Tuesday, 19 June 2012

Is the term "firm" useful?

That's a big question when you study the theory of the firm. If the term isn't useful you get left with the theory of               . Over the Organizations and Markets blog Peter Klein posts on a talk by Harold Demsetz at ISNIE, in a session honouring Yoram Barzel on his 80th birthday. Klein writes
Demsetz’s remarks made me wonder if we should ban “firm” as well. Demsetz pointed out, quite rightly, that Coase (1937) defines the firm in terms of the employment relation. A one-person operation, in this definition, is not a firm, and vertical integration deals with the question of adding producers of intermediate products to the firm’s employment roll. Demsetz thinks independent contractors are firms, and hence it makes little sense to speak of “firm” and “market” as alternatives, as Coase does. (Oliver Williamson, during an earlier session, noted that Coase expressed more interest in intermediate product markets in his 1988 article than in “The Nature of the Firm.”)

For Knight, Williamson, Hart, and other notables, in contrast, the firm is defined not by the employment relationship, but by the ownership of alienable assets. In this approach, the question is who owns what, not who is employed by whom. (Dan Spulber offers yet another approach, defining the firm as nexus of transactions with objectives different from those of its owners.) Of course, even in the Knightian approach, to get from the one-person firm to the multi-person firm requires some theory about the relative transaction costs of employment versus independent contracting, a theory Nicolai and I try to provide in chapter 8 of our recent book, focusing on the conditions under which the entrepreneur to delegate judgment to subordinates.

So, what is a firm?

I would add that with regard to Coase's use of the employment relationship to define a firm in a 1988 paper Coase writes
"I consider that one of the main weaknesses of my article stems from the use of the employer-employee relationship as the archetype of the firm. It gives an incomplete picture of the nature of the firm. But more important, I believe it misdirects our attention".
Seeing a single person as a firm isn't all that silly. Think of a lawyer in practise by himself, is he not a firm? But what makes him a firm. You may say that even if he is the only lawyer in the firm he may have a receptionist which means there is an employment relationship to define the firm. In terms of alienable assets, a single lawyer with no receptionist will still own some assets, if only a client list, so we have a firm in the property rights sense. Note that for Spulber the lawyer is not a firm sense clearly the business doesn't  have objectives different from those of its owners. The business and the owner are one and the same.

So it is not clear what the answer to Klein's question is. But its one worth thinking about. Also if we do away with the term "firm" what do we replace it with and will there be any less in the way of problems with the new term.

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