Just for fun: the theory of the firm 7

A very brief, biased and incomplete history of the theory of the firm. While the theory of the firm has existed for only 70-80 years, in practice firms have existed for several thousand years. In fact Spulber (2008: 5, footnote 8) gives the origin of the word 'firm' as

"The word "firm" derives from the Latin word "firmare" referring to a signature that confirmed an agreement by designating the name of the business."

Silver (1995: 50) notes that

"[p]rivate firms [...] were prominent in late-third-millennium Akkad (the region south of Baghdad), in the Old Assyrian trade with Cappadocia [...] and, somewhat later, at Nippur. In the mid-second millennium the firm of Tehip-tilla played a major role in the real estate transactions and other business activities at Nuzi. A list of about the some time from Alalakh in northwest Syria refers to sixty-four firms participating in leatherworking, jewellery, and carpentry."

Sobel (1999: 21) points out that during the Roman Republic contracting out of economic activities to private firms was the norm:

"[t]he republican Senate left virtually all economic activities to private individuals and companies, known collectively as the publicani. Tax collection, supplying the army, providing for religious sacrifices and ceremonies, building construction and repair, mining, and so on were all contracted out. There was even a contract for summoning the assembly in session and one for feeding the sacred geese."

Micklethwait and Wooldridge (2003: 4) also note the private nature of tax collection in Rome, pointing out that companies were formed for this, and other, purposes:

"[t]he societates of Rome, particularly those organized by tax farming publicani, were slightly more ambitious affairs. To begin with, tax collecting was entrusted to individual Roman knights; but as the empire grew, the levies became more than any one noble could guarantee, and by the Second Punic War (218-202 b.c.), they began to form companies - societates - in which each partner had a share. These firms also found a role as the commercial arm of conquest, grinding out shields and swords for the legions. Lower down the social scale, craftsmen and merchants gathered together to form guilds (collegia or corpora) that elected their own managers and were supposed to be licensed."

The firm, it appears, is such an old and obvious feature of the economic landscape that it has tended to be overlooked by economic theory. The dichotomy between theory and practice could not be more stark. One reason for the firm to be overlooked is that for a long time economists saw the internal workings of the firm to be outside the competence of economists. Arthur Pigou wrote:

"[...] it is not the business of economists to teach woollen manufacturers to make and sell wool, or brewers how to make and sell beer, or any other business men how to do their job. If that was what we were out for, we should, I imagine, immediately quit our desks and get somebody - doubtless at a heavy premium, for we should be thoroughly inefficient - to take us into his woollen mill or his brewery." (Pigou 1922: 63-4).

Lord Robbins argued similarly that

"[t]he technical arts of production are simply to be grouped among the given factors influencing the relative scarcity of different economic goods. The technique of cotton manufacture [...] is no part of the subject matter of economics [...]" (Robbins 1932: 33).

Foss and Klein (2005: 6-7) argue that there is the possibility of an empirical reason for the neglect of the firm; the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. But they also point out that such an explanation is not wholly convincing. Large firms have existed since before the time of Adam Smith and the classical economists knew this. A more precise, and defendable, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently. Thus analysing anonymous "firms" may not have been a bad approximation to the empirical realities of the time.

It is only in more recent times that the firm has attracted attention as an important part of the economic system. As Foss, Lando and Thomsen (2000: 632) note:

"It is only relatively recently, in other words, that economists have felt the need for an economic theory addressing the reasons for the existence of the institution known as the (multi-person) business firm, its boundaries relative to the market, and its internal organization - to mention the issues that are generally seen as the main ones in the modern economics of organization [...] ".

