The Problem of Production

Per Bylund

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317217800
• Edition: 1
• Topic: Economia
• Subtopic: Storia economica

The theory of the firm has been fertile ground for economists. Bylund proposes a new theory, rooted in Austrian economics, which examines the firm as a part of the market, and not as a free-standing entity. In this integrated view, a theory is offered which incorporates entrepreneurship, production, market process and economic development.

1
What we know and what we don’t know about the firm

This book is about what is generally referred to as the ‘firm’, a phenomenon in the market that appears obvious but that remains difficult to explain. While there is a field of study referred to as the theory of the firm, there are in fact a number of noteworthy theories. All of these theories claim to explain the firm’s rationale, value, and purpose. But the theories tend to describe the firm in different ways. The discussion is further complicated as there are several different definitions of this seemingly elusive concept. As a result, our understanding for the economic reality of the firm is inhibited.

The purpose of this book is not to reconcile these theories or definitions, however, but to try a new approach and provide an explanation for the firm by looking at the market setting where we find firms. We start by constructing an economic model of the market as an elaborate yet dynamic system of production without firms. This, in turn, allows us to study the limitations of the economic system of production, and what means are available to overcome them; or, more precisely, how the market deals with this ‘problem of production’. The goal is to elaborate on an explanation for the firm by seeking its economic function within the extensive production apparatus of the specialised market.

This chapter positions this book in the extant literature on the economics of organisations and institutions. It does so by summarising and delineating two strands of the academic literature that are separate but should complement each other: strategic management (or, as it is sometimes referred to, organisational economics), especially the theory of the firm, and the Austrian school of economics. While they have things in common and have recently been approaching each other, we will here draw from both strands to produce a theory of the firm. Our theory is based on the Austrian conception of production in the dynamic market process and it takes market-based production and the evolving dynamic of the market process as its point of departure. The perspective is Austrian, but the object for our analysis is borrowed from strategic management. The discussion thereby indirectly attempts to reconcile these literatures by providing a theoretical explanation for particular phenomena in the overlapping space between them. This first chapter is intended to provide background by making the reader familiar with economic theorising on the firm and what the two aforementioned literatures have in common.

Theorising on the firm

Whereas firms are ubiquitous in the economy and therefore often assumed to be a natural component of the market, the concept of a ‘firm’ poses an interesting question relating to economising, organisation, and production. The question can be stated as simply ‘Why are there firms?’, but its simplicity is deceiving. The question requires both elaboration and contextualisation to make the problem clear. The ‘why’ in the question suggests that there must be a rationale for forming firms such that there is a distinct value of coordinating production specifically within firms, which directs our attention to the question of what possible alternatives to firm organising there could be. The commonly assumed alternative is a model of the market as predominantly decentralised exchange-based coordination of production. The theory of the firm literature aims to formulate an economic argument for firm organising in contrast to decentralised market exchange, and under what specific conditions this is of value and therefore can be the predicted outcome. Due to the importance placed on this distinction between firm and market, a significant and important subset of this literature stresses issues relating to the firm’s ‘boundaries’. A firm’s boundary denotes the point where the firm ends and the market begins (and vice versa), which indirectly suggests what makes the firm different from the market. The ‘why’ of the firm therefore relates to (if not requires) a definition of what constitutes a ‘firm’, since ‘why’ must point towards a certain ‘what’. Knowing the ‘why’ and ‘what’ should also provide insights necessary to investigate the ‘how’ of the firm, which is another important question at the core of the theory of the firm literature.

The questions of the firm’s why, what, and how are generally referred to as the Coasean questions of the firm since they were posed or implied in Ronald H. Coase’s ground-breaking, Nobel Prize-winning 1937 article ‘The Nature of the Firm’.¹ Coase was not the first to pose questions about the firm’s rationale, boundaries, and internal organisation, but his comparative framing was novel and the article’s approach has become starting point for the modern study of economic organisation and the firm. Coase’s basic question, which asserted a clear theoretical distinction between the firm as a planned hierarchy and the decentralised exchange in the market, was stated rather bluntly: ‘in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation [the firm] necessary?’² Indeed, as Coase points out, if the market economy is efficient there should be no need for and certainly no value in such alternative means to organise production. Coase answers the question by introducing a cost specific to market exchange – a marketing or transaction cost – that produces a cost-based rationale for organising hierarchies in the place of markets. The firm is according to the Coasean view a means to economise on the market’s transaction costs.

