Theory of the firm

[Qurratulain]

Theory of the firm

The theory of the firm consists of a number of economic theories which describe the nature of the firm (company or corporation), including its behaviour and its relationship with the market.

The First World War period saw a change of emphasis in economic theory away from industry-level analysis to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved. The need for a revised theory of the firm was emphasised by empirical studies by Berle and Means (1932), which made it clear that ownership of a typical US corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves, and Hall and Hitch (1939) who found that businessmen made decisions by rule of thumb rather than in the marginalist way.



Original Source: Wikipedia

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Transaction cost theory



Ronald Coase (1937)’s transaction cost theory of the firm was one of the first (neo-classical) attempts to define the firm theoretically in relation to the market, where previously neo-classical theory saw the firm as simply an other part of the industry. Coase explicitly attempts to find a definition of the firm which is both realistic and compatible with the idea of substitution at the margin, so that it is susceptible to the instruments of conventional economic analysis. He notes that a firm’s interactions with the market may not be under its control, but its internal allocation of resources clearly represents, in Robertson’s words, an “island of conscious power” where the decisions of the entrepreneur are non-trivial. “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.” (Coase 1937). In other words, the question must be asked, why these alternative methods of production: market and planning? Could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy?

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 supercession of the price mechanism.” Coase identifies several trivial reasons why firms might arise, and dismisses each as unimportant:

(i) if some people prefer to work under direction and are prepared to pay for the privilege (but this is unlikely);

(ii) if some people prefer to direct others and are prepared to pay for this (but generally people are paid more to direct others);

(iii) 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 (the costs of this can be reduced but not eliminated by the use of specialists selling this information), as well as the costs of negotiating and writing enforceable contracts for each exchange transaction, which can be large if there is uncertainty. Moreover, contracts in an uncertain world will necessarily be incomplete and have to be re-negotiated from time to time due, since not all eventualities can be foreseen indefinitely. The costs of this in terms of haggling about division of surplus, particularly if there is asymmetric information and asset specificity, may be considerable.

In contrast to the number of contracts that would be required within a firm if it was completely marketised, a real firm has very few (though much more complex) contracts, which rather than stating specific outcomes and prices define limits to a principal’s power of direction in relation to the agent, in exchange for which delimited direction the agent receives remuneration. These kinds of contracts (with employees or suppliers) have to be drawn up in situations of uncertainty, and in particular for relationships which last long periods of time. The neo-classical market is instantaneous - it has no past or future at any given point in time, which forbids the development of long-term agent-principal relationships, of planning, and of trust (since impersonal relations are in the nature of the competitive market, and once any longer-term relationships are established, the relevant market is no longer competitive). Coase concludes that “a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory,” and that “it seems improbable that a firm would emerge without the existence of uncertainty.” He goes on to note that government measures relating specifically to the market (sales taxes, rationing, price controls) would tend to increase the size of firms, and might bring them into existence if they did not already exist, since firms internally would not be subject to these measures. Coase then 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 less 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 raison d’etre of the firm is to have lower costs than the market, logically the upper limit on the size of the firm must be set by rising costs, such that the point is reached where the costs of the firm internalising an additional transaction equal 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 other words, diminishing returns, caused by diminishing returns to management (rather than to scale, since a firm can easily be multi-plant), or a rise in the supply price of factors (if labour dislikes working for a large firm), are likely to set an upper limit on the size of the firm. In practice, it seems to be principally diminishing returns to management which contributes to raising the costs of organising a large firm, particularly if it has a large spatial distribution, widely differing internal transactions (e.g., a conglomerate), and if the relevant prices change frequently (it is generally assumed that frequently changing prices raise a firm’s costs more than the costs of the equivalent market transaction). 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 determining how many products a firm produces and how much of each.

[Qurratulain]

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 behavioural theories. Managerial theories of the firm, as developed by William Baumol (1959 and 1962), Robin Marris (1964) and Oliver E. Williamson (1966), suggest that managers would seek to maximise their own utility and consider the implications of this for firm behaviour in contrast to the profit-maximising case. (Baumol suggested that managers’ interests are best served by maximising sales after achieving a minimum level of profit which satisfies shareholders.) More recently this has developed into ‘principal-agent’ analysis (eg Spence and Zeckhauser (1971) and Ross (1973) on problems of contracting with asymmetric information) which models a widely applicable case where a principal (a shareholder or firm for example) cannot costlessly infer how an agent (a manager or supplier, say) is behaving. This may arise either because the agent has greater expertise or knowledge than the principal, or because the principal cannot directly observe the agent’s actions; it is asymmetric information which leads to a problem of moral hazard. This means that to an extent managers can pursue their own interests. Traditional managerial models typically assume that managers, instead of maximising profit, maximise a simple objective utility function (this may include salary, perks, security, power, prestige) subject to an arbitrarily given profit constraint (profit satisficing).



