theory of the firm


  • He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within
    a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur … who directs production.” He asks why alternative methods of production (such as the
    price mechanism and economic planning), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.

  • [14] Transaction cost theory According to Ronald Coase’s essay “The Nature of the Firm”, people begin to organise their production in firms when the transaction cost of coordinating
    production through the market exchange, given imperfect information, is greater than within the firm.

  • [6][7][8][9][10][11][12] Background The First World War period saw a change of emphasis in economic theory away from industry-level analysis which mainly included analyzing
    markets to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved.

  • [18] Klein (1983) asserts that “Economists now recognise that such a sharp distinction does not exist and that it is useful to consider also transactions occurring within
    the firm as representing market (contractual) relationships.” The costs involved in such transactions that are within a firm or even between the firms are the transaction costs.

  • The need for a revised theory of the firm was emphasized by empirical studies by Adolf Berle and Gardiner Means, who made it clear that ownership of a typical American corporation
    is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves.

  • [16] Reconsiderations of transaction cost theory[edit] According to Louis Putterman, most economists accept distinction between intra-firm and interfirm transaction but also
    that the two shade into each other; the extent of a firm is not simply defined by its capital stock.

  • In practice, diminishing returns to management contribute most to raising the costs of organising a large firm, particularly in large firms with many different plants and
    differing internal transactions (such as a conglomerate), or if the relevant prices change frequently.

  • [31] All in all, this study shows that smaller firm sizes experience a better output in terms of cost to benefit ratio and foster a hard-working, incentive-focused work environment.

  • Ultimately, whether the firm constitutes a domain of bureaucratic direction that is shielded from market forces or simply “a legal fiction”, “a nexus for a set of contracting
    relationships among individuals” (as Jensen and Meckling put it) is “a function of the completeness of markets and the ability of market forces to penetrate intra-firm relationships”.

  • [28] The concept of boundaries can be linked to Coase’s understanding of The Nature of the Firm, as it recognises that transaction costs are a significant factor in a firm’s
    decision to outsource, or internally produce, but also considers other influences specific to firms, such as their relevant capabilities, and governance decisions.

  • [24] This causes problems if the assets are owned by different firms (such as purchaser and supplier), because it will lead to protracted bargaining concerning the gains from
    trade, because both agents are likely to become locked into a position where they are no longer competing with a (possibly large) number of agents in the entire market, and the incentives are no longer there to represent their positions honestly:
    large-numbers bargaining is transformed into small-number bargaining.

  • Moreover, there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after
    the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the hold-up problem, which occurs when either party asymmetrically
    incurs substantial costs or benefits before being paid for or paying for them).

  • This is partly because it is in the nature of a large firm that its existence is more secure and less dependent on the actions of any one individual (increasing the incentives
    to shirk), and because intervention rights from the central characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the lesser responsibility, thereby diluting incentives.

  • In effect, therefore, this is a “principal-agent” theory, since it is asymmetric information within the firm which Alchian and Demsetz emphasise must be overcome.

  • Hence, whether or not outsourcing an activity to a different firm is optimal depends on the relative importance of the investments that the trading partners have to make.

  • Milgrom and Roberts (1990) explain the increased cost of management as due to the incentives of employees to provide false information beneficial to themselves, resulting
    in costs to managers of filtering information, and often the making of decisions without full information.

  • [citation needed] George Akerlof (1982) develops a gift exchange model of reciprocity, in which employers offer wages unrelated to variations in output and above the market
    level, and workers have developed a concern for each other’s welfare, such that all put in effort above the minimum required, but the more able workers are not rewarded for their extra productivity; again, size here depends not on rationality
    or efficiency but on social factors.

  • [6] An informal answer has been provided by Oliver Williamson (1979), who has emphasized the importance of different transaction costs within and between firms.

  • Hence team production cannot offer the explanation of why firms (in particular, large multi-plant and multi-product firms) exist.

  • Leibenstein (1966) sees a firm’s norms or conventions, dependent on its history of management initiatives, labour relations and other factors, as determining the firm’s “culture”
    of effort, thus affecting the firm’s productivity and hence size.

  • The theory of the firm consists of a number of economic theories that explain and predict the nature of the firm, company, or corporation, including its existence, behaviour,
    structure, and relationship to the market.

  • Organisational structure, incentives, employee productivity, and information all influence the successful operation of a firm in the economy and within itself.

  • [33] According to the property rights approach to the theory of the firm based on incomplete contracting, the ownership structure (i.e., integration or non-integration) determines
    how the returns to non-contractible investments will be divided in future negotiations.

  • If a firm operated internally under the market system, many contracts would be required (for instance, even for procuring a pen or delivering a presentation).

  • [citation needed] The weakness in Alchian and Demsetz’s argument, according to Williamson, is that their concept of team production has quite a narrow range of applications,
    as it assumes outputs cannot be related to individual inputs.

