Theory of the firm
The theory of the firm consists of a number of
Overview
In simplified terms, the theory of the firm aims to answer these questions:
- Existence. Why do firms emerge? Why are not all transactions in the economy mediated over the market?
- Boundaries. Why is the boundary between firms and the market located exactly there in relation to size and output variety? Which transactions are performed internally and which are negotiated on the market?
- Organization. Why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?
- Heterogeneity of firm actions/performances.[3] What drives different actions and performances of firms?
- Evidence. What tests are there for the respective theories of the firm?[4][5]
Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a
Background
The First World War period saw a change of emphasis in economic theory away from industry-level analysis which mainly included analyzing
Transaction cost theory
According to Ronald Coase's essay "The Nature of the Firm", people begin to organise their production in firms when the transaction cost of coordinating production through the market exchange, given imperfect information, is greater than within the firm.[6]
Coase begins from the standpoint that markets could in theory carry out all production and that what needs to be explained is the existence of the firm, with its "distinguishing mark … [of] the supersession of the price mechanism." Coase identifies some reasons why firms might arise, and dismisses each as unimportant:
- if some people prefer to work under the direction and are prepared to pay for the privilege (but this is unlikely);
- if some people prefer to direct others and are prepared to pay for this (but generally people are paid more to direct others);
- if purchasers prefer goods produced by firms.
Instead, for Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about the division of surplus, particularly if there is
If a firm operated internally under the market system, many contracts would be required (for instance, even for procuring a pen or delivering a presentation). In contrast, a real firm has very few (though much more complex) contracts, such as defining a manager's power of direction over employees, in exchange for which the employee is paid. These kinds of contracts are drawn up in situations of uncertainty, in particular for relationships that last over long periods of time. Such a situation runs counter to neo-classical economic theory. The neo-classical market is instantaneous, forbidding the development of extended agent-principal (employee-manager) relationships, planning, and of
He notes that government measures relating to the market (sales taxes, rationing, price controls) tend to increase the size of firms, since firms internally would not be subject to such transaction costs. Thus, Coase defines the firm as "the system of relationships which comes into existence when the direction of resources is dependent on the entrepreneur." We can therefore think of a firm as getting larger or smaller based on whether the entrepreneur organises more or fewer transactions.
The question then arises of what determines the size of the firm; why does the entrepreneur organise the transactions he does, why no more or less? Since the reason for the firm's being is to have lower costs than the market, the upper limit on the firm's size is set by costs rising to the point where internalising an additional transaction equals the cost of making that transaction in the market. (At the lower limit, the firm's costs exceed the market's costs, and it does not come into existence.) In practice, diminishing returns to management contribute most to raising the costs of organising a large firm, particularly in large firms with many different plants and differing internal transactions (such as a conglomerate), or if the relevant prices change frequently.
Coase concludes by saying that the size of the firm is dependent on the costs of using the price mechanism, and on the costs of organisation of other entrepreneurs. These two factors together determine how many products a firm produces and how much of each.[16]
Reconsiderations of transaction cost theory
According to Louis Putterman, most economists accept distinction between intra-firm and interfirm transaction but also that the two shade into each other; the extent of a firm is not simply defined by its capital stock.[17] George Barclay Richardson for example, notes that a rigid distinction fails because of the existence of intermediate forms between firm and market such as inter-firm co-operation.[18]
Klein (1983) asserts that “Economists now recognise that such a sharp distinction does not exist and that it is useful to consider also transactions occurring within the firm as representing market (contractual) relationships.” The costs involved in such transactions that are within a firm or even between the firms are the transaction costs.
Ultimately, whether the firm constitutes a domain of bureaucratic direction that is shielded from market forces or simply “a legal fiction”, “a nexus for a set of contracting relationships among individuals” (as Jensen and Meckling put it) is “a function of the completeness of markets and the ability of market forces to penetrate intra-firm relationships”.[19]
Managerial and behavioural theories
It was only in the 1960s that the neo-classical theory of the firm was seriously challenged by alternatives such as managerial and behavioral theories. Managerial theories of the firm, as developed by
Behavioural approach
The behavioural approach, as developed in particular by
Team production
The weakness in Alchian and Demsetz's argument, according to Williamson, is that their concept of team production has quite a narrow range of applications, as it assumes outputs cannot be related to individual inputs. In practice, this may have limited applicability (small work group activities, the largest perhaps a symphony orchestra), since most outputs within a firm (such as manufacturing and secretarial work) are separable so that individual inputs can be rewarded on the basis of outputs. Hence team production cannot offer the explanation of why firms (in particular, large multi-plant and multi-product firms) exist.
