Theory of the firm

In simplified terms, the theory of the firm aims to answer these questions:

1. Existence. Why do firms emerge? Why are not all transactions in the economy mediated over the market?
2. 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?
3. 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?
4. Heterogeneity of firm actions/performances.[3] What drives different actions and performances of firms?
5. 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 labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for better alternatives. Similarly, it may be costly for companies to find new suppliers daily. Thus, firms engage in a long-term contract with their employees or a long-term contract with suppliers to minimize the cost or maximize the value of property rights.[6][7][8][9][10][11][12]

The First World War period saw a change of emphasis in economic theory away from industry-level analysis which mainly included analyzing markets 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. Economic theory until then had focused on trying to understand markets alone and there had been little study on understanding why firms or organisations exist. Markets are guided by prices and quality as illustrated by vegetable markets where a buyer is free to switch sellers in an exchange. The need for a revised theory of the firm was emphasized by empirical studies by Adolf Berle and Gardiner Means, who made it clear that ownership of a typical American corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves.[13] R. L. Hall and Charles J. Hitch found that executives made decisions by rule of thumb rather than in the marginalist way.[14]

The model shows institutions and market as a possible form of organization to coordinate economic transactions. When the external transaction costs are higher than the internal transaction costs, the company will grow. If the external transaction costs are lower than the internal transaction costs the company will be downsized by outsourcing, for example.

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]

Ronald Coase set out his transaction cost theory of the firm in 1937, making it one of the first (neo-classical) attempts to define the firm theoretically in relation to the market.[6] One aspect of its 'neoclassicism' lies in presenting an explanation of the firm consistent with constant returns to scale, rather than relying on increasing returns to scale.[15] Another is in defining a firm in a manner which is both realistic and compatible with the idea of substitution at the margin, so instruments of conventional economic analysis apply. He notes that a firm's interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur … who directs production.” He asks why alternative methods of production (such as the price mechanism and economic 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 supersession of the price mechanism." Coase identifies some reasons why firms might arise, and dismisses each as unimportant:

1. if some people prefer to work under the direction and are prepared to pay for the privilege (but this is unlikely);
2. if some people prefer to direct others and are prepared to pay for this (but generally people are paid more to direct others);
3. 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 asymmetric information and asset specificity, may be considerable.

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 trust. 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 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]

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 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 behavior 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 (e.g., Spence and Zeckhauser[20] and Ross (1973)[21] 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 that 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).

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.[24] This causes problems if the assets are owned by different firms (such as 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 transaction 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 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 (e.g. 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.[25]

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 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 Coase's understanding of The Nature of the Firm, as it recognises that transaction costs are a significant factor in a firm's decision to outsource, or internally produce, but also considers other influences specific to firms, such as their relevant capabilities, and governance decisions.[30]

In economic theory, the pros and cons of outsourcing have been discussed since Ronald Coase (1937) asked the famous question: Why is not all production carried on by one big firm?[6] An informal answer has been provided by Oliver Williamson (1979), who has emphasized the importance of different transaction costs within and between firms.[32] The boundaries of the firm (i.e., the distinction between transactions taking place within a firm and transactions between different firms) have been formally studied by Oliver Hart (1995) and his coauthors.[33] According to the property rights approach to the theory of the firm based on incomplete contracting, the ownership structure (i.e., integration or non-integration) determines how the returns to non-contractible investments will be divided in future negotiations. Hence, whether or not outsourcing an activity to a different firm is optimal depends on the relative importance of the investments that the trading partners have to make. For instance, if only one party has to make an important non-contractible investment decision, then this party should be owner.[34][12] However, the conclusions of the incomplete contracting theory crucially rely on the specification of the negotiations protocol[35] and on whether or not there is asymmetric information.[36]

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 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.[37] 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, Yochai Benkler further questioned the rigid distinction between firms and markets based on the increasing salience of “commons-based peer production” systems such as open source software (e.g., Linux), Wikipedia, Creative Commons, etc. He put forth this argument in The Wealth of Networks: How Social Production Transforms Markets and Freedom, which was released in 2006 under a Creative Commons share-alike license.[38]

In modern contract theory, the “theory of the firm” is often identified with the “property rights approach” that was developed by Sanford J. Grossman, Oliver D. Hart, and John H. Moore.[39][40] The property rights approach to the theory of the firm is also known as the “Grossman–Hart–Moore theory”. In their seminal work, Grossman and Hart (1986), Hart and Moore (1990) and Hart (1995) developed the incomplete contracting paradigm.[34][12][41] They argue that if contracts cannot specify what is to be done given every possible contingency, then property rights (and hence firm boundaries) matter. Specifically, consider a seller of an intermediate good and a buyer. Should the seller own the physical assets that are necessary to produce the good (non-integration) or should the buyer be the owner (integration)? After relationship-specific investments have been made, the seller and the buyer bargain. When they are symmetrically informed, they will always agree to collaborate. Yet, the division of the ex post surplus depends on the parties’ disagreement payoffs (the payoffs they would get if no ex post agreement were reached), which in turn depend on the ownership structure. Thus, the ownership structure has an influence on the incentives to invest. A central insight of the theory is that the party with the more important investment decision should be the owner. Another prominent conclusion is that joint asset ownership is suboptimal if investments are in human capital.

The Grossman–Hart–Moore model has been successfully applied in many contexts, e.g. with regard to privatization.[42] 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).[43] 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.[44] 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.[45]

• 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. Handbook of Industrial Organization. Vol. 1. pp. 61–133. doi:10.1016/S1573-448X(89)01005-8. ISBN 9780444704344.
• Robé, Jean-Philippe (31 January 2011). "The Legal Structure of the Firm". Accounting, Economics, and Law. 1 (1). doi:10.2202/2152-2820.1001. 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. doi:10.1257/aer.20130232. S2CID 4929270.

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• 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. doi:10.1257/jep.25.2.181. JSTOR 23049459. S2CID 55679839.