Many would date the beginning of a serious theory of the firm as recently as Knight (1921) or Coase (1937), rather than to either the classical school or the neoclassical revolution. O'Brien (1984: 25) takes a contrary position:

"Serious discussion of the history of the theory of the firm has to start with Alfred Marshall." O'Brien's argument is based, in the main, on Marshall (1920). O'Brien also argues that developments subsequent to Marshall have resulted in many of Marshall's insights being lost to succeeding generations of economists. We would therefore argue that Marshall has left little in the way of a legacy in terms of the mainstream theory of the firm. In addition to his views on Marshall's work and later developments O'Brien also argues that any "attempt to construct a pre-Marshallian theory from the materials available is likely to be unsuccessful."

See, however, Williams (1978) for such an attempt. On the neglect of Marshall's 'Industry and Trade' (Marshall 1920) see also Liebhafsky (1955). The development of the "theory of the firm" from Marshall to Robinson and Chamberlin is also dealt with in Moss (1984).

Before the contributions of Knight and Coase, we had discussions of pin factories, but the discussion was about the importance of the division of labour rather than being an 'enquiry into the nature and causes of the firm'. McNulty (1984: 237-8) comments

"Having conceptualized division of labor in terms of the organization of work within the enterprise, however, Smith subsequently failed to develop or even pursue systematically that line of analysis. His ideas on the division of labor could, for example, have led him towards an analysis of task assignment, management, or organization". Such an approach would have foreshadowed the much later-indeed, quite recent-effects in this direction by Herbert Simon, Oliver Williamson, Harvey Leibenstein, and others, a body of work which Leibenstein calls "micro-micro economics". [...] But, instead, Smith quickly turned his attention away from the internal organization of the enterprise, and outward toward the market and the realm of exchange, perhaps because he found therein both the source of division of labour, in the "propensity in human nature [...] to truck, barter and exchange" and its effective limits."

As has been pointed out by Demsetz (1982, 1988 and 1995) before Knight and Coase - and it could be added for much of the period after them - the fundamental preoccupation of economists was with the price system and hence little, or no, attention was paid to either the firm or the consumer as separate, important, economic entities. Firms (and consumers) existed as handmaidens to the price system.

The interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. Butler (2007: 25-6) briefly sums up mercantilism in the following way:

"[...] it measured national wealth in terms of a country's stock of gold and silver. Importing goods from abroad was seen as damaging because it meant that this supposed wealth must be given up to pay for them; exporting goods was seen as good because these precious metals came back. Trade benefited only the seller, not the buyer; and one nation could get richer only if others got poorer. On the basis of this view, a vast edifice of controls was erected in order to prevent the nation's wealth draining away - taxes on imports, subsidies to exporters and protection for domestic industries. [...] Indeed, all commerce was looked upon with suspicion and the culture of protectionism pervaded the domestic economy too. Cities prevented artisans from other towns moving in to ply their trade; manufacturers and merchants petitioned the king for protective monopolies; labour saving devices such as the new stocking-frame were banned as a threat to existing producers."

The free trade versus mercantilism debate was, to a large degree, about the proper scope of government in the economy and the model it gave rise to reflects this. The question implicitly at the centre of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? Adam Smith famously answered "no". Smith

"[...] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' - would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature" (Butler 2007: 27-8).

For Smith, markets are the most prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. For economists, the 200 years following Smith involved a search for conditions under which the price system would not descend into chaos.

The formal (neoclassical) model that arose from this examination is one which abstracts completely from any form of centralised control in the economy. For Smith this would be an abstraction too far. Smith knew of the importance of institutions to the proper functioning of the market economy. Mark Blaug points out

"[...] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect \`{a} la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income." (Blaug 1996: 60-1).

It is a model delineated by "perfect decentralisation". Authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets - prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. This includes, of course, the firm. It doesn't matter whether it is the general equilibrium version of the neoclassical model, characterised by Walras's auctioneer, or the partial equilibrium version, characterised by Marshall's representative firm, there is no serious consideration given to the firm as a problem solving institution. The exact role of the theory of the firm in price theory has been the subject of some confusion. Fritz Machlup has argued:

"[m]y charge that there is widespread confusion regarding the purposes of the ``theory of the firm" as used in traditional price theory refers to this: The model of the firm in that theory is not, as so many writers believe, designed to serve to explain and predict the behavior of real firms; instead, it is designed to explain and predict changes in observed prices (quoted, paid, received) as effects of particular changes in conditions (wage rates, interest rates, import duties, excise taxes, technology, etc.). In this causal connection the firm is only a theoretical link, a mental construct helping to explain how one gets from the cause to the effect. This is altogether different from explaining the behavior of a firm. As the philosopher of science warns, we ought not to confuse the explanans with the explanandum." (Machlup 1967: 9).

