Empirical literature on the firm

From LearnIOE comes this video of Professor Peter Klein discussing the empirical literature on the firm.

The research literature on the economic theory of the firm has greatly expanded in the last several decades. But what is not as well known is that there is a growing empirical literature to go along with that theoretical body of work. In this video, Professor Peter Klein summarizes some of the empirical work that has been done so far and discusses its advantages and weaknesses. He hopes to inspire some of you to do additional empirical research in this area.

What is a firm?

This seems an obvious question which many people would assume would have an obvious answer. And yet it doesn't.

No one can agree on a definition. For neoclassical theory, a firm is little more than a production function or production possibilities set. For Demsetz a firm is an organisation in which production is carried out exclusively for sale to those formally outside the organisation. For Coase the firm is defined as an employment relationship. X is a firm because the owner of X employs A and B to work for him. For Williamson and Hart a firm is defined in terms of the ownership of alienable assets. The question for them is who owns what rather than who employs who. Spulber sees a firm as a transaction institution whose objectives differ from those of its owners. For Foss and Klein a firm is made up of an entrepreneur and the assets owned by them. All of these ideas have some merit. Its much like a group of blind men trying to describe an elephant, each man can tell you about the part he can feel while remaining unaware of the rest of the animal.

At first, it may seem odd that economists can not agree on what a firm is. But is it really that strange? When you think about it, coming up with a definition that covers every organisation from a sole proprietorship to a partnership to a limited liability company to a multinational is asking a lot, maybe too much. Foss, Klein and Linder (2015: 275)  suggest that a "[...] better question than "what is a firm" is "what are the important research questions that can be answered when the firm is defined in a particular way?" ".

That idea does seem to have merit.  At least then you can use a definition which is useful for the question under consideration rather than trying to come up with an all-embracing definition. A lot of otherwise wasted time and energy could be saved by not having to come up with the perfect one size fits all definition.

Ref.:

• Foss, Nicolai J., Peter G. Klein and Stefan Linder (2015). 'Organizations and Markets'. In Peter J. Boettke and Christopher Coyne (eds.), The Oxford Handbook of Austrian Economics (pp. 272-95), Oxford: Oxford University Press.

A dialogue on Israel Kirzner and his contributions to price theory and the competitive market process

From Peter Boettke at the Coordination Problem blog comes this bit of good news,

Liberty Matters this month features an essay by me on Kirzner with commentary by Mario Rizzo, Peter Klein, and Frederic Sautet. Please join the conversation once it opens to the public in a week or so.

Well worth taking the time to read.

Production and the firm

This lecture was presented by Peter Klein at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 23 July 2013.

Peter G. Klein on government and big business

This video was recorded at the Mises Institute in Auburn, Alabama, on 29 July 2016.

Economists and firms

A few days back Donal Curtin posted a piece at the Economics New Zealand blog on raising productivity in the services sector. A one point he writes,

Maybe economists aren't the best people to investigate business management - with exceptions (eg Baumol, Varian), economists tend to see the business production function as a "black box" with inputs in and outputs out, and they don't typically take the lid off the box - but this looks to me like one of the more likely keys to fit the productivity paradox lock.

I have to say that, in the past at least, he has a point. Economists for many years simply didn't see the workings of the firm as an area they should be bothered with. Arthur Pigou (he of the tax) famously once wrote:

“[ ...] it is not the business of economists to teach woollen manufacturers to make and sell wool, or brewers how to make and sell beer, or any other business men how to do their job. If that was what we were out for, we should, I imagine, immediately quit our desks and get somebody - doubtless at a heavy premium, for we should be thoroughly inefficient - to take us into his woollen mill or his brewery”

While Lord Robbins thought that

“[t]he technical arts of production are simply to be grouped among the given factors influencing the relative scarcity of different economic goods. The technique of cotton manufacture [ ...] is no part of the subject-matter of Economics [ ...]”

As to why the firm was ignored in Austrian economics Witt writes,

“[t]he neglect of the firm as the organizational form of an entrepreneurial venture has a tradition in Austrian economics. It may be traced back to a characteristic of the scientific community in the German language countries. There, economic theory (Volkswirtschaftslehre) and business economics (Betriebswirtschaftslehre) were institutionally segregated as early as at the turn of the century to a degree still unknown today in the Anglo Saxon world. As Lachmann once conjectured, Austrian writers therefore considered the organizational form of entrepreneurial activities to be a topic best left to their business economics fellows”

And if one looks at the history of economic one finds little, if any, interest in the firm. When reviewing the contribution of the old institutionalists to the theory of the firm Hodgson writes,

“[ ...] we search in vain for a well-defined ‘theory of the firm’ within the old institutional economics”.

