100 years of the theory of the firm. Or may be only 50.

Depending on how you pick your starting point there has been, roughly, 50 or 100 years of the mainstream economic theory of the firm.

In support of the 100 years view it has been argued that the mainstream approaches to the firm began in 1921. This (minority) view is succinctly expressed by Harold Demsetz

“[ … ] it can be said without hesitation that Knight launched the modern theory of the firm in 1921” (Demsetz 1988: 244).

The more commonly accepted 50-year position is that the theory of the firm did not begin until the 1970s, with the advent of the Coaseian-based approaches to the firm. 

But even if the earlier starting date is accepted, it must be said that the period 1920 to 1970 is something of a ‘dark age’ for the theory of the firm. It is largely one of missed opportunities with just two works contributing to the way mainstream economists think about the firm today. Knight (1921) and Coase (1937) can be seen as ‘precursors’ to the modern theories of the firm while the theories developed from these precursors represent the ‘opportunities taken’. The ‘opportunities taken’, including the transaction cost approach, the principal agent approach, the incomplete contracts approach and the reference point approach, all of which started to develop post-1970.

Those works which apply the division of labour to the theory of the firm (more correctly, to the theory of firm-level production) as well as the partial models of the firm arising from the ‘rationalisation’ debate along with Plant (1937) and Malmgren (1961) are part of the ‘opportunities missed’ from the 1920 to 1970 period.

Despite the division of labour being a very old idea in economics, dating from at least the ancient Indians, Greeks and Chinese, it took more than two thousand years for it to give rise to a theory of production, but it has not generated a genuine theory of the firm. Following on from the ancient scholars, in the medieval period both Islamic and Christian theologians and philosophers analysed the concept, and consequences, of the division of labour. The pre-classical, classical and neoclassical economists continued and expanded the enquiry, but all without applying the division of labour to the theory of the producer or the firm. One possible exception to this rule is Adam Smith. Zouboulakis (2015) argues that Smith’s discussion of the division of labour does offer an elementary explanation for the existence of firms. In Zouboulakis’s view of Smith the existence of firms is explained through division of labour dynamics. As the market grows more firms are created and they become larger thereby employing more labour and capital and thus there is an increase in specialisation and the division of labour. This in turn increases efficiency and productivity which increases general economic wellbeing.

It was not until the 20th century that a division of labour-based theory of production finally appeared. In the 1920s Lawrence Frank saw an increasing division of labour as giving rise to the vertically integrated producer. In the 1930s E. A. G. Robinson argued that the division of labour affected the size of the producer due to its effects on production technology and management. By the 1950s George Stigler was arguing that the size of the producer was limited by the division of labour due to the division of labour being limited by the extent of the market. In the 1990s Gary Becker and Kevin Murphy saw the size of the producer as being limited not just by the size of the market but also, more often, by coordination costs. In 2018 Michael Rauh showed that the division of labour, which translates to the size of the producer, can be, depending on circumstances, limited by the extent of the labour market, moral hazard or an ‘O-ring’ property. In this paper Rauh utilises a stochastic or ‘O-ring’ production function. Importantly with an O-ring production function, if one part of the production process fails, the whole process fails.

But despite this, belated, interest in the division of labour, within the contemporary mainstream economics literature the division of labour is still very much a minority approach to the analysis of production and has had no impact on the mainstream theory of the firm.

Concerning ‘rationalisation’ Cristiano (2015: 601) explains,

"[i]t was associated with the idea that it was possible to reduce average costs per unit of output by means of larger firms without necessarily incurring the problem of monopoly power—an idea that enjoyed wide circulation in the British press at that time. Henry Clay (1929, p. 171) wrote that rationalization “implies industrial combination with the object of securing not monopoly prices, but certain productive economies". Writing about the situation in Lancashire in 1926, John Maynard Keynes sympathized with ``what the Germans are calling `rationalisation', that is, the concentration of demand on the most efficient plants, which are worked at full stretch and the rest closed down" (1971–89, XIX, p. 579; hereinafter CWK ); "a `rationalising' process designed to cut down overhead costs by the amalgamation, grouping or elimination of mills'' ( CWK, XIX, p. 584)".

During the rationalisation debate, Lavington (1927) and Robinson (1931) argued that the size of the firm is determined by a trade-off between increasing returns to scale and decreasing returns to management. However, these are only partial models of the firm because there is no recognition of the need for transaction costs in the models.

