A Mengerian theory of the firm.

In an interesting article in Studies in Emergent Order, Aidan Walsh offers up A Mengerian theory of the origins of the business firm. The analogy is to Menger's theory on how money came into being. Walsh writes,

How could an ‘invisible hand explanation’ (Nozick 1974: 19; Haller 2000) allow us to conjecture a theory of the origins of the business firm? Again, we should approach the problem step by step. However, the problem is more complex, and the solution less visible, than the bilateral problem solved by money.

Step 1. The market order.

We have seen above that a market order arises spontaneously. As we have also seen, it arises naturally, spontaneously, because individuals follow certain common rules of behaviour. The larger this market order becomes, the more people that it involves, generally, the greater prosperity involved. Therefore, there is always the general tendency for a market to grow in size until, as we have now, one market encompassing nearly all of humanity.

Step 2. The problem.

But there is a problem resulting from this extended market order. Hayek argued that in the extended market order that the common rules of behaviour must become ‘attenuated’, that is they must be thinned out as compared to the rules of a small tribe where, for example, everyone is known to everyone else and everyone owes intricate duties to everyone else:

‘This application of the same rules of just conduct to the relations to all other men is rightly regarded as one of the great achievements of a liberal society. What is usually not understood is that this extension of the same rules to the relations to all other men (beyond the most intimate group such as the family and personal friends) requires an attenuation of at least some of the rules which are enforced in the relations to other members of the smaller group. If the legal duties towards strangers or foreigners are to be the same as those towards the neighbours or inhabitants of the same village or town, the latter duties will have to be reduced to such as can also be applied to the stranger. No doubt men will always wish to belong also to smaller groups and be willing to assume greater obligations towards self-chosen friends or companions… A system of rules intended for an Open Society and, at least in principle, meant to be applicable to all others, must have a somewhat smaller content than one to be applied in a small group.’ (Hayek 1976: 88ff)

It is not central to this discussion whether the rules of the Open or Great Society are more attenuated than in a small tribe (although, it is submitted that this is true), more important is the fact that the rules are common to all. This fact alone creates a problem. Individuals solve problems by following the rules. Different cultures have different rules and so will be guided in different ways: ‘Since different values legitimate different objectives, and different objectives generate different kinds of problem[s], societies with different cultures will tend to focus on distinctive types of problem solving. “Learning by doing” is an important aspect of problem solving and so learning effects will give each culture a distinctive type of problem-solving expertise.’ (Casson 1995: 89) It may be that an extended market order creates a problem. If everyone in a market order follows the same rules, then there may only be a limited number of ways that any problem may be solved, only a limited range of options may appear to be open, open options may appear to be closed and so on. (Heiner 1983; Witt 1998, 1999; see also Loasby 2007)

Step 3A. The solution.

‘This difficulty would have been insurmountable, and would have seriously impeded progress in the division of labour, and above all in the production of goods for future sale, if there had not been … a way out.’ (Menger 2007: 258) This way out may have been for an entrepreneur to see or realise that individuals are capable of following different rules in different ‘settings’; by noticing say the behaviour of a company of soldiers or a community of religious.

The entrepreneur has a ‘notion’ (Witt 1999), that, for example, pins can be produced more cheaply his or her ‘way’ than the methods in the larger market order. So the entrepreneur, who ‘must be a natural leader of men’, (Marshall quoted in Streissler 1990: 58) like a general, a Wallenstein (Roscher quoted in Streissler 1990: 58), ‘a cognitive leader’ (Witt 1999, 2000, Ioannides 2003a) convinces others that his or her ‘way’ is a good way to produce pins. Of course, this ‘way’ requires that all the individuals involved follow rules of behaviour that are different, to a greater or lesser extent, to the rules in the larger market order. Furthermore, the entrepreneur may not articulate his ‘way’ in terms of rules or in terms of rule-following behaviour. He or she may clearly envisage a ‘process’ or, more likely, the goal may be still quite vague, and he or she may just tell the other individuals to ‘do what I say’ or ‘follow what I do’.

Step 3B: The solution.

Simultaneously with Step 3A, other individuals make choices and act; they have their goals, but realise that they can, also, only achieve them indirectly. These individuals realise that, in the long or the short term, their self-interest is served best if they do not sell their services, directly, into the larger market order. Instead, he or she realises that if they participate, if they commit, to the sometimes new but always changing order, outside of the market, in a firm that they may obtain benefits that they might not obtain in the larger market order and bring themselves closer to their personal goals. In fact, an entrepreneurial notion may fail because no person may believe that their personal goals can be best achieved directly or indirectly through committing to a particular entrepreneur’s firm. (Witt 1999)

One reason an individual may wish to become an employee is that it allows that individual the opportunity to convert what might otherwise not be an economic good into an economic good. (The individual is, of course, unconscious of this directly but is conscious of the higher remuneration available in a firm, particularly early in a career, and the individual also, as Hayek pointed out, may have a preference for assuming greater obligations towards certain self-chosen companions.) That good, that might otherwise not be an economic good, is the ability of humans to follow complex and usually tacit rules and the ability to follow different rules in different ‘settings’. We are all entrepreneurs in selling our labour; it is natural that individuals would seek, even if unconsciously, a return on all their assets, including the ability to follow complex, tacit, rules of behaviour and the ability to follow different rules in different settings.

Step 4: A further refinement of the solution.

Over time, under the powerful influence of custom, establishing firms, becoming an employer or an employee become well-established behaviours. Thus firms become common in the economy. The skills to manage and control employees in firms become more widespread – skills like double-entry bookkeeping or even reading and writing. In addition, often the habits and practices that are required of employees in a firm become widespread in the larger market order; for example, punctuality.

Step 5: The influence of the state.

There may be one final step in the origin of the firm: within the boundaries of a state, the legal order usually has an influence on the character of the firm which, though small, cannot be denied. ‘A firm’ – it is submitted is an order created by the rule following behaviour of individuals (rules different to the rules in the larger market order) to achieve some purpose, however vague. Firms are, by this definition, larger than the cognitive abilities of any one individual to create, survey or control. The legal personality of the firm may have somewhat blinded observers; Sautet is right and the ‘firm can be seen as a pulling together of entrepreneurial activity by a central entrepreneur… the essence of the firm, in that context, is coordination rather than ownership.’ (Sautet 2000: 134)

However, there is no doubt that the legislative acts of a state can improve the character of firms in many ways and can improve the chances that firms will be created and that the individuals in them will prosper. However, this does not mean that one can go too far in looking for a role of the state in the origin of the firm: firms are not an invention of the state. But the state can have a role, when the firm has already emerged as an economic institution. For example, individuals may be more inclined to establish a firm when there is limited liability and individuals may be more inclined to become employees of a legal fiction than of a particular individual.