Tuesday 21 January 2014

How not to think about the firm

Eric Crampton alerted me to this posting at the Fresh economic thinking blog on Time for a new theory of the firm. The upshot of the posting is that its author doesn't like the standard neoclassical theory of the firm and thinks we need a new theory of the firm to replace the neoclassical one. Let me make two quick comments.
  1. He's a bit out of date. The neoclassical model hasn't been the mainstream theory of the firm since around the 1970s so the call to replace it is only 40 odd years too late. The major difference between the (neoclassical) mainstream theories of the past and the mainstream theories of the present is that the focus − in terms of the questions the theory attempts to answer − of the post-1970 mainstream literature is markedly different from that of the earlier (neoclassical) mainstream theory. The theory of the firm for Ronald Coase, Oliver Williamson, Bengt Holmstrom or Oliver Hart is a very different thing from that of Arthur Pigou, Lionel Robbins, Jacob Viner, Joan Robinson or Edward Chamberlin. The questions the theory seeks to answer have changed from being about how the firm acts in its various markets; how it prices its outputs or how it combines its inputs, to questions about the firm’s existence, boundaries − including the dividing line between state and private enterprises − and internal organisation. That is, in the mainstream theory there has been a movement away from seeing the theory of the firm as simply developing one component (albeit an important component) of price theory, namely the element concerned with the factor and product market behaviour of producers, to the theory being concerned with the firm as a important economic institution in its own right. For anyone who is interested in some of what the current mainstream in the theory of the firm is I suggest checking out the forthcoming paper in the Journal of Economic Surveys entitled "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective" by ... well .... errr .... modesty forbids me.
  2. There are no firms in the neoclassical or I suspect in the "replacement" model we are being offered. Both models work implicitly within zero transaction cost frameworks and within such settings firms have no role. As Foss (2000) puts it,
    With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms (Foss 2000: xxiv).
    Or as Foss, Lando and Thomsen (2000) summarise things:
    [t]he pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure,contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist (Foss, Lando and Thomsen 2000: 632).
    In short, you need incomplete contracts to explain why firms exist.
  • Foss, Nicolai J. (2000). ‘The Theory of the Firm: An Introduction to Themes and Contributions’. In Nicolai Foss (ed.), The Theory of the Firm: Critical Perspectives on Business and Management (pp. xv-lxi), London: Routledge.
  • Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics (vol. III, pp. 631-58), Cheltenham U.K.: Edward Elgar Publishing Ltd.

1 comment:

Cameron Murray said...

Hi Paul, I'm glad you've contributed to the discussion, and congrats on yours Surveys publication (which is actually quite a good read).

I must note that perhaps you've missed the point here. Neoclassical theory still dominates the analysis of firm production decisions, even if it leaves the internal organisation questions unanswered. Our theory improves on this by adding the existence of economies of scale as a necessary condition for production to even take place. This suggests a reason for firm existence considering that economies of scale tend not to be the preserve of a sole trader or even small business.

Indeed, one could argue that the reduction in transaction costs arising from being within the boundary of a single firm is part of the economies of scale. We don’t rule out incomplete contracts or any type of transaction cost. But of course that is not the focus of the paper.

I plan to expand on many of the points I made in the blog post in the coming weeks, and I'd appreciate any comments/feedback given your expertise in this are in general.