From our contemporary perspective, Coase’s article appears as the culmination of a vast literature on economic organisation and management of the firm in the 1920s and 1930s. This literature continued the earlier work by primarily Alfred Marshall, who discussed the abstract conception of a ‘representative firm’³ and offered an extensive study of industrial organisation.⁴ This line of research, to which Coase’s article was likely intended as a challenge but ended up making little if any impact,⁵ subsided within mainstream economics in the late 1930s. The economic study of the firm was not revived until Coase’s pioneering work was rediscovered in the late 1960s and early 1970s, primarily through the work of Oliver E. Williamson who adopted Coase’s comparative institutional analysis (‘firm vs. market’) as well as the concept of ‘transaction costs’. The rediscovery of the Coasean ‘make-or-buy’ perspective on coordination became the starting point for an extensive literature in economics aiming to explain firm organising, which developed over the course of some twenty years.⁶ This literature is still core to the study of the firm.

Austrian economics and the firm

The emergence and development of the literature on economic organisation in the 1920s and 1930s coincides with the Socialist Calculation Debate, one of the great debates in economics. The latter was prompted by the work of Austrian economist Ludwig von Mises, who argued that an economic system based on socialism was both theoretically and practically impossible.⁷ Mises was a proponent of the Austrian or ‘causal-realist’ school of economics founded at the University of Vienna, which focuses on studying the real market through the lens of a deductive theoretical framework. The tradition’s focus on the market as it is, rather than – as in modern mainstream economics – highly formalised mathematical models with only occasional relevance to the real workings of the market, suggests it perhaps should have researched the firm. After all, markets both then and now are predominantly populated with firms; most economic activity takes place within or between such organisations. Yet, in contrast to neoclassical economics, which gave the topic a lot of attention in the 1960s, 1970s, and 1980s, the Austrian school did not develop a theory of formal economic organisation, and even less a theory of the firm.

This appears as a conundrum but is also an opportunity. That it is an opportunity is evident from two recent trends in the literature related to the Austrian body of research, on the one hand, and the study of the firm, its governance, and organisation on the other. One trend is the growing interest for issues relating to economic organisation from within the Austrian school and by Austrian scholars. Since the 1990s, articles and books have been published as part of the Austrian research programme that propose approaches to and directions for developing an Austrian theory of the firm.⁸ The other trend is evident by the (re)discovery of and then growing use and influence of Austrian economic concepts and theory in strategic management and entrepreneurship research.⁹ These two trends, while addressing similar issues, have different starting points and approaches, and build off different theoretical frameworks. But, as we will see, they nevertheless have similar theory implications, however with different emphases, and therefore suggest a possible future convergence.

For scholars in management and entrepreneurship, Austrian economics has offered an opportunity to open new venues for research. While the formal models in mainstream economics, especially industrial organisation (IO), originally laid ground for the study of strategic management, they are deficient for producing predictions and advice in a dynamic world. The formalised economic approach offers little support for more practically oriented or realistic research aiming to understand or aid in the creation or management of real firms. In contrast, the Austrian view of the market as a dynamic, entrepreneurship-driven competitive discovery process, and its focus on realism in aiming to explain real empirical phenomena, has considerable potential to enhance research and practice in both management and entrepreneurship. As we shall see, modern research in these fields has already adopted several core Austrian concepts and insights.