Asset specificity
For
If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing the
Probably the best constraint on such opportunism is
Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm's size increases its hierarchical bureaucracy does too), and the large firm's increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is in the nature of a large firm that its existence is more secure and less dependent on the actions of any one individual (increasing the incentives to shirk), and because intervention rights from the central characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the lesser responsibility, thereby diluting incentives. Milgrom and Roberts (1990) explain the increased cost of management as due to the incentives of employees to provide false information beneficial to themselves, resulting in costs to managers of filtering information, and often the making of decisions without full information.[26] This grows worse with firm size and more layers in the hierarchy. Empirical analyses of transaction costs have attempted to measure and operationalize transaction costs.[5][27] Research that attempts to measure transaction costs is the most critical limit to efforts to potential falsification and validation of transaction cost economics.
Boundaries of the firm
Boundaries of the firm explores the restrictions on size and output variety of firms, and how and why these restrictions affect production and enterprise success. There are two boundaries, horizontal, and vertical. As part of their corporate strategy, firms must choose between being horizontally broad, vertically deep, or both. Firms with horizontal breadth have numerous product lines or types, whereas firms with vertical depth are integrated into various stages of the value chain. Generally, a firm's capabilities are specific to a particular scope direction, for example, marketing skills lead to horizontal breadth, and production expertise lead to vertical depth.[28]
A firm is horizontally broad when it utilises excess indivisible resources to expand into various products, and obtain scope economies. Horizontally broad firms leverage capabilities such as marketing skills, product knowledge, customer service, and reputation for their expansions. Scope economies, or economies of scope, describe the aspect of production wherein cost savings result from the scope of an enterprise, as opposed to its scale (see economies of scale). Meaning, there are economies of scope where it is less expensive for firms to combine two or more product lines into one, than it is to produce each product separately.[29] Scope economies, wherein resources are synergistically used, has been found to improve firm performance.[28] However, coordination, adjustment and execution costs related to producing products synergistically are limiting factors.
A firm is vertically deep if it possesses stronger capabilities than external producers, and thus can produce and distribute its goods or services more efficiently internally - either upstream or downstream on the manufacturing chain.[30] Vertically deep firms leverage capabilities such as production and process expertise, including technology selection, asset utilisation, and supply chain management. Vertical depth often improves a firm's governance of activities, and contributes to a beneficial exploitation of internal capabilities, but is limited by the costs of hierarchical management, such as monitoring and coordination.[28]
The concept of boundaries can be linked to
Importance of boundaries
A study of firms in France illustrated how distortions to the number of employees and size of a firm directly impacts levels of productivity, wage and welfare within the organisation. Firms with at least 50 workers are subject to a number of additional regulations, which leads some firms to stay below the 50-worker threshold. The distortion acts like an additional tax on hiring workers, thereby preventing the reallocation from less productive to more productive firms, and reducing overall welfare.[31]
Economic theory of outsourcing
In
Firm as a Sociotechnical System
The concept of viewing firms as sociotechnical systems finds its roots in the studies conducted by researchers at The Tavistock Institute of Human Relations, particularly the seminal works of Trist and Bamforth [37] and Emery and Trist.[38] These pioneering scholars observed, through extensive field observations employing a systemic perspective, that firms could be comprehended as structured sociotechnical systems. These systems were recognized as being open to the environment, possessing the capacity for self-regulation to achieve their objectives, and adapting by creating alternative pathways when necessary.