  • Coase begins from the standpoint that markets could in theory carry out all production and that what needs to be explained is the existence of the firm, with its “distinguishing
    mark … [of] the supersession of the price mechanism.”

  • In contrast, a real firm has very few (though much more complex) contracts, such as defining a manager’s power of direction over employees, in exchange for which the employee
    is paid.

  • These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating
    and writing enforceable contracts for each transaction (which can be large if there is uncertainty).

  • We can therefore think of a firm as getting larger or smaller based on whether the entrepreneur organises more or fewer transactions.

  • [30] Importance of boundaries[edit] A study of firms in France illustrated how the number of employees and size of a firm directly impacts levels of productivity, wage and
    welfare within the organisation.

  • Instead, for Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism.

  • In Barzel (1982)’s theory of the firm, drawing on Jensen and Meckling (1976), the firm emerges as a means of centralising monitoring and thereby avoiding costly redundancy
    in that function (since in a firm the responsibility for monitoring can be centralised in a way that it cannot if production is organised as a group of workers each acting as a firm).

  • If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing
    the transaction costs.

  • Meaning, there are economies of scope where it is less expensive for firms to combine two or more product lines into one, than it is to produce each product separately.

  • For Alchian and Demsetz, the firm, therefore, is an entity that brings together a team that is more productive working together than at arm’s length through the market, because
    of informational problems associated with monitoring of effort.

  • In particular, an analysis of why firms with employees above the threshold of 50 declined in the early 2000s is conducted to further understand the correlation between size
    and output.

  • In this kind of situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one
    of them from the equation by takeover or merger.

  • For example, in a labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending
    on demand/supply conditions.

  • These two factors together determine how many products a firm produces and how much of each.

  • Thus, firms engage in a long-term contract with their employees or a long-term contract with suppliers to minimize the cost or maximize the value of property rights.

  • [23] Thus according to them the firm emerges because extra output is provided by team production, but the success of this depends on being able to manage the team so that
    metering problems (it is costly to measure the marginal outputs of the co-operating inputs for reward purposes) and attendant shirking (the moral hazard problem) can be overcome, by estimating marginal productivity by observing or specifying
    input behaviour.

  • [34][12][41] They argue that if contracts cannot specify what is to be done given every possible contingency, then property rights (and hence firm boundaries) matter.

  • [42] Chiu (1998) and DeMeza and Lockwood (1998) have extended the model by considering different bargaining games that the parties may play ex post (which can explain ownership
    by the less important investor).

  • Economic theory until then had focused on trying to understand markets alone and there had been little study on understanding why firms or organisations exist.

  • In practice, this may have limited applicability (small work group activities, the largest perhaps a symphony orchestra), since most outputs within a firm (such as manufacturing
    and secretarial work) are separable so that individual inputs can be rewarded on the basis of outputs.

  • Asset specificity can also apply to some extent to both physical and human capital so that the hold-up problem can also occur with labour (e.g.

  • [6] Ronald Coase set out his transaction cost theory of the firm in 1937, making it one of the first (neo-classical) attempts to define the firm theoretically in relation
    to the market.

  • He notes that government measures relating to the market (sales taxes, rationing, price controls) tend to increase the size of firms, since firms internally would not be subject
    to such transaction costs.

  • While, the number of employees will vary from firm to firm, examining existing firms, allows for discrimination in setting boundaries for the firm and are crucial.

  • [44] Schmitz (2006) has studied a variant of the Grossman–Hart–Moore model in which a party may have or acquire private information about its disagreement payoff, which can
    explain ex post inefficiencies and ownership by the less important investor.

  • [37] In sum, the limit to the firm’s size is given where costs rise to the point where the market can undertake some transactions more efficiently than the firm.

  • Since the reason for the firm’s being is to have lower costs than the market, the upper limit on the firm’s size is set by costs rising to the point where internalising an
    additional transaction equals the cost of making that transaction in the market.

  • It might also be costly for employees to shift companies every day looking for better alternatives.

  • However, it is worth noting that firms with employee numbers above 50 become rigid on their wage allocation for each worker.

  • [36] Other models Efficiency wage models like that of Shapiro and Stiglitz (1984) suggest wage rents as an addition to monitoring, since this gives employees an incentive
    not to shirk, given a certain probability of detection and the consequence of being fired.

  • [25] Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm’s size increases its hierarchical bureaucracy does too), and
    the large firm’s increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur.

  • Coase concludes by saying that the size of the firm is dependent on the costs of using the price mechanism, and on the costs of organisation of other entrepreneurs.

  • Traditional managerial models typically assume that managers, instead of maximising profit, maximise a simple objective utility function (this may include salary, perks, security,
    power, prestige) subject to an arbitrarily given profit constraint (profit satisficing).


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