Behavioural approach


The behavioural approach, as developed in particular by Cyert and March (1963) places emphasis on explaining how decisions are taken within the firm, and goes well beyond neo-classical economics. Much of this depended on Herbert Simon’s work in the 1950s concerning behaviour in situations of uncertainty, which argued that “people possess limited cognitive ability and so can exercise only ‘bounded rationality’ when making decisions in complex, uncertain situations.” Thus individuals and groups tend to ‘satisfice’ - that is, to attempt to attain realistic goals, rather than maximise a utility or profit function. Cyert and March argued that the firm cannot be regarded as a monolith, because different individuals and groups within it have their own aspirations and conflicting interests, and that firm behaviour is the weighted outcome of these conflicts. Organisational mechanisms (such as ‘satisficing’, sequential decision-taking, and organisational slack (Leibenstein’s X-inefficiency)) exist to maintain conflict at levels that are not unacceptably detrimental.


Team production


Alchian and Demsetz (1972)'s analysis of team production is an extension and clarification of earlier work by Coase. Thus according to them the firm emerges because extra output is provided by team production, but that the success of this depends on being able to manage the team so that metering problems (it is costly to measure the marginal outputs of the co-operating inputs for reward purposes) and attendant shirking (the moral hazard problem) can be overcome, by estimating marginal productivity by observing or specifying input behaviour. Such monitoring as is therefore necessary, however, can only be incentivised effectively if the monitor is the recipient of the activity’s residual income (otherwise the monitor herself would have to be monitored, ad infinitum). (Would she though? Would not the requirement of the monitor to ensure shirking does not mean the elimination of the team be enough to keep shirking of the monitor herself to a minimum? Moreover, some people take a perverse pleasure in making others work hard.) For Alchian and Demsetz, the firm therefore is an entity which brings together a team which is more productive working together than at arm’s length through the market, because of informational problems associated with monitoring of effort. In effect, therefore, this is a ‘principal-agent’ theory, since it is asymmetric information within the firm which Alchian and Demsetz emphasise must be overcome. In Barzel (1982)’s theory of the firm, drawing on Jensen and Meckling (1976), the firm emerges as a means of centralising monitoring and thereby avoiding costly redundancy in that function (since in a firm the responsibility for monitoring can be centralised in a way that it cannot if production is organised as a group of workers each acting as a firm).

The weakness in Alchian and Demsetz’s argument, according to Williamson, is that their concept of team production has quite a narrow range of application, 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.

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Williamson's approach


For Oliver E. Williamson, the existence of firms derives from ‘asset specificity’ in production, where assets are specific to each other such that their value is much less in a second-best use. This causes problems if the assets are owned by different firms (eg purchaser and supplier), because it will lead to protracted bargaining concerning the gains from trade, because both agents are likely to become locked into a position where they are no longer competing with a (possibly large) number of agents in the entire market, and the incentives are no longer there to represent their positions honestly: large-numbers bargaining is transformed into small-number bargaining. 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 transactions costs. Moreover there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the hold-up problem, which occurs when either party asymmetrically incurs substantial costs or benefits before being paid for or paying for them). In this kind of a situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one of them from the equation by takeover or merger. Asset specificity can also apply to some extent to both physical and human capital, so that the hold-up problem can also occur with labour (eg labour can threaten a strike, because of the lack of good alternative human capital; but equally the firm can threaten to fire). Probably the best constraint on such opportunism is reputation (rather than the law, because of the difficulty of negotiating, writing and enforcement of contracts), if a reputation for opportunism significantly damages an agent’s dealings in the future: this alters the incentives to be opportunistic.

Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm’s size increase 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 centre 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. This grows worse with firm size and more layers in the hierarchy. Efficiency wage models like that of Shapiro and Stiglitz (1984) suggest wage rents as an addition to monitoring, since this gives employees an incentive not to shirk, given a certain probability of detection and the consequence of being of fired. Williamson, Wachter and Harris (1975) suggest promotion incentives within the firm as an alternative to morale-damaging monitoring, where promotion is based on objectively measurable performance. (The difference between these two approaches may be that the former is applicable to a blue-collar environment, the latter to a white-collar one.) Leibenstein (1966) sees a firm’s norms or conventions, dependent on its history of management initiatives, labour relations and other factors, as determining the firm’s ‘culture’ of effort, thus affecting the firm’s productivity and hence size. 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. 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.