Sociotechnical Approach
The sociotechnical approach delineates firms not merely as economic entities but as systems that amalgamate social and technical facets. It delves into the interplay between the human and technological elements within organizations, emphasizing the interconnectedness and interdependence between the social structure—comprising people, relationships, and interactions—and the technical system—encompassing tools, processes, and resources.[38] This approach acknowledges that the effectiveness and functionality of a firm arise not solely from its technical prowess but also from the way its social system interacts and interfaces with the technical framework. The dynamic between these systems, as articulated by Trist, Bamforth, Emery, and Trist, illustrates the need for an integrated understanding of human behavior, organizational culture, and technological systems within the framework of a firm.[38]
Evolutionary and Complexity Theory-Based Approaches.
Evolutionary approaches to understanding firms arose as a parallel branch to classical theories, stemming from the pioneering work of Joseph A. Schumpeter. Schumpeter[39] diverged from the abstract concept of the firm, introducing the notion that each firm possesses a distinct structural identity. He unified the creation and management of a firm into a single economic theory, emphasizing the dynamic nature of firms as evolving entities that learn and innovate within their fundamental routines. He also differentiated between firm development and growth, previously considered interlinked concepts.
Symbiotic Perspective
This structural description paved the way for Terra and Passador [40] to propose a dynamic perspective on firms that goes beyond profit-centric views. The authors utilize sociotechnical concepts, describing firms where the social system meets the self-regulation and self-preservation requirements proposed by Luhmann,[41] imparting an autoreferential dynamic to this subsystem, while technical structures exhibit a goal-oriented dynamic. These two systems symbiotically form the firm's supersystem, also manifesting an autoreferential dynamic, where social systems act as the mind animating the organization's physical body.
From this standpoint, firms represent a system traversed by a continuous flow of information and resources, enclosed within themselves, ensuring their unity. Therefore, they lack inputs or outputs in the same sense as in finalistic views of firms. Due to their structural determinism, once the system emerges, its development inherently involves a history of recurrent interactions within the environment that both emerges with it and contains it. Both the system's structure and the environment spontaneously change congruently and complementarily as the firm strives to maintain its organization and operational coherence. Its ultimate product refers not to its outputs per se but to its own organization and realization of identity and autonomy.[40][42]
As an organization is a self-referential entity, enclosed within operational closure, its function focuses on its own constitution. In this context, the exchanges it conducts with its supra-systems merely represent disturbances and residues allowing it to capture from the environment the necessary order for its survival and sustenance of its identity. This contrasts with finalistic conceptions of firms, where the scope is to meet external demands. Under this perspective, the firm's purpose is to ensure its own existence.[40][42]
Boundaries
Under the perspective of the firm as a symbiotic entity, boundaries are defined through its operational closure. These boundaries encompass not only hierarchical relationships among agents but also various classes of relations linking social agents to a particular technical and social system. This occurs through the values and bonds of trust established by agents, ensuring the self-production of the organization's values and their relative stability over time.[40][42]
Viable Contour
The viability of the firm, as a self-referential entity enclosed within operational closure, is linked to the rate of regeneration of its sociotechnical systems and the flow of resources and information traversing it. If the rate of disintegration exceeds the pace at which the firm can repair itself, the structure of this network of interactions unravels. This makes disintegration a powerful constraint on the maximum size for a viable contour structure. The flow of resources and information also places the firm in a situation of constant threat since such structures rely on relationships with the environment to sustain their dynamics. This underscores the necessity for an adjustment field that compensates for environmental disturbances—a crucial factor in preventing the system from reaching thermodynamic equilibrium, which ultimately signifies the demise of the structure.[40][42]
Social Attractors
Experiments conducted by Terra and Passador underscored the significant role of attraction basins governing firm dynamics. In this context, technical systems emerged as the central element of organizational dynamics, around which social attractors orbit. These social attractors create secondary attraction basins and are surrounded by their own social "satellites" in a structure analogous to a planetary system. Here, the star can be understood as the technical system, the planets as leaders, and other agents as satellites or free bodies not confined to a single social attraction basin but related to the technical system.[42]
