Monday, 2 May 2011

Firms in economics

An obvious question to ask when thinking about the production side of the economy is, What is a firm? After all most production takes place in organisations which people would tend to regard as firms. When commenting on this question in a recent Journal of Economic Literature article Oliver Hart writes,
The fact that this question is so difficult to answer may be one reason that the theory of the firm is one of the less developed and agreed-upon areas of economics.
A more likely reason, if New Zealand experience is anything to go by, for the underdeveloped state of the theory of the firm is 1) a general anti-theory bias in research and teaching. How much “research” is of the form ‘I ran a million regressions and picked the one that confirmed my prejudices, or is a report on some experiment or another, or is a vacuous piece on some policy issue. Just what are the costs of alcohol in New Zealand? 2) an anti-production bias is the research that is done, both theory and empirical. And the teaching side is no better. How many student get though an economics degree and only meet the neoclassical model of the firm? Of course the lack of interest in teaching organisational economics should not surprise us given the lack of interest in researching this area.

Returning to the original question, What is a firm? A recent answer has been offered in a book by Daniel Spulber. In “The Theory of the firm: Microeconomics, with Endogenous Entrepreneurs, Firms, Markets and Organizations” Spulber argues that
The firm is defined to be a transaction institution whose objectives differ from those of its owners. The separation is the key difference between the firm and direct exchange between consumers” (p. 63).
Think of Robinson Crusoe, if he wants to eat apples he has to produce apples, so his consumption and production objectives are basically one and the same. Now consider Crusoe in a market economy. If he wants to consume apples he just buys apples in the market, he doesn’t have to produce apples. He could produce oranges, sell them and use the money to buy his apples. His consumption and production objectives differ. For Spulber, while Crusoe produces apples in the first case, he is not a firm, but the production of oranges, with consumption of apples, in the second case means he is a firm. This definition means that consumer organisations like clubs and basic partnerships are not firms since ``the objectives of consumer organizations cannot be separated from those of their owners” (p. ix). Similarly, many family businesses are not firms, and nor are worker cooperatives, nonprofit organizations, or public enterprises (chapter 1, pp. 42–61). At the same time, clubs (and worker and consumer cooperatives and partnerships) become firms if and when a market is created in memberships. (Hart 2011: 108).”

Hart notes that,
The intellectual stimulus for Spulber’s approach is Irving Fisher’s famous separation theorem (Fisher 1930). Fisher addressed the separation of the firm’s investment decisions from owners’ consumption and savings objectives. As Spulber says: “Under reasonable assumptions the firm’s optimal investment decisions are independent of the preferences of its owners and independent of how the investment is financed” (p. 65). The firm’s owners are affected by the firm’s decisions only through their wealth.
The separation of consumption and production objectives is what gives rise to profit maximisation in the neoclassical model of the firm. As the firm only effects the owners via the owner’s wealth, the owners want the firm to maximise profits, thereby maximising their wealth, so they can maximise consumption.

So the independence of consumption and productions objectives is the basis for telling a firm apart from other organisations. Hart takes issue with this idea:
There are some very important institutions in the United States that almost everyone would regard as firms, but it is not clear that they pass the Spulber test. Bill Gates is still a significant owner of and quite involved in Microsoft, so is Microsoft a firm? Larry Page and Sergey Brin are significant owners of and (even more) involved in Google, so is Google a firm? Will these organizations become firms only when their founders are long gone? Similar questions arise in varying degrees with respect to other companies with large and active owners, e.g., News Corporation, Berkshire Hathaway, CBS, and the New York Times.
In addition to this you have to ask, How can you apply this test to see if real world organisations are firms? How empirically can we say a firm’s objectives do or do not differ from their owner’s objectives? How do you determine a firm’s objectives? You can’t run your million regressions if you don’t know what data to collect in the first place.

So we are back where we started, we still don’t have a fully satisfactory definition of the firm. Without this we will have trouble in getting a satisfactory theory of the firm, if we are looking for A theory of the firm at all. Should we be looking for one theory that encompasses all organisational forms we see in the `real world’? Or should we be looking for several different theories? To answer any of these question we will need economists to show more enthusiasm for the study of the firm than we see now.

All of this said, Spulber's book is still a must read, agree with it or not, for anyone wanting to be up with the play in the theory of the firm. Not that he will get too many sales from New Zealand.
  • Hart, Oliver D. (2011). `Thinking about the Firm: A Review of Daniel Spulber's The Theory of the Firm', Journal of Economic Literature, 49(1) March: 101-13.
  • Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.
PS: one reason for not getting too many sales is the price of this book: US$130.00 for the hardback and US$46.00 for the paperback. Someone should point out to CUP that demand curves really do slope downwards!

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