Despite the pioneering efforts of Knight (1921) and Coase (1937), the neoclassical model held sway, in mainstream economics, up until the 1970s. It was only then that serious attention began to be payed to the firm. Work by Oliver Williamson (see, for example, Williamson (1971, 1973, 1975)), Alchian and Demsetz (1972) and Jensen and Meckling (1976) were among the main driving forces behind this upswing in interest.

Foss, Lando and Thomsen (2000: 634) classify the mainstream post-1970s economics literature on the theory of the firm into two general groups:

1. Principal-agent type models where agents can write comprehensive contracts characterised by ex ante incentive alignment under the constraints imposed by the presence of asymmetric information.
2. Incomplete contracts models which are based on the idea that it is costly to write contracts and thus contracts will have holes, and therefore there is a need for ex post governance.

This division can be seen as resulting from the breaking of two different assumptions embedded in the general equilibrium (Arrow-Debreu) version of the neoclassical model. Note that the Arrow-Debreu framework was not originally conceived as a theory of contracting per se, but rather it was seen as an analytical apparatus for modelling competitive equilibrium. But the efficiency properties associated with trade involving complete contingent claims contracts - that is, contracts specifying the price, date, location and physical characteristics of a commodity for every future state of nature - made such contracts the standard against which other, more realistic, contracts are compared. The first group corresponds to the breaking of the assumption that there are no asymmetries of information between parties and thus no principal-agent problems, of either the adverse selection or moral hazard kind. The second grouping results from breaking the assumption that agents can foresee all future contingencies and can costlessly contract on all such eventualities. We discuss each group in turn.

Within the principal-agent classification Foss, Lando and Thomsen (2000: 636-8) identify three sub-groups: 1) the nexus of contracts view, 2) the firm as a solution to moral hazard in teams approach and 3) the firms as an incentive system view.

The nexus of contracts view was developed in papers by Alchian and Demsetz (1972), Jensen and Meckling (1976), Barzel (1997), Fama (1980) and Cheung (1983). The important innovation here was to see that it is difficult to draw a line between firms and markets, firms are seen as a special type of market contracting. What distinguishes firms from other forms of market contract is the continuity of the relationship between input owners.

Most famously in the Alchian and Demsetz version of this approach, they argue that the authority relationship between the employer and employee is in no way the defining characteristic of a firm. The employer has no more authority over an employee than a customer has over his grocer. "Firing", of either the employee or grocer, is the ultimate punishment that either the employer or customer can use in cases of "disobedience". Alchian and Demsetz argue that, in economic terms, the customer "firing" his grocer is no different from the employer firing his employee. In both cases one party stops dealing with the other, terminating the "contract" between them. In this approach the firm is seen as little more than a nexus of contracts, special in its legal standing and characterised by long term nature of the relationship between the input owners. In this approach it is not generally useful to talk about firms as distinctive entities, a nexus of contracts could be called more firm-like if, for example, the residual claimants belong to a concentrated group but the term "firm" has little meaning beyond this.

Roberts (2004: 104) responds to this line of argument:

"While there are several objections to this argument, we focus on one. It is that, when a customer "fires" a butcher, the butcher keeps the inventory, tools, shop, and other customers she had previously. When an employee leaves a firm, in contrast, she is typically denied access to the firm's resources. The employee cannot conduct business using the firm's name; she cannot use its machines or patents; and she probably has limited access to the people and networks in the firm, certainly for commercial purposes and perhaps even socially."

