The Theory of the Firm

An overview of the economic mainstream

Paul Walker

• Publisher: Routledge
• Year: 2016
• Topic: Business
• eBook ISBN:
  9781317277026
• Subtopic: Economic Theory
• Index: Business

Firms are a ubiquitous feature of the economic landscape, with much of the activity undertaken within an economy taking place within their boundaries. Given the size of the contribution made by firms to economic activity, employment and growth, having a theoretical understanding of the nature and structure of firms is crucial for understanding how an economy functions.

The Theory of the Firm firstly offers a brief overview of the past, consisting of a concise discussion of the classical view of production, followed by an outline of the development of the neoclassical - or 'textbook' - approach to firm level production. Secondly, the 'present' of the theory of the firm is discussed in three sections. The first section considers the post-1970 theory of the firm literature per se, while the second section scrutinises the relationship between the three most prominent of the modern sets of theories: the reference point, property rights and transaction cost approaches. The third section looks at the theory of privatisation. The unique aspects of this book includes its discussions of the post-1970 contributions to the theory of the firm; the integration of the theory of the entrepreneur with the theory of the firm; and the theory of privatisation.

This volume offers an intuitive introduction to the theories of the firm as well as simple formal models of the most important contributions to the literature. It also outlines the historical evolution of the traditional and modern theories of the firm. This book is of great interest to those who study history of economic thought, industrial economics and organizational studies.

1
Introduction

Firms¹ are a ubiquitous feature of the economic landscape with much of the activity undertaken within an economy taking place within their boundaries. McMillan (2002: 168–9), for example, estimates that less than a third of all the transactions in the US economy occur through markets, and instead over 70 percent are made within firms. Lafontaine and Slade (2007: 629) state that the “[d]ata on value added, for example, reveal that, in the United States, transactions that occur in firms are roughly equal in value to those that occur in markets”. With regard to the number of firms and their importance to employment Otteson (2014: 30) takes the United States as an example and reports that: “[i]n 2008, the United States had some 31.6 million businesses across thousands of industries employing some 120 million people”. The scale of activity within firms ranges from that of global giants to that of sole proprietorships. Kikuchi, Nishimura and Stachurski (2012: 2) note that

[…] in 2011, Royal Dutch Shell operated in over 80 countries, had annual revenue exceeding the GDP of 150 nations, and paid its CEO 35 times more than the president of the United States. In the same year, the total number of employees at Wal-Mart exceeded the population of all but 4 US cities. In addition to such giants, tens of millions of smaller firms operate around the world.

Bowen (1955: 1) highlights the importance of firms to people’s well-being by noting that

The business enterprise is one of the most pervasive and influential institutions of our society, and one in which innumerable important decisions and responses are made. These decisions and responses, in small and large enterprises, are links in the chain of factors determining the range of products available to consumers, the level of national income, the degree of economic security, the rate and direction of economic progress, and the distribution of income. These decisions and responses also significantly influence the character of human relations in industry, the quality of the lives of those who work in industry, and even the power structure of our society.

Micklethwait and Wooldridge (2003: xv) argue that “[t]he most important organization in the world is the company: the basis of the prosperity of the West and the best hope for the future of the rest of the world”.

Given the size of the contribution made by firms to economic activity, employment, innovation, growth, income and well-being, having a sophisticated theoretical understanding of the nature and structure of firms is a crucial component of a proper understanding of how an economy functions.² And yet

The theory of the firm has been a neglected area of study in mainstream economics. Despite Ronald Coase bringing the issue up for discussion in 1937, it was not on the research agenda until the 1970s. Even now, as both Coase and Oliver Williamson, the founder of and prominent scholar in the transaction cost-focusing analysis of firm organization, have received the Nobel Prize in economics, the area remains in the periphery of economic analysis.

(Bylund 2011: 189)

This distinct lack of interest by the majority of economists in the theory of the firm has also been commented on by Fleckner (2016: 5, footnote 2),

Probably the best evidence of the traditional disinterest in the theory of the firm is the fact that the firm has no prominent place, if it is broached at all, in books on the history of economic thought. Two examples: In Sandmo 2011, a new and very readable book, none of the almost 500 pages are devoted to the theory of the firm (the selection of topics is explained on pp. vii, 2–3, 11–2); in Heilbroner 1999, one of the best-selling books in economics of all time, firms are mentioned more frequently, especially those whose shares are publicly traded, but there is no discussion of the issues that are typically associated with the theory of the firm (which, given the broad scope of the book, is not meant to be a criticism; neither Heilbroner nor Sandmo would have been well advised to focus on the firm).

