Just for fun: theory of the firm 13

As has been noted previously the theory of the firm is not well developed within Austrian economics. But his does not mean there have been no attempts at formulating an Austrian approach to the firm. One such attempt is that of Nicolai Foss and Peter Klein in their book Organizing Entrepreneurial Judgment: A New Approach to the Firm.

The classic questions in the theory of the firm are, Why do firms exist, what determines a firm's boundaries and how are firms organised internally? To see Foss and Klein's answers lets begin with the one-person firm. For Foss and Klein the explanation for such a firm lies in the fact that markets for judgement are incomplete. A combination of two factors result in an entrepreneur having to form a one-person firm. To begin, entrepreneurs may know their ideas are "good risks" but my not be able to communicate this to the capital markets. A similar problem arises in a more standard model in Rabin (1993). Rabin works within an adverse selection framework and shows that the adverse selection problems can be such that, in some cases, an informed party has to take over the firm to show that their information is indeed useful. For Rabin an informed party has information about how to make a firm more productive but can't reveal the information to the owners of a current firm. If the information is revealed the current firm can produce using it without any payment to the informed party. If the information is not revealed why should the firm believe the information is in fact useful? Within the Rabin framework it is suggested that firms are more likely to trade through markets when informed parties are also superior providers of productive services that are related to their information. But if, on the other hand, information is a firm’s only competitive advantage, it is likely to obtain control over assets, possibly by buying firms that currently own those assets or setting up his own firm. Second, Foss and Klein argue that entrepreneurship represents judgement under "genuine" uncertainty and such judgement can not be assessed in terms of its marginal product and thus it can not be be paid a wage. This idea is more innovative since standard models of the firm work, at best, within environments of risk, rather than uncertainty. In short, there is no market for the judgement and therefore exercising judgement requires the person with judgement to control the firm. Foss, Klein and Linder (2013: 25-6) explain an implication of this incompleteness of the judgement market,

Exercising judgment implies [...] asset ownership, for judgmental decision-making is ultimately decision-making about the employment of resources, that is: to arrange or organize the capital goods the entrepreneur owns (or has influence over). Obtaining ownership rights over tangible and intangible assets also strengthens the bargaining position. Ownership rights—as stressed in organizational economics—allow parties to “fill in the blanks” of a contract, including the right to exclude others from accessing or using an asset [...]. It thus also ensures that the entrepreneur can appropriate rents from his/her entrepreneurial idea.

Similarly the standard property rights approach to the firm sees asset ownership at the centre of the explanation of the firm. Both the Rabin(1993) adverse selection model type model and the related moral hazard model of Brynjolfsson (1994) utilise the property rights framework and both result in the informed party (the entrepreneur) owning the firm (controlling the physical assets of the firm) so they can appropriate rents.

But what of the multi-person firm? As many attributes of capital only become apparent via using those assets, experimentation in an effort to discover the best uses for the particular assets the firm owns is needed.

Given the interdependence that typically exists in a multi-state value chain and involving different inputs, the best time and place to use a particular asset depend on the specification of the uses of all other assets that are needed in value delivery [...] Thus, entrepreneurs need a contractual set up that allows them to experiment at low cost. (Foss, Klein and Linder 2013: 26).

Such experimentation can lead to hold-up problems if a market contract is used to coordinate collaborators. The basic argument Foss and Klein (2012) make is that foregoing the market as a means of coordination in favour of a firm lowers the costs of experimentation. Under market contracting collaborators have the power to veto changes in the experimental set-up which allows them to extract extra quasi-rents from other collaborators in return for their agreement to make the changes to the set-up. Within a firm, a hierarchical relationship, the entrepreneur can redefine and reallocate decision rights among the collaborators, who are now employees, and can sanction those who do not utilise their decision rights efficiently. The use of a firm therefore allows the entrepreneur to experiment without enduring the costs, bargaining and drafting costs, of constant contract renegotiation. For Foss and Klein (2012) this provides the basic rationale for the multi-person firm.

When considering the boundaries of the firm, Foss and Klien (2013) argue that Austrian ideas developed in the socialist calculation debate suggest that when organizations are large enough to conduct activities that are exclusively internal – so that no reference to the outside market is available – they will face a calculation problem. That is the firm's size is limited by the fact that the more a firm does internally the fewer genuine market prices in has as a basis for rational rational judgements about the scarcity of the resources and whether an entrepreneurial profit exists.

With regard to the internal organisation of firms Foss and Klein (2012) note a problem arises in that the entrepreneur will typically lacking information or knowledge to make optimal decisions. One way to deal with this dispersed knowledge is for the entrepreneur delegate decision rights to managers who have better information. This delegation allows the firm is able to exploit the locally held knowledge without having to codify it for internal communication or motivating managers to explicitly share their knowledge. There is however a trade-off with such delegation.

Unlike independent players in markets, managers within firms never possess ultimate decision rights and thus there are incentive limits to the extent to which market principles can be applied within firms [...] This gives rise to problems of motivation, i.e. moral hazard – to use the organizational economics terminology. Managers and employees may use the delegated decision-rights in both productive, that is, functional or value-enhancing from the owners’ perspective, and destructive (i.e. dysfunctional or value-diminishing) ways [...]. They may pursue new profitable business opportunities or engage in developing new forms of exploiting (quasi)-rents from the firm by creating new forms of hold-ups etc (ibid.). Yet, delegation may also imply risks of duplication of effort due to a lack of coordination of activities. The benefits of delegation in terms of better utilizing dispersed knowledge thus need to be balanced against the costs of delegation due to problems of interest alignment (what organizational economics would call “agency costs”) and coordination [...]  (Foss, Klein and Linder 2013: 29-30)..

This means entrepreneurs need to exercise judgement about other people's judgement in insofar as they must evaluate employees according to their ability to use delegated decision rights properly.

One point that Austrians share with their mainstream counterparts has been the reluctance until recently to open the "black box" of the firm. The judgement-based approach suggest that the Austrians have much to offer now that the box is has been opened.

Refs.:

• Foss, Nicolai J., and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
• Foss, Nicolai J., Peter G. Klein and Stefan Linder 2013. 'Organizations and Markets', SMG Working Paper No. 8/2013 April, Department of Strategic Management and Globalization, Copenhagen Business School.