The second grouping, the "firm as a solution to moral hazard in teams approach", was developed by Alchian and Demsetz (1972) and Holmstrom (1982). Alchian and Demsetz (1972) extend their discussion by noting that the firm is more than just a special legal arrangement, it is also characterised by team production. The problem that arises here is that with team production, the marginal products of the individual members of the team are hard to measure. This means that free-rider behaviour is now possible since team production can act as a cover for shirking. The Alchian and Demsetz solution is to give the right to hire and fire the members of the team to a monitor who observes the employees and their marginal products. To ensure that the efficient amount of monitoring takes place, the monitor is given the rights to the residual income of the team.

Holmstrom (1982) looks at the incentive problems to do with monitoring and identifies possible solutions. Holmstrom assumes that the members of the team each take actions which are unobservable to the monitor but the overall result of the combined actions is observable. What Holmstrom shows is that it is only under very restrictive assumptions that the monitor can ensure that efficient effort levels will be provided by each team member. The way the monitor would ensure this is to design a sophisticated incentive scheme. But Holmstrom shows that given unobservable effort levels, the requirements of the incentive scheme being a Nash equilibrium, budget balancing and Pareto optimality, can not be met. More specifically, a budget-balancing incentive scheme can not reconcile Nash equilibrium and Pareto optimality. This is because each team member will equalise the costs and benefits of extra effort: that is, if the team revenue is increased by the efforts of a single member, that member should receive that revenue to ensure that they are properly motivated. But as the monitor only knows that team revenue has increased and not the effort levels of each individual member, all members of the team would have to each receive the extra revenue to ensure that the hard working member is rewarded for his efforts. But this will, obviously, violate the balanced budget condition. This suggest that there is an advantage, in terms of incentives, in the team not having to balance their budget.

Clearly the role of the "monitor" in the Alchian and Demsetz model is very different to their role in the Holmstrom model. For Alchian and Demsetz, the monitor oversees the behaviour of the team members, in the Holmstrom model, the monitor injects the capital needed so that the team members do not have to balance their budget.

The third subgroup is the "firms as an incentive system view". Early contributors to this approach where Holmstrom and Milgrom (1991, 1994). In Holmstrom and Milgrom (1994) it is stressed that the firm should be viewed as 'a system', that it is a set of contractual relationships which endeavour to mitigate incentive problems. In their view the firm is characterised by a number of factors: 1) the employees do not own the non-human assets of the firm; 2) the employees are subject to a 'low-powered incentive scheme' (see below); and 3) the employer has authority over the employee.

Holmstrom and Milgrom (1991) makes two observations. First, they note that there are a number of ways that an employee can spend their time, many of which can be of value to an employer. But if these multiple activities compete for the worker's attention then the incentives offered for each of the activities must be comparable. Otherwise, the employee will put most effort into those things that are most well compensated and put less effort into the others activities. The second observation relates to the provision of strong incentives to a risk-averse employee. Providing strong financial incentives is costly because it loads extra risk into the worker's pay. In addition, the cost is greater the more difficult it is to measure performance. This means that, other things being equal, tasks where performance is hard to measure should not be given as intense incentives as ones that are more accurately observed. But having low-powered incentives means that the employer needs to be able to exercise authority over the use of the employee's time, since the employee will not have the proper incentives to be productive.

This logic suggest that, conversely, an independent contractor should face the opposite combination of instruments. The choice between the having an employee or using an independent contractor depends on the ability of the principal to measure each dimension of the agent's contribution. Thus, in the Holmstrom and Milgrom approach, measurability of performance is one important determinant of the boundaries of the firm. In addition their approach incorporates the importance of the allocation of property rights to the physical assets in determining incentives via determination of bargaining positions as is the case with the Williamson and Grossman-Hart-Moore approaches.

In the incomplete contracting theories group Foss, Lando and Thomsen (2000: 638-43) identify five subgroups: 1) the authority view, 2) the firm as a governance mechanism, 3) the firm as an ownership unit, 4) implicit contracts and 5) the firm as a communication-hierarchy.