When considering the state of contemporary price theory Coase and Wang (2011: 1) remark

But the gain in rigor achieved in modern price theory comes with a heavy price tag. The most obvious and serious omission in price theory is that it sees no role for production, let alone entrepreneurship. How goods and services are actually produced, how new goods and services and new ways of production are constantly invented in the economy, how production and innovation are organized, and what forces are at work are rarely on the research agenda in economics. It is extraordinary that the process of production is virtually invisible in economic theory.

While Coase himself commented in a 2013 interview that: “Modern economics shows little interest in production” (Wang 2014: 118). Oliver Hart argues“[…] that the theory of the firm is one of the less developed and agreed-upon areas of economics” (Hart 2011: 102). With regard to the more general area of organisational economics, for which the theory of the firm is a foundational component, Gibbons and Roberts (2013: 1) say that: “However, organizational economics is not yet a fully recognized field in economics – for example, it has no Journal of Economic Literature classification number, and few doctoral programs offer courses in it”.

With this book we hope to help remedy this neglect, if only a little, by showing that ongoing developments in the theory of the firm³ justify moving the analysis of the firm from the margins of economic inquiry to its centre.⁴ We aim to do this by providing a short overview of these developments. Our objective is to show how the theory of the firm has been formulated within the ‘mainstream’⁵ of economics, both ‘past’ and ‘present’. We emphasise the mainstream theory because it is these theories that dominate the teaching of and literature on the theory of the firm. In terms of undergraduate teaching, aspects of the pre-1970 mainstream theory – the ‘past’ – constitute the most common, often the only, ‘theory of the firm’ taught to students. Few of the post-1970s advancements have made it into the standard undergraduate economics textbooks. Part of our purpose here is to help address this shortcoming. In graduate courses, and in the research literature, the post-1970 mainstream theories – the ‘present’ – provide the dominant theoretical frameworks. We aim to offer an accessible and concise introduction to the major theories that make-up the contemporary literature.

An analysis of the past of the theory of the firm is undertaken to help cultivate an understanding of the historical developments that have resulted in the contemporary theories. This inquiry helps to add depth to our knowledge of ideas that are commonly used today but whose origins lie in past debates to do with production and the firm. It also allows us to see how and why changes in thinking took place. We will argue that over time a more sophisticated understanding of firms has been developed, which has in turn led to the development of related areas such as the theory of privatisation. We will also look at some of the possible ways that the mainstream theory of the firm could evolve to continue this trend into the future.

Foss and Klein (2006) have noted that there has been a close relationship between advances in the general economic mainstream and the development of the theory of the firm,

[…] the evolution of the theory of the firm has never taken place far away from the economic mainstream. On the contrary, it has in fact been much driven by advances in the mainstream, and the relatively limited borrowing from other disciplines that has taken place has usually been strongly adapted to conform to central mainstream tenets. To be sure, the theory of the firm may have been revolutionary in the (somewhat limited) sense of introducing new explanation to economics, but it is generally true to say that it has not been revolutionary in the sense of representing a radical break with any of the main tenets of mainstream economics.

(Foss and Klein 2006: 3–4).

One implication of this is that the heterodox approaches to the firm have had little direct effect on the development of the economic theory of organisations. Thus, this survey’s concentration on the mainstream literature may do little damage to the story of the emergence of the theory of the firm but it does mean that little will be said of those non-mainstream or heterodox ideas, such as those from the overlap between economics and management, or the Marxist approaches, or the Austrian inspired theory of the firm, or the relevant contributions from business history, that have developed outside of the orthodoxy.⁶

1970 is used as a convenient, if not entirely accurate, dividing line between what constitutes the ‘past’ and the ‘present’ of the theory of the firm since it was around this time that the present mainstream – largely Coaseian based – approaches to the firm started to develop with works such as Williamson (1971, 1973, 1975), Alchian and Demsetz (1972), Jensen and Meckling (1976) and Klein, Crawford and Alchian (1978). The major difference between the mainstream theories of the past and the mainstream theories of the present, at least as far as they are conceived of here, is that the focus – in terms of the questions the theory attempts to answer – of the post-1970 mainstream literature is markedly different from that of the earlier (neoclassical) mainstream theory. The theory of the firm for Ronald Coase, Oliver Williamson, Bengt Holmström or Oliver Hart is a very different thing from that of Arthur Pigou, Lionel Robbins, Jacob Viner, Joan Robinson or Edward Chamberlin.