With reference to the German historical school Le Texier explains

“[m]embers of the German historical school such as Gustav von Schmoller analysed at length the birth and growth of the business enterprise, but they were more historians than economists. None of these thinkers proposed a theory of the business firm”

About the work of Joseph Schumpeter, Hanappi says

“[a] well-defined theory of the firm thus cannot be found in Schumpeter’s oeuvres”.

As to Austrian economics Per Bylund writes,

“[b]ut despite the focus in Austrian economics on [ ...] “mundane economics,” and the fact that “the Austrians [have] so many necessary ingredients for a theory of the firm” [ ...], there is no Austrian theory of the firm”

and

“[w]hereas the theory of the firm has been a neglected area of study in mainstream economics, it has been missing from the Austrian economics literature”.

In the mainstream of economics up until around 1970 the standard theory of the firm was the neoclassical theory which as Donal notes treated the firm as a "black box", a production function or production possibilities set, a means of transforming inputs into outputs with no one asking how the transformation took place.

Since the 1970s, however, things have started to improve. During the 1970s work by Oliver Williamson Alchian and Demsetz and Jensen and Meckling started an upswing in interest in the firm as an significant economic institution. Today one only has to consider works like the "Handbook of Organizational  Economics", edited by Robert Gibbons and John Roberts, Princeton: Princeton University Press, 2013, to see that the firms and their inner workings are taken much more seriously. There are 1200 pages of people at least trying to take the lid off the "black box".

So I would suggest that there are good reason for letting economists, among others, investigate business management.

Given the concern with productivity of firms an additional area of investigation would be the relationship between firms and entrepreneurs. It is, after all, entrepreneurs who innovate and force change in business practises as well as in production techniques of goods and services. One only has to think of the effects of 'just in time' manufacturing to see how organisational change can affect costs and productivity.

The relationship between the theory of the firm and the theory of entrepreneurship is not as yet well understood but process is being made even here as witnessed by the Foss and Klein book "Organizing Entrepreneurial Judgement: A New Approach to the Firm", Cambridge: Cambridge University Press, 2012 (see this previous post) or Daniel Spulber's book "The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Markets, and Organizations" , Cambridge: Cambridge university Press, 2009.

Interview: Nicolai J. Foss and Peter G. Klein on “Organizing Entrepreneurial Judgment”

Nicolai Foss and Peter Klein are interviewed on the contents of their 2012 book “Organizing Entrepreneurial Judgment: A New Approach to the Firm”. The book is worth the time to read.

A brief discussion of the Foss and Klein book can be found in Section 3.2 of  "Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective". Journal of Economic Surveys, forthcoming.

A few questions:

Question: The aim of your book is, as you state, to define a program for research in the intersection of the theory of the firm and entrepreneurship. What is wrong with current theory in these fields?

Klein: Until the 1980s, the economic theory of the firm was a branch of neoclassical production theory. “Firms” were highly stylized, abstract units that convert inputs into output – everything economically relevant about the firm could be expressed as a production function. There was little interest in why firms exist, how firms are governed and managed, why some firms perform better than others, and so on. Any behaviors not consistent with “perfect competition” were regarded as efforts to exploit monopoly power. Basically, the theory had little to do with business firms as they actually exist.

Things got better with the emergence of agency theory, transaction cost economics, and the economic analysis of property rights. Even these approaches, however, are fairly static and “closed,” with little room for entrepreneurship and uncertainty. There was a standalone academic discipline of entrepreneurial studies, but it was mainly descriptive and focused on startup companies and self-employed individuals. Even today, the theory of firm doesn’t incorporate entrepreneurs, and much of entrepreneurship theory abstracts from the firms that entrepreneurs establish and operate.

Question: What are those “neglected insights” you want to revitalize?

Foss: In this book we pick up on a number of themes associated with less conventional thinkers in economics, notably Frank Knight and his seminal book, Risk, Uncertainty and Profit from 1921. In fact, our book may well be described as “Knightian.” What we appreciate in Knight is his emphasis on uncertainty rather than risk as characteristic of most business decisions and not just the major ones. Someone has to shoulder the uncertainty (it is uninsurable) associated with setting up an enterprise and because these ideas are often not fully or clearly articulable, the result is that entrepreneurs set up firms, bearing responsibility for any profits or losses the venture make. However, Knight’s ideas go much beyond start-ups.