In the authority view, the firm is seen as being defined as an employment relation. This view is most closely associated with Coase (1937) and Simon (1951). For Coase a firm will arise when it is cheaper to carry out a transaction in a firm than it is to do so over the market. Given it costs something to enter into a market contract, that is, there are transaction costs, firms will emerge to carry out what would otherwise be a market transaction when it is cheaper for the firm to handle that transaction. The size of the firm (the boundaries of the firm) will be determined when the cost of organising a transaction within the firm equals the cost of using the market. Coase notes that within the firm contracts are not eliminated but are greatly reduced and the nature of the contract changes. When a factor of production is employed within the firm the contract controlling it is incomplete. The factor (or its owner) agrees, for remuneration, to obey the directions of the manager of the firm, within certain limits. In the last section of Coase (1937), it is noted that the relationship that constitute the firm corresponds closely to the legal concept of the relationship between the employer and employee. Coase explains that direction is the essence of the legal concept of the employment relationship, just as it is for the concept of the firm that he developed.

For Simon (1951) the issue is a comparison of an employment contract against a contract between two autonomous agents. A contract between autonomous agents specifies an action to be taken in the future along with its price while an employment contract specifies a set of acceptable instructions that the employee has to accept if asked to carry them out by the employer. The advantage of the employment contract is its flexibility, the employer does not have to pre-commit to an action and can adapt the choice of action to the state of the world that occurs.

A more modern approach to these issues is Wernerfeld (1997). He compares three alternative governance structures (game forms) for situations where a buyer needs a sequence of human asset services: 1) the hierarchy game form, 2) the price list game form and 3) the negotiation-as-needed game form. Wernerfeld (1997: 490) introduces the game forms with three simple examples:

1. As a typical day unfolds, you learn that you will need several services from your secretary. In principle, the two of you could contract over the provision of each service as its nature becomes clear. However, under such an arrangement you would spend a lot of time negotiating. We therefore have the institution normally called the employment relationship under which the secretary has agreed to supply ex ante unspecified services for a certain number of hours.

2. Consider what happens if a general contractor remodels your house. You may change your mind during construction, but because these adaptations are infrequent they are typically handled through negotiation on an as-needed basis.

3 . Suppose next that you are at H & R Block getting help with your tax return. While at the store, you may realize that you need additional services: there may be more schedules to file or you may want to prepay part of next year's taxes. In this case you know the price of each adaptation ex ante and no new negotiation is needed. Since the number of possible adjustments is small, the price list governs adaptation cheaply.

An employee is defined as someone who sells his services in a specific game form characterised by the absence of bargaining over adaptations to changing circumstances. The firm is seen as consisting of the buyer of human asset services, along with a set of sellers, provided that the human services are traded in the "employment relationship" or "hierarchy" game form. The hierarchy game form is defined as the situation in which the parties engage in once-and-forall wage negotiation, the manager describes desired services sequentially, and either party may terminate the relationship at will. In this model, the boundaries of the firm are given by the set of agents employed by the buyer. Whether one uses the employment relationship or an alternative game form depends on the nature of the expected adaptations. If many diverse and frequent adjustments are needed, the employment relationship involves lower adjustment costs than any of the other governance structures. The price list game form is better when the list of possible adjustments is small and the negotiation-as-needed game form is better when adjustments are needed infrequently.

The second subgroup "the firm as a governance mechanism" is based round the work of Oliver Williamson which I will discuss in more detail in a later posting and so will delay discussion until then. The third subgroup "the firm as an ownership unit" is the Grossman/Hart/Moore approach which I outlined here. That leaves subgroups 4) implicit contracts and 5) the firm as a communication-hierarchy. These I will briefly discuss below.

