Ch. 6, The Volatile Character of the Firm

We have seen that the firm can be viewed as an ‘island of specialisation’ that establishes production outside the limits of the existing market. Production that utilises a more intensive division of labour, one that is ‘different in degree and kind’ than that already employed in the market, is from an economic point of view necessarily located outside the extent of the market, which makes it observable as a separate entity of sorts and thereby has clearly defined boundaries. There is a real difference between market production and the type of highly intensive, specialised production that is established outside the market’s extent. This type of ‘island’ is defined by its distinct internal organisation, which is what separates it from the market as well as determines its boundaries. This provides a single answer to two of the Coasean questions, while making the remaining question about rationale irrelevant: there is no specific rationale for integrating production in a firm for the simple reason that the firm is not the intended purpose or even the means – it is the result of implementing a novel production process.

Note that this explanation of the firm is not dependent on a specific legal apparatus or institutional context. It is not a ‘legal fiction’, but is a purely economic explanation: the firm, as it here emerges, is an implemented production process that utilises extra-market specialisation and is thereby distinct from the existing market. It is defined by the fact that its internal organisation is not and cannot be coordinated through a market – it supersedes the market specifically by establishing productive innovation outside its scope. The theory of the firm is hence not a separate theory of organisation, but an explanation of how productive innovation is implemented within (or, perhaps more accurately, outside) the larger context of market production to better satisfy consumer wants. The firm is a ‘formal organisation’ in the sense that it is naturally and observably separate from the market’s price coordination due to the strict interdependence between tasks that compose its production process. The identification of the firm as ‘an entity’ arises due to the fact that it necessarily is one: all parts of the innovative production process are necessary as it would otherwise suffer incompleteness and therefore fail. It indeed relies on a non-price means for coordinating production, just like Coase and others have asserted, but it is not formed with the intention to replace it. In fact, this central point is much more general than that: the firm is not a means chosen in order to avoid the market or to minimise costs or to control information, but the outcome of implementing innovative production through intensive specialisation. The firm is the necessary outcome of implementing productive innovation that cannot be realised through means available in the market.

But the question is if we can conceive of the firm as anything but an intentional construction, a means to attain some specific end. The empirical firm appears to be real in a different way than an intensively specialised production process consisting of interdependent (due to uniqueness and therefore insubstitutability) parts. The usual way we think of a firm is as a formal, concrete organisation that exists in a very real sense. The concept of the firm that arises from our discussion on the distinction between market-based and extra-market production – as an ‘island of specialisation’ – seems much more fluid and volatile. There are two ways of approaching this question about the ‘nature’ of the firm and attempt to answer it. One becomes available by decomposing and, as a consequence, criticising the common understanding of the firm by realising that the substantive nature of the firm is in many respects an illusion. The other is to elaborate on our previous discussion on specialised production in order to show that the type of firm that arises from it in fact significantly (or even perfectly) overlaps with the empirical firm’s economic being.

The Elusive Nature of the Empirical Firm

The contemporary theory of the firm tends to begin with an implicit assumption of what a firm entails based on empirical observation, and then theorise on its meaning. To again refer to Coase’s ground-breaking article, his starting point is the identification that the market is not a pure market as assumed in economic theory’s model of perfect competition. In contrast, he notes that in ‘a large sphere in our modern economic system’ production is coordinated within firms in a way that ‘is akin to what is normally called economic planning’.[i] Coase asserts that the firm is a formal organisation that is based on the concept of authority, which supersedes the market’s price mechanism and therefore is distinct from market coordination. This view, he maintains, suggests a definition of the firm that ‘corresponds to what is meant by a firm in the real world’[ii] and is therefore both useful and relevant from a theoretical point of view.

It is worth nothing, however, that Coase here avoids much of the complexity by uncritically accepting the common perception of the empirical phenomenon as definition. By asserting that the firm is constituted by economic planning through authority, Coase’s theory can only reiterate and reinforce this assertion – his theory is fundamentally constrained by this definition, which should raise doubt about the conclusions drawn from his theorising. His identification that production within the firm is hierarchical and ‘directed’, in contrast to market production as only passively coordinated through prices, emanates from his definition but is ultimately questioned by his later work. The reciprocal nature of economic action and its implications, a major contribution in Coase’s other seminal article,[iii] suggests that authority cannot be established through market contracting. The very nature of contract is to specify rights and duties for all the parties involved, and unless there is some other basis than economic incentives for the contract (such as legal mandates or decrees) there can be no authority established that does not also imply reciprocal authority for the counterparty.