The questions that the theory seeks to answer have changed from being about how the firm acts in its various markets: how it prices its outputs or how it combines its inputs; to questions about the firm’s existence, boundaries – including the boundary between state and private enterprise – and internal organisation. That is, within the mainstream theory there has been a movement away from seeing the theory of the firm as simply developing one component (albeit an important component) of price theory, namely the element concerned with the factor and product market behaviour of producers, to the theory being concerned with the firm as an important economic institution in its own right.

In addition, there are recent contributions to the theory of the firm which exploit ideas that on the surface make it seem as though they are developing an approach which undermines the mainstream theories. But it will be argued in this book that these new theories can be more usefully interpreted as following a course which extends, rather than subverts, the orthodox literature. In particular these contributions allow for the integration of the theory of the entrepreneur⁷ with the theory of the firm. Questions to do with the importance of “judgement” (decision making in situations involving Knightian uncertainty⁸) to the role of the entrepreneur with regard to the existence and organisation of firms, as well as the importance of the entrepreneur to the formation of firms, and through them the creation of markets are beginning to be examined.

The rest of this book consists of five more chapters. Chapter 2 examines the ‘past’ of the theory of the firm. This chapter concentrates mainly on a discussion of the classical theory of production and the development of the neoclassical model of the ‘firm’. Consideration is also given to two of the first, be they largely unsuccessful in terms of affecting the trajectory of the mainstream economics literature, theoretical attempts to look inside the ‘black box’ that is the neoclassical firm. The theories briefly examined are the behavioural and managerial models of the firm. Following on from this comes an outline of Harold Demsetz’s,‘non-Coaseian’, interpretation of the neoclassical model.

The third chapter of this book consists of a short survey of the founding works – Knight (1921b) and Coase (1937) – on which the present versions of the mainstream theory of the firm are based, while the fourth chapter deals with the ‘present’ mainstream theories themselves.

The fourth chapter’s first section covers the post-1970 Coaseian/Knightian inspired theories of the firm. Within this category two general groups of theories are identified: principal–agent models and incomplete contract models. In both groups, simple formal models of the major contributions are presented. Following on from this we consider three of the more recent contributions to the theory of the firm. Given their recent origins, these theories are not as well known as the other contributions considered in this section and they have yet to be integrated into standard discussions of the theory of the firm. The reference point approach to the firm developed by Hart and Moore (2008) is looked at first with this discussion being followed by an analysis of the theory put forward in Daniel Spulber’s book The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations. The last of the three approaches considered is the ‘entrepreneurial judgement’ perspective associated with Foss and Klein’s 2012 book Organizing Entrepreneurial Judgment: A New Approach to the Firm. These contributions offer a number of possible springboards to future advances in the theory of the firm. Specifically it is the last two of these theories that open pathways to the integration of the theory of the entrepreneur with the theory of the firm.

The second section of the fourth chapter involves a discussion of the relationship between the three main contemporary theories of the firm: the reference point, property rights and transaction costs approaches.

The theory of privatisation is concisely summarised in the third section of the fourth chapter. The close relationship between the theory of the firm and the theory of privatisation – that is, both sets of theories are concerned with the boundaries of firms – is emphasised.

The fifth chapter examines the use of partial versus general equilibrium modelling within the contemporary theory of the firm. It is noted that since the 1970s partial equilibrium analysis has come to dominate general equilibrium analysis as the preferred approach to modelling the firm.

The last chapter is the conclusion.

Notes

1 Spulber (2008: 5, footnote 8) gives the origin of the word “firm” as “[t]he word ‘firm’ derives from the Latin word “firmare” referring to a signature that confirmed an agreement by designating the name of the business”.

2 Certainly such a view has been put forward in the past. Bowen (1955: 6–7) argues

Many economists, but by no means all, believe that greater and more exact knowledge of the decisions and responses of business enterprises would enhance our ability to predict the outcome of changes in basic economic variables and of changes in public policy. For example, it is frequently asserted that if economists knew more about the factors determining rates of investment in enterprises, they s...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Preface and acknowledgements
• A note on the numbering of equations, theorems and figures
• 1 Introduction
• 2 The ‘past’
• 3 The founding works
• 4 The ‘present’
• 5 Partial versus general equilibrium
• 6 Conclusion
• Appendix 1: the particular expenses curve
• Appendix 2: Simon (1951)
• Appendix 3: monotone comparative statics
• Appendix 4: examples of poor SOE performance
• References
• Index