Implicit contracts: There are many cases where it is difficult, if not impossible, to write complete state-contingent contracts. This is the case when, for example, certain variables are either ex-ante unspecifiable or ex-post unverifiable. In these cases we often see that people often rely on 'unwritten codes of conduct', that is, on implicit contracts. Foss, Lando and Thomsen (2000: 642) explain

The basic idea in the implicit-contract theory of the firm is that implicit contracts may function differently within firms than between firms; a person is hired as an employee rather than as an independent contractor when coordinating with him requires an implicit contract that is easier to implement within the firm than in the market place.

In a recent paper, Baker, Gibbons and Murphy (1997) emphasize that implicit contracts occur both within firms (in the employment relationship) and between firms (‘relational contracting’). The difference lies in the options which are open to the parties if the implicit contract breaks down. Contrary to an independent contractor, an employee cannot leave the relationship with the assets belonging to it. Specifically, in their model, independent contracting is defined by the feature that the supplier has the possibility to sell the finished product elsewhere, while firm-contracting is defined by the supplier (the employee) not owning the finished product and hence not having the option of leaving with the asset or the product. The strength of the threat to leave the relationship determines the implementability of implicit contracts. For example, if the market for the good is volatile, relational contracts are vulnerable since the supplier is tempted to break out from the implicit contract when the market price is high. If the supplier is a division within the firm, this option does not exist and the implicit contract which holds the (internal transfer) price constant may therefore be self-enforcing. The implicit-contract theory is linked with Williamson’s idea that dispute resolution is easier to carry out within a firm than between firms: Mechanisms for dispute resolution can be seen as part of the system of self-enforcing implicit contracting within a firm.

The Firm as a Communication-Hierarchy: An obvious and important requirement for any firm is to adapt to and process new information. The world is ever changing and firms have to adapt or die. Marschak and Radner (1972), is a classic contribution on team-theory which pointed to a completely different approach to economic organization, one in which incentive conflicts were disregarded, or at least assumed to have been solved, and where coordination and communication were highlighted instead. Writers within this approach view the firm as a communication network that is designed to minimize both the cost of processing new information and the costs of communicating this information among agents.

A simple but important point is that communication is costly given that it takes time for people to absorb new information sent to them. But this time usage can be reduced by specializing in the processing of particular types of information.

In Bolton and Dewatripont’s (1994) model, for example, each agent handles a particular type of information, and the different types of information are aggregated through the communication network. When the benefits to specializing outweigh the costs of communication, teams (firm like organizations) arise. (Foss, Lando and Thomsen 2000: 643)

There is a problem here in that the theory of the firm as a communication hierarchy has difficulty explaining the boundary of the firm. An open question is why communication hierarchies cannot exist between firms. However, if this can be given an explanation, that explanation together with the theory of the firm as a communication hierarchy may constitute a theory of the firm.

This potted history has centred on what would be considered the mainstream approaches to the theory of the firm and thus has overlooked a number of non-mainstream contributions. In the pioneers category the work by Malmgren should be mentioned. Malmgren's paper draws on many influences, such as the work of Keynes, Hayek, Penrose and Richardson, As Foss (2000: xxi) puts it

[...] Malmgren (1961) is the first contribution to 1) "operationalize" the Coasian approach to the theory of the firm, 2) suggest that ideas on firm capabilities may be combined with ideas from the contractual approach to the firm, and 3) to treat in economic terms a number of concepts (such as "business culture") the economic analysis of which has begun only recently. Assuredly, addressing each one of these three points would have been a remarkable contribution from somebody writing in 1961; to address all three, and do so in a way that still inspires, is extraordinary.

Penrose (1955/1959) and Richardson (1972), and the knowledge based perspective on the firm that they helped found, are also deserving of mention. There is also the contributions from business history and firm strategy to consider. Alfred D. Chandler's work is a must read. Then there is the Austrian view of the firm, the managerial theories of the firm and the behavioural. All of this tells us there in no generally accepted theory of the firm and that one is unlikely to appear in the near future. Which, at least, means it is unlikely that those working on the theory of the firm are about to become redundant.

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