As discussed in previous chapters, there is reason to question the relevance and validity of much of what is commonly thought of as characteristics or qualities of the firm. The basis for authority within the firm, especially when assumed to be different from any authority arising in the market, is at best unclear. The assumption that unidirectional authority is established through voluntary contract, employment contract or other types, does not hold water unless we also consider extra-economic aspects and implications of contracting. The identification of the firm as a formal hierarchy that is thereby distinguishable from the horizontal and undirected market exchange also appears to be an assertion without much basis.

It is very difficult to find the definitive explanation for why we consider a corporation such as IBM an organisational entity. The exercise of finding a purely economic definition of a business organisation amounts to peeling an onion in search of its core. Much of our ‘real world’ understanding of what the firm is appears to hinge on identifications that are primarily of legal origin. To explain the economic function of the firm, which is our purpose here (as it was Coase’s), we must decompose the empirical conception and rid it of legal fictions. We must also consider the social implications of these legal aspects, as the formal legal entity of IBM and its thereby assumed legal authority give rise to identifying ‘it’ as a concrete presence. The fact that we believe there is a corporation called IBM that is involved in certain types of production undoubtedly affects our actions, but this does not in itself suggest that IBM exists independently of our perceptions or that it is a specific economic phenomenon in itself. It also does not provide a basis for an economic function provided by the presumed identity IBM independently of the market actors presumed to be ‘inside’ the firm. In other words, the function of the firm remains to be discovered despite the vast literature intended to solve this exact problem.

Unless the firm, however we conceive of the phenomenon, solves a problem or in some other way provides a value that is not possible through non-firm market action, it has neither a function nor a rationale. It is not sufficient to assert that the firm is different from the market and then uphold this difference as a reason for firm organising. Coase ultimately asserts that the firm is defined by the supersession of the price mechanism through reliance on authority, itself without explanation, and that there is value to firm organising because authority escapes the costs of non-authority (in Coase’s case marketing costs, later termed transaction costs). This type of circular reasoning based on a seemingly realistic but essentially unargued-for assertion (such as the unique implications of the employment contract) gave rise to the extensive and important discussion on the legal fiction of the firm in the 1970s. Despite this discussion, this type of reasoning is still commonplace in the theory of the firm literature.

It is the purpose and contribution of this book to shift the focus in the literature toward the economic function provided by the firm. Rather than starting with some conception of the firm, the discussion here starts with the market and looks specifically to the limits of production due to the extent of the market. The assumption is that firms play a role in production, and that it is in some distinct value provided to the market’s productive apparatus that we find the economic function of the firm. We elaborated on this in previous chapters in terms of a ‘specialisation deadlock’ that limits the market’s ability to implement innovative production processes. This discussion suggested that production processes implemented outside the extent of the existing market are integrated by default, if not encapsulated, by being subject to strict interdependence and therefore devoid of market as there is no redundancy. It is not a supersession of the price mechanism in the Coasean sense, since it is not a means to avoid costs of the market. Rather, it is impossible to establish this type of production outside the extent of the market using market means, and therefore the firm is necessarily non-market. But this suggests that it comes at great cost, since the nature or production relying on extra-market specialisation is subject to excessive uncertainty due to strict interdependence and deferred returns on investment. It is for these reasons not a preferred course of action or a choice, but necessary in order to realise the type of productive innovation imagined. Whenever the costs of uncertainty can be avoided through adopting market means, doing so should be preferred by those involved in the endeavour.

The Cost of Uncertainty

It is possible to “break free” from the market’s specialisation deadlock, but doing so is fraught with uncertainty due to implementational unknowability and incompleteness in case of failure. The costliness of this uncertainty suggests that projects to realise innovations would not be undertaken unless there was significant potential for gain through productivity. Innovator entrepreneurs should therefore find that innovations of lacking originality, which may not be sufficiently novel and productive to make up for the uncertainty, have very limited appeal. In other words, innovations of only limited originality that are therefore expected to increase productivity merely to a limited extent may be unrealisable. There is an ‘infeasibility zone’ between the market’s present specialisation intensity, that is, market production, and the intensively specialised productive innovations that increase productivity sufficiently to cover the cost of uncertainty, or what we refer to as the firm. This ‘zone’ arises due to the fact that all productive innovations that are impossible to realise through market means suffer from unknowability and that their internal strict interdependence suggests incompleteness even due to failure in one of their parts. Implementation of these innovations should therefore primarily take place for innovations that constitute radical rather than marginal change in the structure of production.