Plant (1937) made a notable, and most surely underrated, contribution to the theory of the firm. The paper is usual for its time in that it made a notable contribution to the theory of organisations before the 1970s renaissance of the theory of the firm. Plant’s ‘Centralize or Decentralize?’ furnished detail and content for several aspects of Coase’s arguments where those facets were left underdeveloped by Coase. 

It is a contribution in which, for example, the “[ . . . ] discussion provides more empirical content than Coase regarding the costs of using the price system and the results on firm size [ . . . ]” (Boudreaux and Holcombe 1989: 149). In Robert Hébert and Albert Link’s view, Plant develops a transaction cost approach to the firm independently of Coase. 

“A “transaction costs” approach to the firm was pioneered independently by Plant (1937), who attempted to explain why firms become centralized or decentralized” (Hébert and Link 2006: 383).

 Carlo Cristiano also sees transaction cost arguments in Plant’s work, 

“[t]he concept of a cost in using the market, along with the idea that business size depends on the balance between this cost and coordination costs, is implicit but nonetheless rather clear in Plant’s argumentation” (Cristiano 2015: 610). 

All this is no mean feat. 

And yet today we see no ‘Plantian’ research agenda. Plant’s work has been ignored in the history of the theory of the firm.

Malmgren (1961) provided the first amplification of Coase’s analysis in his ‘The Nature of the Firm’ paper. 

Malmgren’s primary sources of insight came from the works of Coase, Hayek, Richardson and Penrose. Lise Arena argues that 

“[h]is contributions favoured a multi-disciplinary approach, incorporating ideas not only from economics, but also from organisational theory, game theory and information theory” (Arena 2021: 88).

 Klaes (2000) argues that Malmgren was the first person to associate Coase’s analysis with the idea of transaction costs. 

“Malmgren (1961) was also the first to link Coase (1937) with the notion of transaction costs. It appears that Malmgren broadly adopted Coase’s general strategy of analysing the nature of the firm. However, while Coase focused predominantly on the costs of organizing transactions across the market, while following closely the reasoning of Kaldor (1934) and Robinson (1934) regarding internal limits to firm size, Malmgren predominantly sought to exploit Marschak’s theory of information for the analysis of internal organization” (Klaes 2000: 571, footnote 10).

 Malmgren combined the ideas of Coase, Hayek, Richardson and Penrose in such a way as to be able to examine ideas which have only begun to be examined in the mainstream theory of economic organisation in recent times.

 Three central contributions have been identified in Malmgren’s work (Foss 1996: 349).

 1.  Malmgren ‘operationalised’ the Coaseian approach to the theory of the firm. He ‘operationalises’ - in the sense of Williamson (1985) – the Coaseian approach insofar as he analyses the determines of transaction costs which is something Coase did not investigate in any depth. Transactions within the firm may be less costly than across the market because of the firm’s ability to control information. Firms can provide ‘precedents’ and ‘customs’ which can act as a focal point which eliminates divergence of expectations. Thus ‘intra-firm’ transactions are less costly than ‘inter-firm’ transactions.

“Not only are a number of events predictable over the duration of the entire production plan, but also less information is required to describe that set of events for control purposes [ . . . ] operating rules of quite simple nature replace a more thorough analysis of every possible transaction which might arise in market determined allocation of resources over the set of activities which make up the firm”. (Malmgren 1961: 404).

 2. Malmgren also managed to combine contractual and knowledge-based approaches to the firm and

 3. Also he took an economic approach to notions such as ‘business culture’ which are still not well theorised.

Malmgren argued that if agents shared a common ‘business culture’ or ‘firm-specific mental constructs’ (Foss 1997: 192) (sometimes also referred to as ‘corporate culture’ (Cremer 1990) or ‘models of the world’ (Marengo 1995)) then getting the incentives right was the main objective of organisational design. But if different sections of a firm differ in their understanding of a given message, then creating a common knowledge base and getting a uniform ‘business culture’ so that everyone is on the same page becomes the major organisational objective. That is, Malmgren saw that the coordination of the within-the-firm division of knowledge required a shared ‘corporate culture’.

Along with this Malmgren’s work suggests it could be possible to construct an opportunism-free approach to the theory of the firm, something not contemplated in the economic mainstream even today. Malmgren’s approach sees firms as not as institutions that align incentives, but rather as organisations that control information. So while he takes an overall Coaseian approach it is something of a variation on the Coasian theme and a different variation from that of other later Coaseian followers.

