Friday, 14 August 2009

Just for fun: the theory of the firm 6

The neoclassical theory of the firm. The only model of the "firm" that most students meet and that found in most microeconomic textbooks, isn't a "theory of the firm" in any meaningful sense. The output side of the standard neoclassical model is a theory of supply rather than a true theory of the firm. In neoclassical theory, the firm is a 'black box' there to explain how changes in inputs lead to changes in outputs. It is a black box in the sense that inputs go in and outputs come out, without any explanation of how one gets turned into the other. The firm is taken as given; no attention is paid to how it came into existence, the nature of its internal organisation, where the boundary between one firm and another is or between a firm and the market; or whether anything would change if two firms merged and called themselves a single firm. The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who place their inputs in the highest value uses, and makes sure that production is separated from consumption. The firm produces only for outsiders, there is no on-the-job or internal consumption, no self-sufficiency. In fact there are no managers or employees to indulge in on the job consumption and as production is separated from consumption, no self-sufficiency. Production for outsiders is, according to Demsetz (1995), the definition of a firm in the neoclassical model:
"[w]hat is needed is a concept of the firm in which production is exclusively for sale to those formally outside the firm. This requirement defines the firm (for neoclassical theory), but it has little to do with the management of some by others. The firm in neoclassical theory is no more or less than a specialized unit of production, but it can be a one-person unit" (Demsetz 1995: 9).
As inputs are combined in the optimal fashion by the actions of independent owners of inputs motivated solely by market prices, there is no need for `management of some by others', there is no role for managers or employees. Also note that as competition assures the absence of profits and losses in equilibrium, there is no need to have a residual claimant. This means that, in one sense at least, there are no owners of the firm. Hansmann (1996), for example, states
"[a] firm's "owners," as the term is conventionally used and as it will be used here, are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm's profits, or residual earnings (that is, the net earnings that remain with the firm after it has made all payments to which it is contractually committed, such as wages, interest payments, and prices for supplies)." (page 11)
He later adds
"[n]ot all firms have owners. In nonprofit firms, in particular, the persons who have control are barred from receiving residual earnings." (page 12).
As there are no physical assets controlled by the firm, there are no (residual) control rights over these assets to allocate. This implies there are no owners of the firm in the Grossman Hart Moore sense.

The neoclassical production function is a way of representing the (efficient) black box conversion of inputs into outputs but tells us little about the inner workings of the black box. The production function is independent of the institutional framework of output creation. It can be given two interpretations: it can represent the production method of a single firm, of which all known firms are just divisions or, equally, it could represent the outcome of a series of purely market based transactions which give rise to the observed outputs. Thus it represents the 'firm' without explaining the 'firm'. The boundaries of the firm is an issue described by Williamson (1993: 4) as one of
"[...] make-or-buy. What is it that determines which transactions are executed how? That posed a deep puzzle for which the firm-as-production function approach had little to contribute."
Hart (1995: 17) criticises the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores incentive problems within the firm. The firm is a perfectly efficient `black box'. Second, the theory has nothing to say about the internal organisation of the firm. Nothing is said about the hierarchical structure, how decisions are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as much a theory of plant or division size as firm size. As Hart points out
"[t]o put it in stark terms [...] neoclassical theory is consistent with there being one huge firm in the world, with every existing firm [...] being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm" (Hart 1995: 17).
Cyert and Hedrick (1972) addressed similar points. They argue that in the neoclassical system the firm doesn't exist, that no real world problems of firms are considered, that there are no organisational problems or any internal decision-making process at all.
"In one sense the controversy over the theory of the firm has arisen over a non-existent entity. The crux of microeconomics is the competitive system. Within the competitive model there is a hypothetical construct called the firm. This construct consists of a single decision criterion and an ability to get information from an external world, called the "market" [8, Cyert and March, 1963, pp. 4-16]. The information received from the market enables the firm to apply its decision criterion, and the competitive system then proceeds to allocate resources and produce output. The market information determines the behavior of the so called firm. None of the problems of real firms can find a home within this special construct. There are no organizational problems nor is there any room for analysis of the internal decision-making process" (Cyert and Hedrick 1972: 398).
Thus within the neoclassical model of the price system, the firm's only role is to allow input owners to convert inputs into outputs in response to market prices. Firms have no internal organisation since they have no need of one, they have no owners since there is nothing to own. Questions about the existence, definition and boundaries of the firm are to a large degree meaningless within this framework since firms, by any meaningful definition of that term, don't really exist. As Foss, Lando and Thomsen (2000: 632) summarise it:
"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist" (Foss, Lando and Thomsen 1998: 1-2).
Another way to think of why the neoclassical firm is just a phantom is follow Coase (1937) and note that the neoclassical model in one of zero transaction costs, and as Martin Ricketts has noted,
"If market transaction were costless there would be no rationale for the existence of firms." (Ricketts 1999: 50, note 15)
Given there is no serious modelling of the firm within the neoclassical framework it is not surprising that there are no organisational problems or any internal decision-making process, in fact, that there is no organisational structure at all. And thus there is no role for managers, employees or owners. There are no boundaries to the firm, we can't say where one "firm" begins or ends or where firms end and markets begin because they are all one and the same. In short, there are no firms.


  • Coase, Ronald Harry (1937). 'The Nature of the Firm', Economica, n.s. 4 no. 16 November: 386-405.
  • Cyert, Richard M. and Charles L. Hedrick (1972). 'Theory of the Firm: Past, Present, and Future; An Interpretation', ournal of Economic Literature, 10(2) June: 398-412.
  • Cyert, Richard M. and James G. March (1963). A Behavioral Theory of the Firm, Englewood Cliffs, New Jersey: Prentice-Hall, Inc.
  • Demsetz, Harold (1995). The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press.
  • Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
  • Hansmann, Henry (1996). The Ownership of Enterprise, Cambridge, Mass.: Harvard University Press.
  • Hart, Oliver D. (1995). Firms, Contracts, and Financial Structure, Oxford: Oxford University Press.
  • Ricketts, Martin (1999). The Many Ways of Governance: Perspectives on the control of the firm, London: The Social Affairs Unit.
  • Williamson, Oliver E. (1993). 'Introduction'. In Oliver E. Williamson and Sidney G. Winter (eds.), he Nature of the Firm: Origins, Evolution, and Development, New York, Oxford: Oxford University Press.

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