Monday 20 February 2012

Just for fun: theory of the firm 12

A recent, but still relatively unknown, contribution to the theory of the firm which can be seen as outside, if related to, the mainstream of the economic approach to the theory of the firm is Daniel F. Spulber, "The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations", Cambridge: Cambridge University Press, 2009. If we think of the mainstream theory of the firm as being concerned with three basic issues to do with the existence, boundaries and internal organisation of the firm then Spulber's book is somewhat outside of the mainstream but the issues it deals with are related closely enough to those of the mainstream to justify a brief overview. (For criticisms of the Spulber approach to the firm from inside the mainstream see Hart (2011).) In addition Spulber offers insights into a number of important issues missing from the mainstream and thus lays the groundwork for future research in both the theory of the firm and industrial organisation more generally. Spulber "[ ... ] seeks to explain (1) why firms exist, (2) how firms are established, and (3) what firms contribute to the economy" (Spulber 2009: ix). These issues are clearly related to those of the mainstream but they are not the same. In particular the mainstream does not have a theory of the entrepreneur or market creation. Spulber's book in an attempt to create a general approach to microeconomics in which entrepreneurs, firms, markets, and organizations are all endogenous.

To start Spulber defines a firm "[ ... ] to be a transaction institution whose objectives differ from those of its owners. This separation is the key difference between the firm and direct exchange between consumers". (Spulber 2009: 63). Note that under this definition organizations such as clubs, basic partnerships, many family firms, worker cooperatives, non-for-profit organisations and public enterprises are not firms. The basic reason being that the objectives of these types of organizations cannot be separated from those of their owners. The separation of objectives between owners and firms also justifies the profit maximisation objective. Consumers who are the owners of the firm, obtain income via the firm's profits and thus want profit maximisation so they can maximise their consumption (utility).

Spulber has three additional players in his story: consumers, organisations and markets. Consumers are individuals who consume the goods and services generated within the economy. Organisations are transaction institutions whose objectives cannot be separated from those of their owners. Markets are transaction mechanisms that bring buyers and sellers together.

For Spulber the entrepreneur is important because it is their efforts that leads to the creation of firms. A combination of market opportunities interacting with the individual's preferences, endowments and other such characteristics leads the consumer to take on the role of entrepreneur. The individual is an entrepreneur for the time it takes to establish the firm. Assuming that the firm is successfully established, the entrepreneur's role changes to that of an owner of the firm. Ownership is valuable insofar as it provides returns to the (former) entrepreneur. This change from entrepreneur to owner is in Spulber's terms, `the fundamental shift'. (Spulber 2009: 152). The point is that before the change from entrepreneur to owner, the objectives of the organisation cannot be separated from those of the (then) entrepreneur. After the fundamental shift has occurred, the entrepreneur is now the owner and the firm's objectives are separate from those of the owner, which means a firm has been established.

Other organisations can be formed that allow consumers to take advantage of joint production. Such advantages include economies of scale, public goods, common property resources and externalities. Unlike the firm, the objectives of the organisation reflect the consumption objectives of the members of the organisation. A problem with an organisation is that it can experience inefficiencies due to free riding. Firms overcome such problems by separating the objectives of the organisation from the consumption objectives of its owners and thus inducing profit maximisation. Profit maximisation may not achieve full efficiency due to problems such as allocative inefficiencies that result from market power. Thus the comparison between a firm and an organisation depends on the trade-off between profit maximisation and free riding. When the number of consumers is small, free riding problems tend to be small and thus an organisation may be more efficient than the firm.

Given we have firms, firms can create markets. Firms can act as intermediaries and in doing so they increase the gains from trade and reduce transactions costs when consumers are separated by time, distance and uncertainty. Firms create markets by providing centralised mechanisms for matching consumers, in their roles as buyer and sellers, in a more efficient manner than decentralised exchange can achieve. Market making firms are required to buy and sell at any moment meaning that buyers and sellers avoid the costs involved with trading delays and the risk of being unable to find a trading partner. In the world of financial markets, market-making firms provide liquidity by being ready to buy and sell financial assets. Addition transaction efficiencies are bought about by market-making firms being able to consolidate trades which allows traders to reduce the costs involved with having to find multiple trading partners or with having mismatched trades. Firm can also avoid the problems inherent with complex bartering arrangements by simplifying the trading process vis the use of posted prices. Supply and demand can be equated in a market by firms adjust their buying and selling behaviour thereby reducing potential losses due to market imbalances. Thus market creation is endogenous.

Spulber offers insights into a number of issues that the mainstream theory of the firm does not deal with well, if at all. The discussion of issues such as the role of the entrepreneur and the creation of markets are important issues that lie outside of the mainstream of the theory of the firms, at least as far as the mainstream is conceived of here. Such issues do however raise questions for the future of the theory of the firm and industrial organisation.
  • 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.

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