That the firm is different from the market, in Malmgren’s framework, is because of its ability to store knowledge and simulate learning. Firms exist because they can more efficiently solve knowledge-related problems than can the market. The pooling of information in the firm lowers the cost ‘of discovering what the relevant prices are’ and the providing of ‘ ‘precedents’and ‘customs’ which can act as a focal point’ can help ‘complete’ the missing clauses in a long, (incomplete) open-ended employment contract. Thus firms save on information and transaction costs relative to the market. This provides an incentive to create firms.

But, Coase (1937) and Knight (1921) aside, all this post-1920 work has been to no avail as it has not been applied to modern mainstream thinking to do with the theory of the firm. This work represents ‘opportunities missed’ so that the first 50 years of the 1920-2020 period resulted in little of importance being contributed to the theory of the firm.

It had to wait until the 1970s before the theory of the firm took off. It was only post-1970 that the importance of Coase (1937) and Knight (1921) was recognised and the development of the contemporary theory of the firm got underway. 

So counting from 1970, there has only been 50 years of the theory of the firm.

References:

• Arena, Lise (2021). Oxford’s Contributions to Industrial Economics from the 1920s to the 1980s. In Robert A. Cord (ed.), The Palgrave Companion to Oxford Economics (pp.75-100), Cham, Switzerland: Palgrave Macmillan.
• Boudreaux, D. and R. Holcombe (1989). `The Coasian and Knightian Theories of the Firm', Managerial and Decision Economics, 10(2) June: 147-54.
• Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4 no. 16 November: 386-405.
• Crémer, Jacques (1990). ‘Common Knowledge and the Coordination of Economic Activities’. In Masahiko Aoki, Bo Gustaffson and Oliver E. Williamson (eds.), The Firm as a Nexus of Treaties (pp. 53-76), London: Sage.
• Cristiano, Carlo (2015). `Theories of the Firm in England Before Coase: Stemming the Tide of `Rationalization' on the Eve of The Nature Of The Firm ', Journal of the History of Economic Thought, 37(4) December: 597-614. 
• Demsetz, Harold (1988). ‘Profit as a Functional Return: Reconsidering Knight’s Views’. In Harold Demsetz, Ownership, Control, and the Firm: The Organization of Economic Activity, (vol. I pp. 236-47), Oxford: Basil Blackwell.
• Foss, Nicolai J. (1996). ‘Harald B. Malmgren’s Analysis of he Firm: lessons for modern theorists?’, Review of Political Economy, 8(4): 349-66.
• Foss, Nicolai J. (1997). ‘Austrian insights and the theory of the firm’. In Advances in Austrian Economics (Advances in Austrian Economics, Vol. 4, pp. 175-98), Bingley: Emerald Group Publishing Limited.
• Hébert, Robert F. and Albert N. Link (2006). `Historical Perspectives on the Entrepreneur', Foundations and Trends in Entrepreneurship, 2(4): 261-408.
• Klaes, Matthias (2008). ‘Transaction Costs, History Of’. In Steven N. Durlauf and Lawrence E. Blume (eds.), The New Palgrave Dictionary of Economics, 2nd edn., Basingstoke: Palgrave Macmillan.
• Knight, Frank H. (1921). Risk, Uncertainty and Pro t, Boston: Houghton Mifflin Company.
• Lavington, F. (1927). `Technical Influences on Vertical Integration', Economica, 7 (No. 19) March: 27-36.
• Malmgren, H. B. (1961). `Information, Expectations and the Theory of the Firm', Quarterly Journal of Economics, 75(3) August: 399-421.
• Marengo, L.(1995). ‘Structure, Competence, and Learning in Organizations?’, Wirtschaftspolitische Bläter, 42(6): 454-64. 
• Plant, Arnold (1937). `Centralize or Decentralize?'. In Arnold Plant (ed.), Some Modern Business Problems: A Series of Studies (pp. 3-33), London: Longmans, Green and Co.
• Robinson, E. A. G. (1931). The Structure of Competitive Industry, London: Nisbet & Co.
• Williamson, Oliver E. (1985). The Economic Institutions of Capital ism, New York: The Free Press.
• Zouboulakis, Michel S. (2015). ‘Elements of a theory of the firm in Adam Smith and John Stuart Mill’. In George C. Bitros and Nicholas C. Kyriazis (eds.), Essays in Contemporary Economics: A Fests chrift in Memory of A. D. Karayiannis (pp. 45-52), Heidelberg: Springer.