Although the experiments highlighted technical systems as primary attractors, the authors' model also demonstrates a recursion in this system, where agents contribute to what attracts them in the technical system, just as the technical system shapes social structures by attracting agents. Hence, an intimate and symbiotic relationship exists between the social and technical systems, wherein the former shapes the latter. This grants leaders a crucial role in the growth and regeneration of structures since their control capacity directly impacts the organization's viable boundary.[42]
The model also reveals that relocating or including an agent or subsystem in an organization can affect its dynamics by altering the attraction basins governing it. This may lead to undesired qualitative leaps or even rupture of the organization's self-referential network, potentially resulting in the collapse of one of its subsystems. Simultaneously, such restructuring in relationships and social attraction basins can also promote innovation, akin to DNA mutations, creating new dynamics and altering the variety and redundancy within organizations.[42]
Essential conditions for a firm's emergence
Regarding the essential conditions for a firm's emergence and sustenance, Terra and Passador identified four crucial elements: (1) the ability to integrate external agents into its formal network of relations; (2) being pervaded by a resource flow sustaining its self-referential network; (3) offering advantages for agents to associate with it; and (4) the capability to regenerate its formal network of relations when an agent is lost, especially at the supervisory level.[42]
While regeneration of the formal network of relations appeared possible without specialized structures, organizations lacking such systems tend to be structurally unstable. Establishing routines specialized in replacing and reconstituting the social network enhances stability and significantly extends the organization's lifespan. This suggests that mechanisms specialized in reconstructing the organization's social network topology, even in simplified forms, are vital to ensure the longevity of such structures.[42]
Relationships with the environment and sustainability
The theory of Symbiotic Dynamics is based on the intimate association between organizations and the systems that surround them, in such a way that the survival of these is correlated. Thus, it is important for the organization's survival that the deterioration and transformation of supersystems, such as markets, society, and the environment, occur at a pace that allows them to regenerate to maintain their identity and organization, or that enables the firm itself to adapt to the new realities imposed by qualitative leaps that may occur in the dynamics of supersystems. If this need is neglected, it can lead the environment to deteriorate at a rate greater than the compensatory fields of organizations can support, leading them to disintegrate.[40][42]
In this context, organizations need to be guided by a hybrid logic, blending proactivity and reactivity, where organizations recognize their impact on the environment as a whole and act in an organized manner to reduce their degeneration, while adapting to the demands that may arise from these interactions. In the context at hand, organizations need to include in their decisions all the other systems with which they are coupled, making it possible to envision the construction of complex socio-economic systems where they integrate in a stable and sustainable manner.[40][42]
Other models
George Akerlof (1982) develops a gift exchange model of reciprocity, in which employers offer wages unrelated to variations in output and above the market level, and workers have developed a concern for each other's welfare, such that all put in effort above the minimum required, but the more able workers are not rewarded for their extra productivity; again, size here depends not on rationality or efficiency but on social factors.[43] In sum, the limit to the firm's size is given where costs rise to the point where the market can undertake some transactions more efficiently than the firm.
Recently,
Grossman–Hart–Moore theory
In modern
The Grossman–Hart–Moore model has been successfully applied in many contexts, e.g. with regard to privatization.[48] Chiu (1998) and DeMeza and Lockwood (1998) have extended the model by considering different bargaining games that the parties may play ex post (which can explain ownership by the less important investor).[35] Oliver Williamson (2002) has criticized the Grossman–Hart–Moore model because it is focused on ex ante investment incentives, while it neglects ex post inefficiencies.[10] Schmitz (2006) has studied a variant of the Grossman–Hart–Moore model in which a party may have or acquire private information about its disagreement payoff, which can explain ex post inefficiencies and ownership by the less important investor.[36] Several variants of the Grossman–Hart–Moore model such as the one with private information can also explain joint ownership.[49]
See also
Notes
- ISBN 978-0-907776-34-5. Description & review..
• Spulber, Daniel F. (2009). The Theory of the Firm, Cambridge. Description, front matter, and "Introduction" excerpt - JSTOR 1057429.
- S2CID 203225756.
- ^ Thomas N. Hubbard (2008). "firm boundaries (empirical studies)," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- ^ S2CID 1299439.
- ^ .
- .
