TN Theories of the Firm(2)

THEORIES OF THE FIRM The central issue Why do firms (in general ) exist? This question is one that has preoccupied many scholars of organisations. However, it is probably true that economists, rather than those interested in management or business, have spent a greater amount of time (and paper) investigating the twin questions of ‚Why do firms exist? Why isn’t everything done by the market‛ (The Economist, 2010, para. 1). 1

One view—presented by Kantarelis, an economist— argues that a firm is … a needs-satisfying machine; it is an entity invented and employed by society to better satisfy the society’s interests. A society is better off when properly regulated business firms are allowed to carry the bulk of economic activity than when they are not allowed to exist or are severely regulated by the state. And, as history has documented, societies fare better when they are dependent on such business firms than when they are dependent on central planning (2010, p. 3). You might like to reflect on Kantarelis’s statement, especially in the light of the discussions around corporate social responsibility. In the classic book The wealth of nations, Adam Smith (1776) describes how the division of labour—the splitting up of jobs into small parts—can produce significant increases in productivity. The example he uses is of pin making: … a workman not educated to this business … could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on .. it is divided into a number of branches. … One man draws out the wire; another straights it; a third cuts it; a fourth points it; a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business; to whiten the pins is another; … to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations …. I have seen a small manufactory of this kind … make among them [the ten persons in the factory] about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. (Smith, 1776, pp. 11-12, italics added). In other words, by dividing the work in to small tasks, in which people can become very efficient, productivity rose from 20 pins to around 40,000 pins per person per day. However, is productivity alone the explanation as to why firms exist?

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This is a different question to asking why does a particular firm exist.

Theories of the firm 2 The perspectives from economics Since Adam Smith’s time, four main theories have emerged that seek to explain why firms exist. These main theories are the Transaction Cost Theory of the Firm, the Principal-Agent Theory of the Firm, and the Evolutionary Theory of the Firm. The Transactions Cost Theory of the Firm is attributed to Coase (1937) and more recently to Williamson (1975). TCE, as it is sometimes called, focuses on problems that arise during transactions because of asymmetric information; that is to say, the seller and buyer know different things. The fundamental argument behind TCE is that it is sometimes cheaper to do things inside the firm rather than incurring the expense of going to market. In particular, Coase argues that the more specific the inputs required by the firm, the more likely it is that the firm would do or produce them internally rather than going to the market to buy them. This theory explains the rise of the highly diversified business (The Economist, 2010), but it does not account well for how firms utilise their advantages, or how they evolve over time. The Principal–Agent Theory of the Firm, sometimes called agency theory, extends the TCE by considering the impact of information asymmetry again. But instead of differences in the information known between the buyer and the seller, agency theory is concerned with the differences in information between the principal (say, the owner) and the agent (say, the manager to whom the owner has delegated authority and responsibility). In particular it looks at: … resolving two problems that can occur in agency relationships. The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing (Eisenhardt, 1989, p. 58). How does one ensure that the agent is doing what the principal wants them to do (in the face of information asymmetry between them). Principal-agent theory goes beyond the owner-manager situation and considers all relationships where there might be such an asymmetry. Agency theories weakness is the challenges of structuring incentive mechanisms. It often relies on complicated—and sometime incomplete or unenforceable— contracts. Furthermore, while sharing some of the same routes as TCE, it doesn’t address some of the problems as effectively as ‘pure TCE’, neither does it explain the evolution of firms. The Evolutionary Theory of the Firm (Nelson & Winter, 1982), unlike neo-classical theories (such as TCE) which focus on equilibrium and stability, is a dynamic theory that seeks to address how and why change happens. According to Kantarelis (2010, p. 6), the evolutionary theory of the firm: … emphasis on production capabilities and process as well as product innovation. The firm, according to this theory, possesses unique resources, tied semi-permanently to the firm, and capabilities; the firm’s resources can be classified into four categories: financial, physical, human and organisational. The theory sees the firm as a reactor to change and a creator of change for competitive advantage. The firm, as a creator of change, may cause creative destruction, which in turn may

Theories of the firm 3 give birth to new industries and enable sectors of, or entire, economies to grow‛. A more managerial perspective These three theories of the firm are grounded in economics. However, outside of economics there are a number of other theories of the firm, but the most notable is the Behavourial Theory of the Firm. This approach, associated with Cyert and March (1963), emphasises the behavioural nature of decision-making in firms. Such decisions are made in situations of uncertainty, a situation that arises because ‚rational actors are significantly constrained by limitations of information and calculation‛ (1963, p. 214) and so they have ‘bounded rationality’. As a result, individuals and groups tend to ‘satisfice’ (Augier & March, 2008), rather than maximise the outcome of their decisions. The notions of ‘bounded rationality’ and ‘satisficing’ are very important ideas in the management arena. Further reading If you want to know more about the Behaviour Theory of the Firm, rather than jumping in and reading the book, you might begin with the retrospective review written by Augier and March (2008). References Augier, M., & March, J. G. (2008). A retrospective look at A Behavioral Theory of the Firm. Journal of Economic Behavior & Organization, 66(1), 1-6. doi:10.1016/j.jebo.2008.01.005 Coase, R. H. (1937). The nature of the firm. Economica, 4(16), 386-405. doi:10.1111/j.14680335.1937.tb00002.x Cyert, R. M., & March, J. G. (1963). A behavioral theory of the firm. Englewood Cliffs, NJ: Prentice-Hall. Eisenhardt, K. M. (1989). Agency theory: An assessment and review. The Academy of Management Review, 14(1), 57-74. doi:10.2307/258191 Kantarelis, D. (2010). Theories of the firm (3rd ed.). Geneva: Inderscience Enterprises. Nelson, R. R., & Winter, S. G. (1982). An evolutionary theory of economic change. Cambridge, MA: Harvard University Press. Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations (Vol. 1). Chicago: Chicago University Press. The Economist. (2010, December 16). Why do firms exist? The Economist. Retrieved from http://www.economist.com/node/17730360/print Williamson, O. E. (1975). Markets and hierarchies, analysis and antitrust implications: A study in the economics of internal organization. New York: Free Press.