems of private property and of information acquisi-

tion and dissemination.

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There are also unresolved problems in the economic theory of pricing and
competition. In an economy in which information is important for both cost
and utility, competition between firms is conducted under large fixed costs.
The two standard paradigms, due to Cournot and Bertrand respectively, are
both inadequate to model this competition. In the simplest form of these
paradigms, both postulate a market price, in the sense that any buyer can
buy as much as he or she pleases at a fixed price. With fixed costs, it is
reasonable to expect more complicated pricing schemes, for example, two-
part prices or prices depending on how much is purchased. More generally,
one might expect the firm to announce a price to a buyer for each amount
purchased. There has been very little research on this question. Sanford
Grossman [1981} has shown that, under very strong assumptions, the out-
come would be the same as under perfect competition. This solution is not,
however, even feasible if there are large fixed costs. The role of information
would seem to require a new approach to the theory of oligopoly.

References
Arrow, K. J. (1994), 'Information and the Organization of Industry,' Rivista internazionale di scitnu sociali,
102,111-116.
Coase, R. H. (1937), "The Nature of the Firm,' Economic,, N.S., 4, 386-405.
Grossman, S. (1981), 'Nash Equilibrium and the Industrial Organization of Markets with Large Fixed
Costs, Econometrics, 49,1149-1172.
Williamson, O.E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications. The Free Press: New
York.

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