- ^ Jean Tirole (1988). The Theory of Industrial Organization. "The Theory of the Firm", pp. 15–60. MIT Press.
- ^ Luigi Zingales (2008). "corporate governance," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- ^ S2CID 52232613.
- S2CID 47680121.
- ^ S2CID 15892859.
- ^
ISBN 978-0-88738-887-3.[page needed]
- ^
Hall, R.; Charles J. Hitch (1939). "Price Theory and Business Behaviour". Oxford Economic Papers. 2 (1): 12–45. JSTOR 2663449.
- ^ Archibald, G.C. (1987 [2008]). "firm, theory of the," The New Palgrave: A Dictionary of Economics, v. 2, p. 357.
- JSTOR 765013.
- ISBN 978-0-521-47092-6.[page needed]
- ^
JSTOR 2230256.
- SSRN 94043.
- ^ Spence, Michael A.; Zeckhauser, Richard (1971). "Insurance, Information, and Individual Action". American Economic Review. 61 (2): 380–387.
- JSTOR 1817064.
- ^
ISBN 978-0-631-17451-6.[page needed]
- ^
JSTOR 1815199.
- ^
ISBN 978-0-02-935360-8.
- JSTOR 25470605.
- SSRN 1175102.
- ^ Special Issue of Journal of Retailing in Honor of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2009 to Oliver E. Williamson, 86(3), pp. 209-290, article-preview links (2010). Edited by Arne Nygaard and Robert Dahlstrom.
- ^ S2CID 204776573.
- JSTOR 1815729.
- ^ ProQuest 225003014.
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- S2CID 8559551.
- OCLC 32703648.[page needed]
- ^ S2CID 215807368.
- ^ .
- ^ S2CID 154717219.
- .
- ^ a b c Emery, F. E.; Trist, E. L. (1960). "Socio-technical systems". Management Sciences, Models and Techniques: Proceedings of the 6th- International Meeting of the Institute of Management Sciences. 2. New York: 83–97.
- ^ Schumpeter, J.A. (2012). The Theory of Economic Development: An Inquiry into Profits, Capital. New Brunswick: Transaction Publichers.
- ^ .
- ^ Luhmann, N. (1995). Social Systems. Stanford: Stanford University Press.
- ^ .
- .
- ^ Benkler, Yochai (2006). The Wealth of Networks: How Social Production Transforms Markets. New Haven: Yale University Press.
- ISBN 978-0-262-02576-8.[page needed]
- S2CID 154638241.
- ^ Hart, Oliver (1995). Firms, contracts, and financial structure. Oxford University Press.[page needed]
- S2CID 16270301.
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References
- Crew, Michael A. (1975). Theory of the Firm. New York: Longman. p. 182. ISBN 978-0-582-44042-5.
- Clarke, Roger; McGuinness, Tony (1987). The Economics of the Firm. Cambridge: Blackwell. ISBN 978-0-631-14075-7.
- Foss, Nicolai J., ed. (2000). The Theory of the Firm: Critical Perspectives on Business and Management. Taylor and Francis. v. I–IV. Chapter preview links, including Bengt Holmström and Jean Tirole, "The Theory of the Firm," v. I, pp. 148–222
- Holmstrom, Bengt R.; Tirole, Jean (1989). "Chapter 2 the theory of the firm". Handbook of Industrial Organization Volume 1. Vol. 1. pp. 61–133. ISBN 9780444704344.
- Robé, Jean-Philippe (31 January 2011). "The Legal Structure of the Firm". Accounting, Economics, and Law. 1 (1). S2CID 167919558.
- Garicano, Luis; Lelarge, Claire; Van Reenen, John (1 November 2016). "Firm Size Distortions and the Productivity Distribution: Evidence from France". American Economic Review. 106 (11): 3439–3479. S2CID 4929270.
Further reading
- Kroszner, Randall S.; Putterman, Louis, eds. (2009). The Economic Nature of the Firm: A Reader (3rd ed.) Cambridge University Press.
- Aghion, Philippe; Holden, Richard (1 May 2011). "Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years?". Journal of Economic Perspectives. 25 (2): 181–197. S2CID 55679839.