Whereas this fact is limiting in terms of the scope of what can and will be realised, it also indicates that only the most promising productive innovations will be undertaken. In this sense, the productive innovations that see the light of day are the ones that can potentially disrupt the present state of market production. The effect of a successful endeavour should therefore be noticeable on a market level since existing production becomes relatively unproductive. We will return to this issue from a market process perspective in chapter 8. The discussion here is limited to the effects and implications on the actor or firm level.

As indicated by the nature of a productive innovation, conceived here in terms of intensified specialisation through implementing a novel and more far-reaching division of labour, the undertaking is uncertain, costly, and likely transient. It is uncertain because it is fundamentally unknowable prior to being implemented, and it is costly because of this uncertainty as well as because the process itself – due to being firmly placed outside the extent of the market – is subject to incompleteness. Whereas a process that has been implemented, completed, and shown its worth through profitability should be subject to lesser costs of uncertainty, it may still be subject to severe inefficiencies. The only feedback available to the entrepreneur is in terms of the process as a whole, as we saw in previous chapters, since it either makes a profit or fails the market test. But the value of the individual parts is necessarily unknowable, and this state of affairs translates into strong reasons for the firm as an island of specialisation to be a transient phenomenon – a ‘temporary’ solution, as it were.

The first reason is the expected competitive pressures from imitating entrepreneurs that will see the opportunity to implement similar structure and thereby capture part of the profits. This in fact provides the firm with a function in the macro-level discovery process of the market and the development and evolution of society through productivity and economic growth that we will discuss in chapter 8 and 9.

The second reason applies on the micro level and relates to the internal organisation of the firm irrespective of external competitive pressures. Whether or not the new process is implemented by an original entrepreneur with contractually employed labourers or as a collaborative effort by a team, there is no figuring out whether any single part of the process contributes to or subtracts from the bottom line. The reason for this is that each part is unique and previously untested, and therefore there can be no market valuation. This state of affairs, at least to some limited extent, suggests that there may be an incentive for those involved to shirk in their specific duties (to the degree effort is not measureable). As shirking could cause incompleteness and therefore failure, workers have no incentive to go ‘too far’ in doing this, and as long as the process does not suffer failure through incompleteness the infeasibility zone suggests that it should be sufficiently productive to at least compete on par with existing market production. This type of opportunism should therefore typically not be a cause of failure.

Nevertheless, there is incentive to minimise waste and effort as well as to maximise output – to increase profitability. Improvements that do not constitute the implementation of a new productive innovation are impossible, since they are necessarily carried out as tweaks to the process and/or its parts. But the efficiency and effectiveness of the parts are fundamentally unknown. Some technical improvements can of course be implemented as this type of information can be acquired through limited trial-and-error and by observation; as workers gain experience carrying out their specific tasks, they will identify better ways of carrying out the tasks (as we discussed above). However, the economic or allocative efficiency remains both unknown and unknowable. It may therefore be the case that a certain task is carried out in the wrong way, by the wrong person, or for the wrong reasons. More importantly, some tasks as well as features of the output may be economically unnecessary, and some that would greatly increase the value may remain undiscovered. Whether the output of this productive innovation is in its most valuable form (both in terms of quantity and quality) cannot be known and should therefore never be optimal or maximised. This type of essential knowledge can be available only when there is a market and scarce resources are allocated toward their most valued uses through the bidding of entrepreneurs and, as a result, the determination of market prices.

The reader may recognise this argument about economic (as opposed to technological) efficiency as an application of Ludwig von Mises’s argument against socialist planning.[iv] As the ‘island’ of intensive, extra-market specialisation by necessity is located outside the extent of the market, its internal economic efficiency cannot be discovered or learned. It is in this sense similar to a purely socialist economy, but not because it is centrally planned or directed (as in Coase’s firm) but because it functions without market input. This in itself is a cost to the entrepreneur(s), which is avoidable only through the making of market for the individual tasks of the innovated process. The profit generated through this productive innovation could typically be increased through improving the process economically, and this loss of potential profit is a burden on the venture whether or not it is already profitable in absolute terms. This becomes all too clear when imitating entrepreneurs establish competing production processes that capture part of the potential profits, and possibly outcompete the original implementation.

