Austrian and mainstream approaches to the theory of the firm

Are the Austrian and mainstream approaches to the firm incompatible?

While thinking about issues arising from my previous post on The firm in classical economics I reread the paper "Austrian Economics and the Transaction Cost Approach to the Firm" by Nicolai J. Foss and Peter G. Klein. The transactions cost approach to the theory of the firm is one of main contemporary theories of the firm and has developed out of Coase's 1937 paper on "The Nature of the Firm". In fact Coase won the 1992 Nobel Prize in economics for "For his discovery and clarification of the significance of transaction costs and property rights for the traditional structure and functioning of the economy".

When discussing the importance of dynamics to the economic theory of organisations Foss and Klein write,

One way to interpret this Austrian insight is that absent change there are no transaction and information costs; that is, in the absence of the knowledge and appraisement problems introduced by economic change there would be no costs of identifying contractual partners, drafting and executing contracts, monitoring production, constructing contractual safeguards, judging quality, and so on. In the absence of transaction costs the choice between price-mediated market transactions and firm hierarchies is indeterminate.

Thus in a world of zero transaction costs there is no need for firms. This point is highlighted by the zero transaction cost neoclassical approach to the firm. As Nicolai Foss has noted elsewhere

With perfect and costless contracting [due to zero transaction costs], 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.

In terms of the standard neoclassical approach Peter Klein puts it this way,

In neoclassical economic theory, the firm as such does not exist at all. The “firm” is a production function or production possibilities set, a means of transforming inputs into outputs. Given the available technology, a vector of input prices, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. That is all there is to it. The firm is modeled as a single actor, facing a series of relatively uncomplicated decisions: what level of output to produce, how much of each factor to hire, and so on. These “decisions,” of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In the long run, the firm may also choose an optimal size and output mix, but even these are determined by the characteristics of the production function (economies of scale, scope, and sequence). In short: the firm is a set of cost curves, and the “theory of the firm” is a calculus problem.

When thinking terms of general equilibrium theory Foss, Lando and Thomsen write,

[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.

All this suggests the importance of positive transaction costs to a theory of the firm.

Foss and Klein go on to say that their argument indicates a link between Austrian insights from the socialist calculation debate and Coasian insights in economic organisation. In their view it is only with this kind of dynamic economic reality inherent in Austrian economics that Coase's argument acquires its full force.

Later Foss and Klein admit that there is debate about the compatibility between Austrian economics and the Coasian based contractual perspective on the firm but they argue that there are two Coasian traditions, one of which is, they claim, consistent with Austrian ideas.

There is some debate within the Austrian literature about the basic Coasian approach and its compatibility with the Austrian perspective. O’Driscoll and Rizzo (1985, p. 124), while acknowledging Coase’s approach as an “excellent static conceptualization of the problem,” argue that a more evolutionary framework is needed to understand how firms respond to change. Some Austrian economists have suggested that the Coasian framework may be too narrow, too squarely in the general-equilibrium tradition to deal adequately with Austrian concerns (Boudreaux and Holcombe, 1989; Langlois, 1994). However, as Foss (1993) has pointed out, there are “two Coasian traditions.” One tradition, the moral-hazard or agency-theoretic branch associated with Alchian and Demsetz (1972), studies the design of ex ante mechanisms to limit shirking when supervision is costly. Here the emphasis is on monitoring and incentives in an (exogenously determined) agency relationship. The above criticisms may apply to this branch of the modern literature, but they do not apply to the other tradition, the governance or asset-specificity branch, especially in Williamson’s more heterodox formulation. Williamson’s transaction cost framework incorporates non-maximising behaviour (bounded rationality); true, “structural” uncertainty or genuine surprise (complete contracts are held not to be feasible, meaning that all ex post contingencies cannot be contracted upon ex ante); and process or adaptation over time (trading relationships develop over time, typically undergoing a “fundamental transformation” that changes the terms of trade). In short,

at least some modern theories of the firm do not at all presuppose the “closed” economic universe—with all relevant inputs and outputs being given, human action conceptualized as maximization, etc.—that [some critics] claim are underneath the contemporary theory of the firm (Foss, 1993, p. 274).

Stated differently, one can adopt an essentially Coasian perspective without abandoning the Misesian view of the entrepreneur as an uncertainty-bearing, innovating decision maker.

One of the positives of the Austrian approach to the firm is the importance given to the entrepreneur in the theory of the firm. In the Coasian world there is a manager who runs the firm but he does act as a true entrepreneur, in that he does not form the firm. The Austrians - e.g. Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press - and some other approaches to the firm - e.g. Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press -  are starting to develop genuine theories of entrepreneurial activity.

The Foss and Klein (2012) book shows that Austrian and the mainstream approaches to the firm are not completely incompatible. While the basis of their theory, a combination of Knightian uncertainty and Austrian capital theory, places their work outside the conventional theory of the firm, Foss and Klein are not completely opposed to the standard theory. In fact they see themselves “not as radical, hostile critics, but as friendly insiders”.

When discussing the multi-person firm Foss and Klein argue that the need for experimentation with regard to production methods is the underlying reason for the existence of the firm. Given that assets have many dimensions or attributes that only become apparent via use, discovering the best uses for assets or the best combination of assets requires experimenting with the uses of the assets involved. Thus entrepreneurs seek out the least-cost institutional arrangement for experimentation. Using a market contract to coordinate collaborators leaves the entrepreneur open to hold-up, collaborators can threaten to veto any changes in the experimental set-up unless they are granted a greater proportion of the quasi-rents generated by the project. By forming a firm and making the collaborators employees, the entrepreneur gains the right to redefine and reallocate decision rights among the collaborators and to sanction those who do not utilise their rights effectively. This means that the entrepreneur can avoid the haggling and redrafting costs involved in the renegotiation of market contracts. This can make a firm the least-cost institutional arrangement for experimentation. The notions of hold-up over quasi-rents and the importance of the allocation of decision rights and their use to avoid haggling costs are features of more standard theories of the firm like the transaction cost based theory of Oliver Williamson and the incomplete contracts theory of Grossman-Hart-Moore.

The takeaway message from all of this is that the Austrian approach and the mainstream approaches to the theory of the firm are not necessarily incompatible. There are areas of overlap and thus gains from trade arising from interaction between them. They can learn from each other.