The study of strategic management was originally an offshoot of the so-called Bain/Mason paradigm of IO. While IO focused on the overall efficiency of the economic system as compared to the perfectly competitive model, strategic management developed strategies for the individual firm to exploit the efficiency logic and so establish monopoly power through which it can earn above-normal returns.¹⁰ But the empirical market in which business leaders draft strategies and make decisions is scarcely similar to the perfectly competitive model. Also, in stark contrast to the model, real production is neither perfectly optimised nor instantaneous (which is often the case in formal economic models), and business decisions are always made under uncertain conditions. The market, in other words, is dynamic and uncertain, it is in a constant flux, and is fundamentally less than perfectly foreseeable. Businesses consequently operate in a changing world – that is, disequilibrium – that is rather far from a stable equilibrium state, and this makes the formalised models describing maximising behaviour of rational actors with perfect information quite inapplicable in real business management.

It should therefore have been an obvious and expected development within strategic management to move towards adopting and analysing a more dynamic conception of the market and the firm. The change to focusing on the analysis of a more dynamic and ‘messier’ view of the market constituted a shift from the formal models of mainstream economics towards an Austrian conception of the market as a competitive and equilibrating process. As Robert Jacobson observed in the early 1990s, there are ‘relatively few strategy researchers [who] explicitly attribute or link their analysis to Austrian economics’, but ‘the influence of Austrian thinking is more widespread than this lack of attribution might suggest’. He continued by noting that much of the then-recent strategy research ‘fit[s] squarely into the Austrian school of thought’ and that this work even ‘can be seen as forming an “Austrian School of Strategy”’.¹¹

A similar shift has occurred in the study of entrepreneurship, though this field (at least the research done outside economics departments) never adopted as fully the streamlined economic models on which strategic management was originally based. Entrepreneurship is here commonly perceived as some form of open-ended change, whether it is the fundamental ‘driving force of the whole market system’, as Mises puts it,¹² or simply the act of creating firms.¹³ As it constitutes a process of change, the concept and its impact on the market are profoundly difficult to express in formal notation. As a result, entrepreneurship could never rely on the models of modern economic theory as was the case in strategic management. This may be a reason why, as William J. Baumol noted, ‘[t]he theoretical firm is entrepreneurless – the Prince of Denmark has been expunged from the discussion of Hamlet’.¹⁴

Expunged is probably a proper description. Since at least the early eighteenth century, studies in economic theory have placed the entrepreneur at the centre. Richard Cantillon, for instance, defines entrepreneurship as working for non-fixed income (and therefore the bearing of uncertainty)¹⁵ and saw in the entrepreneur the force that brings equilibrium to the market.¹⁶ Adam Smith, commonly regarded as the ‘father’ of economics, saw in the ‘undertaker’ an agent that transforms demand into supply.¹⁷ Jean-Baptiste Say saw the entrepreneur as a speculator who runs the firm for profit.¹⁸ The common denominator of these classical approaches to entrepreneurship is that the concept is considered primarily in terms of the role or function it plays in the economy. Modern entrepreneurship, in contrast, has to a great extent approached entrepreneurship as an empirical phenomenon, in which entrepreneurship is measured as ‘self-employment’ or as the degree of non-concentration in an industry.¹⁹

It was not until the work of Scott A. Shane and Sankaran Venkataraman,²⁰ who suggested the study and implications of the entrepreneurial opportunity as common denominator for studies in entrepreneurship, that theorising without direct basis in empirical observation regained its foothold in the field of entrepreneurship. Shane and Venkataraman relied heavily on the work of Israel M. Kirzner in reformulating the study of entrepreneurship, and contrasted Kirzner’s ‘alert’ entrepreneur with a conception of Joseph A. Schumpeter’s ‘disruptive’ innovator-entrepreneur.²¹ This has ultimately led to Austrian economics having a strong influence in entrepreneurship.

The use of Austrian concepts in strategic management is as prevalent as in entrepreneurship, but far from as explicitly attributed. Whereas entrepreneurship theory was built on an openly Austrian foundation, strategic management research only infrequently recognises that many of the field’s core concepts have already been used, elaborated on, and scrutinised by the Austrians. While there are indeed a number of studies in s...