The initiating entrepreneur or entrepreneurial team must bear the uncertainty of the new process, and the cost thereof (at least part of which is in the form of unrealised profits) is a reason to seek and engage in market-making. Without a market, the parts of the process cannot be evaluated separately and therefore the output cannot be properly positioned. The only way to economically improve the process is to blindly test changes and then wait for real market feedback through effected changes in profitability levels. This is a costly and onerous process that could ultimately lead to failure; even tweaks and changes that are judged to have little or no effect on the output may have important implications on the innovation’s ability to meet real demand. In a dynamic market situation with changing customer preferences even seeming improvements to a product (or the production process) can lead to losses.

Without market signals, the firm is blind whether or not it is profitable. It is therefore an easy target for imitating entrepreneurs, who – with different knowledge or understanding of market needs – could find ways to undercut the original firm and improve on its design technically, organisationally, or economically. There is no means of protection against such threats, since the economic imperfections and inefficiencies of the implemented process are undiscoverable. This uncertainty is a burden on the shoulders of those involved in the project. The burden is further increased as the whole process is subject to failure due to incompleteness – which would mean losses across the board – if any task or worker should fail. For these reasons, the original entrepreneur and workers would welcome the introduction of market signals as guidance and to relieve them of the cost of uncertainty.

Market-making and the Firm

Even if a competitor emerges with the purpose of and is successful in capturing part of the profits made available by the innovation, this may be a welcome development for the original entrepreneur(s). The reason for this is that even a single competitor means there will be bidding for resources throughout the production process and therefore introduction of market prices that facilitate economic appraisement. The original implementation of the productive innovation took place outside the limits of the market, but the introduction of a single competitor in this production space effectively expands the extent of the market to encompass the new innovation. This change therefore relieves the original entrepreneur(s) of the burden of economic uncertainty. It makes it possible to discover and implement improvements to the process, to continue to develop the production process, improve or even replace individual tasks, and adjust the quality of the output to better fit real demand.

From our perspective, this development also indicates a beginning of the end of the firm. Whether or not the individuals involved continue to work together and be co-located, the economic function of the firm ceases to exist. With the entrant competitor, market prices – even though they are of limited reliability, in the sense that they may not properly reflect real consumer demand, as there are only two bidders – are established for intermediate goods that facilitate market appraisals of the separate tasks that compose the (formerly) productive innovation, and therefore the extent of the market has expanded. Indeed, even though there are only two parallel processes we find that this limited redundancy pushes competition down from the process to the task level. Less efficient workers as well as tasks are now as easily identifiable as they are avoidable, and this makes all the difference. Errors and failures must no longer affect the totality of the process, but can be limited to the task where the error is made; it is possible for all other tasks to remain profitable even should one task fail. The strict interdependence between tasks is relaxed and this limits the uncertainty assumed by those involved in the productive endeavour. This solves the knowledge problem within the process.

The firm, as we have here identified it, is necessarily a transient phenomenon, which exists only as far and as long as there is no market. Any other conclusion would be unintuitive, since we found the firm to be the implementation of a productive innovation outside the market’s extent and thereby unaffected by the existing market’s limited reach. The firm is then integrated in terms of its ‘internal’ strict interdependence and its parts united through the shared responsibility and uncertainty due to incompleteness. Its function from the perspective of the market is to ‘break free’ from the specialisation deadlock and thereby break new ground and achieve production unattainable through market means. If this undertaking is successful and profitable, which is to say that others may attempt to imitate for a share in the revealed profits, it leads to market-making and therefore an expansion of the extent of the market by including the new type of productive innovation.

It should be noted that expanding the extent of the market is not the aim of those involved in the original undertaking, but it is the possible end result. Implementing productive innovation through extra-market specialisation does not itself create a market, and in this sense it is possible for a firm to be long-lived – all it takes is that nobody else competes for the same profits. Market-making does not happen until competitors enter and compete with the original productive innovation and therefore determine market prices for intermediate goods. Market valuation is formed between competing processes not because there is explicit bidding for every intermediate good, resource or task, but because there is the potential for bidding. It is sufficient that there are potential other buyers to bid up payment, just like the potential for other sellers is sufficient to bring about lower prices. The original entrepreneur may attempt to bid up the price for resources used in the firm for the purpose of keeping other entrepreneurs from entering this production space. This is in itself market feedback that signals real valuation, since insufficiently high prices invite competitors and too high prices cause losses – even though the exact origin of those losses on a task level cannot be identified. This facilitates indirect appraisement of resources and thereby economic efficiency through allocation of resources toward real wants.