Another source of inspiration is the Austrian school of economics. In the book we put much emphasis on resource heterogeneity and all the many problems of measuring, monitoring, combining, coordinating and so on that arise in a world of heterogeneity. All management problems are caused by such heterogeneity in conjunction with uncertainty. This is something mainstream economics still has to embrace.

Question: You make the point that “problem-solving activities in firms have many of the features of experimental activity“. This view radically contrasts with the typical microeconomics textbook view whereby firms face a simple optimization problem (maximizing profits subject to known constraints) ....

Foss: True. But economics simply has to accommodate the fact that the choice of production methods, the combination of resources, the sourcing of knowledge and so on are not “data”.Hayek was very explicit about this in a brilliant essay from 1948 (“The meaning of competition”). Firms may be groping towards optimum resource combinations, but they are really tracking a moving target, because of shocks to technology, tastes, policies, and so on. And to the extent that they succeed in tracking the target it is because of sound managerial judgment. I must say, though, that I see many of the younger applied microeconomists, such as Nick Bloom and John van Reenen, adopting this basic view. They need to make sense out of the managerial function.

Question: You have a very interesting chapter on internal organization and intrapreneurship (entrepreneurship within firms), where you disagree with the trendy claim in the tech start-up world “that authority and traditional firm organization are fading under the impact of delegation of decision rights to entrepreneurial employees who control critical knowledge.” Why?

Foss: Well, the “trendy claim”, as you call it, has some truth to it. There is evidence of increased delegation, particularly in fast moving industries, and it is also evident that there is a tendency to shift decision rights to employees that are high in human capital. Some of my empirical work with my CBS colleague Keld Laursen speaks to this issue. However, authority has efficiency advantages that just don’t disappear like that. First, authority economizes on the costs of transmitting knowledge: Rather than telling someone why he should carry out a task, how it fits into the big picture, and so on, the holder of authority simply tells someone to get it done. Second, bosses often have superior knowledge, in which case they should give direction. Third, there is a need for someone to operate and maintain reward systems.

For another approach that explains why this "trendy claim" may not be true for all firms see "Simple models of a human-capital based firm: a reference point approach". Journal of the Knowledge Economy, forthcoming.

Are business schools to blame?

This video is of a presentation by Professor Peter G. Klein at the Mises Circle in Newport Beach, California in November 2009 on "Are Business Schools to Blame?" for the financial crisis.

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.

Transaction costs 2

Peter Klein over at the Organisations and Markets blog asks What Are “Transaction Costs” Anyway? He writes,

A friend complains that management and entrepreneurship scholarship is confused about the concept of transaction costs. Authors rarely give explicit definitions. They conflate search costs, bargaining costs, measurement costs, agency costs, enforcement costs, etc. No one distinguishes between Coase’s, Williamson’s, and North’s formulations. “Transaction costs seem to be whatever the author wants them to be to justify the argument.”

It’s a fair point, and it applies to economics (and other social sciences and professional fields) too. I remember being asked by a prominent economist, back when I was a PhD student writing under Williamson, why transaction costs “don’t simply go to zero in the long run.” Indeed, contemporary organizational economics mostly uses terms like “contracting costs,” and since 1991 Williamson has tended to use “maladaptation costs” (while retaining the term “transaction cost economics”).

Klein also usefully points us to two articles on transaction costs: Doug Allen’s essay from the Encyclopedia of Law and Economics and Lee and Alexandra Benhams’ more recent survey from the Elgar Companion to Transaction Cost Economics.

But not only do we have the problems of defining transaction costs we also have to worry about, when it comes to the theory of the firm, the difference between the transaction costs, property rights and reference point models each of which claims to use some concept of "transaction costs". As I have written before:

Hart (2008, p. 406) argues that shading costs are akin to ‘haggling costs’. The modelling of haggling costs can be seen as a move towards the modelling (however imperfectly) of transaction costs. Hart and Moore (2008, pp. 4–5) argue that ‘[...] the costs of flexibility that we focus on–shading costs–can be viewed as a shorthand for other kinds of transaction costs, such as rent-seeking, influence, and haggling costs’. Exactly how similar the reference point and transaction-cost explanations are is, however, open to debate. There is also the question of the relationship between these two approaches to the firm and the property rights approach.

