Summary theories of the firm

By Bill Kaye-Blake 11/02/2014

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.