Competition from imitating entrepreneurs helps the original innovator-entrepreneur identify the proper scope of the firm as they establish limited a pricing mechanism through bidding and provide benchmarks for individual parts of the process. Even if the competing production process is different from the original innovation, the fact that the processes to some extent compete for resources to use in production as well as for buyers of the end product is sufficient to provide guidance in improving the process. Competition also reveals to the entrepreneur what parts of the established process may be less valuable or efficient, thereby facilitating further improvements and a change of scope. It may very well be that what the entrepreneur was convinced was the proper scope of process, quality of product, and so forth is improper given the demand. This information is revealed as competitors do better or worse by choosing different approaches and as they make tweaks and adjustments to the processes to better serve customers.

This market-making as competitors enter the same production space and compete directly with the original innovator entrepreneur ultimately leads to the dissolution of the firm. It no longer serves a function as competing entrepreneurs bid for the same resources and competencies and thereby establish market prices for the individual parts of the production process. The market in this sense expands to include the firm, and for this reason the process can and will be broken up into its parts as they are no longer interdependent. Yet this ultimate effect is not established immediately as a competitor emerges. The first result is that reliable information about the proper scope of the process is made available. This allows for the entrepreneur to tweak and make improvements to the process economically, which means that it better satisfies the wants and needs of those buying the product or service.

In addition to tweaks and changes to quality, quantity, and composition of the output of the process, the information that is revealed and made available through competition guides the entrepreneur in terms of what tasks should or shouldn’t be carried out. It is possible that competition reveals that more tasks should be part of the production process. In other words, the entrepreneur can realize that the firm should expand through insourcing tasks that were previously thought to be separate or unrelated to the process. More likely, especially in the longer run, the firm will engage in outsourcing of specific tasks that are no longer necessary to include ‘internally’ and that are better carried out by others. Whereas this may be the case for parts of the core production process, this should not often be the case since this is the unique contribution of the firm. But supporting services, which are originally part of the firm but not core to the productive innovation, could more easily become spinoffs as competitors should also rely on those services. For example, a novel production process could necessitate innovation in accounting, marketing, logistics, or skills development processes that are necessary to support the core production process but are in fact separate to it. This is a possible opportunity for breaking out such services if competitors who attempt to establish similar production processes, or form unique production structures that recreate similar benefits only in the end result, could also benefit from such services. The original entrepreneur can choose to keep such services internally, but it is likely that they are spin off and let go. The reason for this is that they are not core to but established to support the production process, and therefore not essential to keep at arm’s length. Even if separating the core process from supportive processes would make them available for competitors, it means the entrepreneur benefits from being able to purchase the service at market price. With competition in such services, the cost is likely to go down. But it also releases resources, at a minimum in terms of the entrepreneur’s own time and attention, by allowing him or her to focus on the core contribution: the productive innovation. For these reasons, it can often be beneficial to let go of direct control of such services. This narrows the firm’s scope and makes it, as an entity, more specialised and therefore potentially much more effective and profitable. It thereby relieves the entrepreneur of uncertainty by both allowing market forces to regulate the supporting services and by being able to focus fully on the core process. We will return to the interplay between the firm and the competitive market process in chapter 8.

[i] R. H. Coase, ‘The Nature of the Firm’, Economica, 4:16 (1937), pp. 386-405, p. 388.

[ii] Coase, ‘The Nature of the Firm’, p. 386.

[iii] R. H. Coase, ‘The Problem of Social Cost’, Journal of Law and Economics, 3:1 (1960), pp. 1-44.

[iv] See L. v. Mises, ‘Economic Calculation In The Socialist Commonwealth’, in Hayek (ed) Economic Calculation In The Socialist Commonwealth (London: George Routledge & Sons, 1935), pp. 87-130, L. v. Mises, Socialism: An Economic and Sociological Analysis (1936) (New Haven, CT: Yale University Press, 1951).