In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000, pp. 605–606) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010, p. 283) explains it this way:

'[t]he model in question is Grossman and Hart’s (1986), which explores an alternative to Williamson’s (2000, p. 605) emphasis that “maladaptation in the contract execution interval is the principal source of inefficiency.” Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency is in endogenous specific investments.

It is striking how different the logic of inefficient investment can be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example, the lock-in necessary for Williamson’s focus on inefficient haggling could result from contractible-specific investments chosen at efficient levels. But by assuming efficient bargaining and hence zero maladaptation in the contract execution interval, Grossman and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives to invest; in Williamson’s argument, an important cost of non-integration is inefficient haggling. In short, the two theories are simply different’.

This emphasis on ex post haggling and maladaptation can be interpreted as reflecting a view that internal organisation is better at reconciling the conflicting interest of the parties to a transaction and facilitating adaptation to changing supply and demand conditions when such cost are high. The reference point approach can be seen as a movement away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post. This fact, as Hart (2008, p. 294) points out ‘[...] is a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex post (for example by a court of law). Here we are assuming that only perfunctory performance can be enforced: consummate performance is always discretionary’, and thus inefficiencies can arise ex post. The development of a tractable model of contracts and organisational form that exhibits ex post inefficiency is one of motivations for advancing the reference point approach in the first place. (Hart and Moore, 2008, p. 4). Hart’s interpretation of the reference point theory is ‘[i]n a sense, this work can be viewed as a “merger” of the transaction cost and property rights literatures’. (Hart, 2011b, p. 106).

Also the reference point approach differs from the property rights theory in that it does not require an assumption of the use of relationship-specific investments as is standard in the property rights theory. Relationship-specific investments can be introduced to the reference point theory, Hart (2011a) is an example where this is done, but, in general, the reference point theory does not rely on such investment.

The reference point approach also highlights the importance of Williamson’s notion of the ‘fundamental transformation’. Hart and Moore argue that the move from an ex ante competitive market to an ex post bilateral setting – what Williamson (1985, pp. 61–63) terms the fundamental transformation – provides a rationale for the idea that contracts are reference points. ‘A competitive ex ante market adds objectivity to the terms of the contract because the market defines what each party brings to the relationship. HM assume that the parties perceive a competitive outcome as justified and accept it as a salient reference point’. (Fehr et al., 2009, p. 562). This is an idea which finds experimental support: see Fehr et al. (2009), Fehr et al. (2011) and Hoppe and Schmitz (2011).

But we must also be aware that important features of the transaction-cost theory may still have been left out. How fully shading costs capture the costs of ex post maladaptation and haggling is an open question. When discussing some opportunities for the future of transaction-cost economics, Robert Gibbons (2010, p. 283) notes that ‘[...] it may be that Hart and Moore’s (2008) “reference points” approach is a productive path. Time will tell [...]’. Hart (2011b, p. 106) concludes ‘[w]hether this merger [resulting in the reference point theory] will be successful remains to be seen’.

Audio of Peter Klein on "The Theory of the Firm"

This audio is of a lecture presented by Professor Peter G. Klein at the Ludwig von Mises Institute's 2003 Mises University conference on the topic of The Theory of the Firm.

Well said, that man!

Peter Klein writing at the Organisations and Markets blog explains,

Speaking of pet peeves, here’s another of mine: the regular misuse of the word “methodology” in academic papers. Methodology is the study of scientific methods, a branch of epistemology. Econometric techniques, strategies for gathering data, means of testing hypotheses, etc. are methods, not methodologies. Yet how many empirical papers include a section titled “Methodology” or “Data and Methodology”? It makes me cringe. “We use an instrumental-variables methodology,” or “our methodology employs case studies and structured interviews.” No, those are your methods. Unless you’re citing Popper or Kuhn or Lakatos or Feyerabend or Blaug or Mäki you probably don’t have a methodology section.

If only econometricians could speak English as well as Greek.

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.

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.

Vertical integration sometimes looks very strange

This odd sounding example of  vertical integration comes from Peter Klein at the Organizations and Markets blog:

The WSJ reports that Delta Airlines wants to acquire a Pennsylvania oil refinery. The reporters, quoting the ubiquitous “people familiar with the situation,” says that Delta “could save between $20 and $25 a barrel on some of its jet-fuel costs by acquiring the refinery, a big advantage as industry costs now approach $140 a barrel, up 11% so far this year.” But how? No particular economies of integration are mentioned in the article (apparently the WSJ doesn’t consider this an important point). Jet fuel is a standardized commodity, so asset specificity isn’t an issue. Organizational capabilities don’t seem to be relevant. Market power? Price discrimination? I don’t see it. In short, I can’t imagine where these cost savings would come from. Any ideas?

