Just for fun: theory of the firm 9

One of the most well known approaches to the theory of the firm is often referred to as the "nexus of contracts view." While this approach derives its name from a passage in Michael Jensen and William Meckling's 1976 paper "The Theory of the Firm: Managerial Behavior, Agency costs and Ownership Structure",

The private enterprise or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and which is also characterized by divisible residual claims on the assets and clash flows of the organization which can generally be sold without the permission of the other contracting individuals. (page 311)

the idea that the firm is nothing but a legal fiction can be seen in the 1972 paper by Armen Alchian and Harold Demsetz, "Production, Information Costs, and Economic Organization".

For Alchian and Demsetz, and the others following this approach, it is meaningless to draw a hard line between firms and markets. Although firms are clearly legal entities, and this fact has important economics consequences such as limited liability, the right to tax deductions for input costs, infinite lifetime for the firm and so on, they are still best thought of as a special kind of market contracting. A possible distinction firms and other market contracts is that firms have a continuity of association between input owners that other forms of contracting may not have.

An important result of this line of argument is that the distinction emphasised by Coase’s 1937 paper between authority-based and price-based modes of allocation is a misnomer. In reality, claim Alchian and Demsetz, there is no difference between “firing” one grocer and firing one’s secretary. What looks like a employment relationship is little more than a market relationship.

However the firm is a special form of market contracting and what makes it so has to do with team production. That is production where the individual production functions are inseparable. This means that marginal products are costly to measure. From this comes the fact that free riding is a problem since team-production can be a cover for shirking. With unknown individual productivities it is difficult to know who has done what and thus to detect shirking.

The Alchian and Demsetz answer to this problem is to appoint a monitor who has the right to hire and fire team members based on his observations of the employees’ marginal productivities. The monitor carries out the efficient amount of monitoring since he is given the right to the residual income of the team. The firm in this case is explained in terms of the reduction in post-contractual measurement costs.

There are, however, a number of problems with the Alchian and Demsetz approach to the firm. First, it is not clear why the monitor has to be the employer of the firm where he carries out his monitoring activities. He could be an employee of another firm which specialises in providing monitoring services. Also why can’t the employees monitor each other? Second, is it plausible that specialised monitoring eliminates the problem of inseparable production functions? Third, is it really meaningless consider authority in a situation where the employer/monitor has the right to prevent the employee from accessing the non-human capital – tools, machinery, equipment etc – that the employee needs to be productive? That is, if you fire your secretary, you keep the non-human assets but if you fire your grocer, the grocer keeps the non-human assets. In a world where human and non-human assets can be strongly integrated, this matters. Last, we observe more firms in the real world than can be explained by team production.

Despite these problems Alchian and Demsetz is still to be considered a seminal contribution to the theory of the firm. This is not just because it is still heavily cited but mainly because it gave rise to a still on going series of papers on the theory of the firm: see, for example, Barzel (1997 chapter 4), Fama (1980), Fama and Jensen (1983) and Jensen and Meckling (1976).

References:

• Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
• Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
• Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
• Fama, Eugene F. and Jensen, Michael C. (1983). 'Agency Problems and Residual Claims', Journal of Law and Economics, June, v. 26, iss. 2, pp. 327-49.
• Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.