Summary theories of the firm

05/02/2014 § 4 Comments

Paul Walker over at antidismal mentioned that he has a new article in the Journal of Economic Surveys on theories of the firm. There’s a pre-publication version on his University of Canterbury website. It’s highly recommended reading if you have any interest in why firms exist and what they do.

Titled ‘Contracts, entrepreneurs, market creation and judgement: the contemporary mainstream theory of the firm in perspective’, it reviews the standard theories and provides a bit of history and context for how they fit (or don’t) into mainstream economics theory. Essentially, if you assume perfect information and foresight, why do we need firms when we could all be individuals contracting amongst ourselves? The two reasons usually offered are principal-agent problems as a result of asymmetric information, and the incompleteness of contracts, which leads to the need for post-contract flexibility.

Walker also goes on to look at a few recent developments. One is the idea that firms are institutions whose objectives differ from those of the owners — a type of owner/management split that will be familiar to financial types. The other is a focus on the entrepreneur, familiar to Austrians (and Schumpeterians, if IIRC).

This is material I have to deal with reasonably often, but I know only bits and pieces of it. We are often thinking about why specific institutional arrangements have arisen, or what kind of information asymmetry or transaction cost we are facing and how to resolve it. Having a well-structured framework of the literature with commentary is really helpful.

I will gin up my Opinion-Inator for one point. I’m less convinced about entrepreneur-led theories of the firm. First, they fit with the same world-view (Weltanschauung) that focuses on great-man explanations of history, which I find insufficient. Secondly, entrepreneurs in the flesh are not as heroic as they are in theory. It is possible to rescue the Entrepreneur from this observation, but only by making a distinction between Entrepreneurs and ordinary business owners. That just seems like a ‘no true Scotsman‘ fallacy. And finally, even if the above criticisms didn’t hold, lots of firms in the current economy aren’t entrepreneur-led. They are massive bureaucracies. That needs explaining, which other theories do.

It is important to remember the legal fiction/arrangement that produces modern firms, the Limited Liability Company/Corporation. It is a device to limit the liability of individuals; it separates individuals from the full consequences of their actions. In a micro sense, it allows entrepreneurs and investors to take advantage of the upside of economic activity while protecting them from the downside. In a macro sense, the arrangement has fostered a good deal of investment and risk-taking and economic activity with widespread benefits. That protection is an important reason for people choosing to organise into legally distinct organisations.

Walker’s article includes this ‘nexus of contracts/legal fiction’ view of firms, as well as lots of others. It is a concise and readable survey that I’ll be using myself and recommending to others.

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§ 4 Responses to Summary theories of the firm

  • Paul Walker says:

    Thanks Bill. You did catch me out in that the version of the paper I had on line wasn’t the latest and had a mistake in it! All fixed now. As to the idea that lots of firms in the current economy aren’t entrepreneur-led, Spulber in particular would agree with you. For him firms become firms only when the entrepreneur becomes an owner.

    • I do hope people download the paper, so thanks for fixing it. Your comments have made me interested in Spulber’s paper, but it will have to wait. I’m leery of explanations that re-define common words like ‘firm’.

  • Paul Walker says:

    Interestingly on the limited liability point, Henry Hansmann and Reinier Kraakmann have two papers – “The Essential Role of Organizational Law,” 110 Yale Law Journal 387-440 (2000) and “Organizational Law as Asset Partitioning,” 44 European Economic Review 807-17 (2000) – in which they argue that the essential role of all forms of organizational law is to provide for the creation of a form of “asset partitioning”. One aspect of this asset partitioning is the delimitation of the extent to which creditors of an entity can have recourse against the personal assets of the owners or other beneficiaries of the entity. But this function of organizational law—which includes the limited liability that is a familiar characteristic of most corporate entities—is, they argue, of distinctly secondary importance. The truly essential aspect of asset partitioning is, in effect, the reverse of limited liability—namely, the shielding of the assets of the entity from claims of the creditors of the entity’s owners or managers.

    • Well, that flips things on its head, doesn’t it?

      I was thinking while posting that we have developed several such mechanisms. We have not just firms but also incorporated societies and trusts. They are all separating people from either things or consequences. We must have decided that’s useful, given their continued existence.

      This paper you’ve cited sounds intriguing. They put assets in the centre of the argument, not people. It means we want the assets/property to have continuity of use despite the vicissitudes of ordinary life. Which I guess could be a definition of ‘capitalism’.

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