Delta may think that ownership of a refinery would guarantee them supply in times of uncertainty but the market for jet fuel seems to work perfectly well so I don't see why owning a refinery is necessary to ensure supply. What's the bet that the deal won't go though or if ti does it will be reversed quickly?

Entrepreneurship and the economic theory of the firm

This is the title of a talk given by Peter Klein at the University of São Paulo. Click here to see the whole lecture.

Klein on "The Capitalist and the Entrepreneur"

Peter Klein, of Organizations and Markets fame, has a new book out: The Capitalist and the Entrepreneur: Essays on Organizations and Markets. In the introduction he writes,

Austrian economics, I am convinced, has important implications for the theory of the firm, including firm boundaries, diversification, corporate governance, and entrepreneurship, the areas in which I have done most of my academic work. Austrian economists have not, however, devoted substantial attention to the theory of the firm, preferring to focus on business-cycle theory, welfare economics, political economy, comparative economic systems, and other areas. Until recently, the theory of the firm was an almost completely neglected area in Austrian economics, but over the last decade, a small Austrian literature on the firm has emerged. While these works cover a wide variety of theoretical and applied topics, their authors share the view that Austrian insights have something to offer students of firm organization.

This point that there is little in the way of a truly Austrian theory of the firm has always puzzled me. They have written extensively on the market (and the entrepreneur) but haven't devoted much energy to exploring what underlies either side of the market: demand (households) or supply (firms). What determines the boundaries of a firm? How are the internal structures of the firm determined? In what organisational framework does the entrepreneur carryout his activities? Or in short, Does the entrepreneur need a firm?

There seems to be obvious, but as yet unexplored, overlaps between the Austrian approach to microeconomics, mainly to do with the market, and other institutions or organizations, such as the firm. Why such inactivity on the part of Austrian economists on the question of these other institutions? It seems to be a shortcoming in current Austrian thinking.

Austrian economics and the theory of the firm

Peter Klein maintains an online bibliography of articles and books dealing with applications of Austrian economics to the theory of the firm. Unfortuately he hasn't been able to update the bibliography on a consistent basis.

He has a bleg, please send him, pklein at missouri dot edu, any suggested additions and corrections (ideally with URLs). Self-nominations are welcome!

Empirical Research on Firms’ Boundaries

In an earlier message I referred to the Lafontaine and Slade survey paper "Vertical Integration and Firm Boundaries: The Evidence" which appeared in the Journal of Economic Literature, Vol. XLV (September 2007). Now the May 2008 issue of the Canadian Journal of Economics, contains a another review article covering the same area. Thomas Hubbard writes on the "Empirical Research on Firms’ Boundaries." Hubbard's aim is not to give a survey of the empirical literature in the normal sense but rather he tries to give sense of where he thinks the literature is, how it got there, and where it might go next. The four main points he makes in the essay are:

• A large share of the empirical literature has examined whether firms’ boundaries vary with the degree of asset specificity. Most papers in this literature find evidence that integration is more likely where asset specificity is higher, though many of them examine contexts where assets are large and long-standing and relationship-specific investments are accordingly large.
• A more recent literature, which emphasizes incentives and control, has examined contexts where relationship-specific investments are not as prominent. Variation in the contracting environment plays an important role in these studies. My general inference from this literature is that outsourcing implies strong, but not necessarily good, incentives. Whether outsourcing’s strong incentives are good incentives depends critically on the contracting environment and the interaction between asset ownership and the division of labor. The specific implications of this general conclusion thus depend on context-specific details.
• The empirical literature is long on examining the nature of firms’ boundaries in specific contexts and relating it to theory, but short on quantifying the effect of this organizational decision and on establishing general cross-industry patterns. More evidence on these fronts would usefully complement the theory-testing industry studies that have dominated the literature to date.
• Researchers have made important methodological advances, though not in the same sense as in other empirical fields where such advances are more rooted in econometrics. This progress has led researchers to establish strong ties between theoretical concepts, the applied context, and the data in the context of these industry studies. These advances have led to a more-or-less standard way of conducting and communicating theoretically motivated industry studies; advances in other dimensions are necessary for broader or more quantitatively oriented research to become equally developed.

The Hubbard paper can be usefully read along side the Lafontaine and Slade survey and this paper by Peter Klein.

(HT: Organizations and Markets)