Previous chapters established how the firm, conceived of as an ‘island of specialisation’, emerges as a result of establishing innovative production processes that fall outside the extent of the existing market. Focus was on primarily the practical aspects of technical production – how to overcome the ‘specialisation deadlock’ that inhibits further specialising and division of labour through productive innovation. Market exchange cannot support novelty that goes beyond recombination or reconfiguration of already existing and traded resources. New types of production processes must therefore be established outside the extent of the market, which makes the novel production structure stand out as a separate, non-market phenomenon: a firm. This type of production structure suffers from strict interdependence between its ‘internal’ parts due to the lack of compatibility with production in the existing market, which is akin to integrated production. It also causes another impediment: an increased need for financial capital.
For a new production structure to be established outside the extent of the market, it is not sufficient to populate each imagined task with specialised labour (possibly supported by novel capital goods). As we saw in the previous chapter, the outcome of the new process is unknown until it is completed. Should any part of the process fail, the outcome is incomplete and therefore incompatible with production taking place in the market. For this reason, the whole process fails. Even if the process is successful, income will not be available until the full process is completed and the outcome sold. Yet costs of production are incurred whether or not the firm will accrue revenue upon completion, which means the firm will always have a lag between costs and revenue – which can be substantial where the process is highly roundabout. To establish a new production process, therefore, requires an investment over time: costs in the present, both for implementing the process and carrying out production tasks, must be covered for the promise of future earnings. Or, in other words, goods in the present are traded for goods in the future.
We therefore see that whoever makes the initial investment to cover the immediate costs, as well as costs that arise as the production process is implemented and then market-oriented production carried out, bears the burden of uncertainty for the whole process. Returns to any investments made in production processes outside the extent of the market will accrue only after the production process is completed and the outcome has proven to be marketable. This means that the capitalist function of supplying temporal investments is in large part indistinguishable from the entrepreneurial function of bearing uncertainty: whoever makes the initial investment necessarily also bears the uncertainty of the enterprise, since any returns to the novel production structure are fundamentally unknown and unknowable (though not unimaginable) prior to its completion. Whereas the returns from investments in novel production processes outside the extent of the market may be expected to be greater than the going rate of return on investments made within the existing market, the investor also risks losing the principal. This risk of loss amounts to an increase in the cost of capital invested in the firm, whether it is in the form of debt or equity, which further suggests that the productive innovations that successfully attract capital investments are those that promise to revolutionise production. Extensive, revolutionising productive innovations should be more likely to have high expected returns than comparatively minor adjustments or additions to existing production. Such minor improvements to production would normally fall in one of two categories: they are either realisable from within the existing market (and are therefore not of the kind discussed here) or, in cases where implementation falls outside the extent of the market, offer only limited returns that may not cover the cost of capital.
As productive innovations necessarily see a lag between investment and returns, possibly a lag of several or extensive time periods, its implementation is impossible without capitalist investment. Sufficient funds must be made available in the present to cover costs of implementing as well as carrying out the production process before revenue is generated. This does not mean that the capitalist function must be undertaken by a single party – it can be a cooperative endeavour, perhaps by those called upon to carry out the tasks that make up the new production process. Yet it requires that funds are made available through investment in the present, which can neither be repaid nor earn returns until some time period in the future. As market demand for as well as the market value of outputs in the future are unknown, the undertaking to establish novel production (create a firm) is uncertain. This makes it a fundamentally entrepreneurial undertaking.
We may wish to think of the entrepreneur as the genius who comes up with the idea and drafts the novel process, and sets the implementation process in motion. But whoever invests capital or time in the project must bear the uncertainty of the undertaking through this investment. This includes those carrying out the tasks, since the strict task interdependence within the firm and the all-or-nothing nature of production in the face of incompleteness make all parties dependent on the end result. Furthermore, those employed within the firm have likely abandoned profitable market positions in order to enter the firm, and therefore they have already made an indirect investment by giving up income in the present for the promise of future returns in their new employment. So they too bear the uncertainty of the firm, at least before it has generated revenue through sales and thus passed the market test, by taking part in the process. This can be easily understood when considering the time period between the initial investment and the first sale, since the whole enterprise incurs costs and therefore faces incompleteness failure with a negative capital balance unless completed. This affects those employed within the firm, even if they are paid at regular intervals. But the main uncertainty is borne by the capitalist-entrepreneur through investing funds to cover outlays during implementation and initial production.
Investing and divesting in the ‘firm’
A major part of the uncertainty borne by the capitalist-entrepreneur arises due to the strict interdependence within the production process and therefore the threat of incompleteness. We touched on the cost of uncertainty in the previous chapter, and noted that there is both technical and economic uncertainty. The former relates to whether the totality of the imagined production process can be completed without errors and without causing incompleteness due to failures in materials or practical production tasks. Economic uncertainty relates to the issue of whether the outcome of the process will find sufficient effective demand to generate revenue that covers the costs, and whether the process is an efficient use of resources. It also relates to the issue of economic efficiency in allocation and use of resources within the separate tasks – without market prices the entrepreneur is essentially ‘blind’ to what would be the socially most highly valued use of resources (or even what uses should be considered destruction of capital). The opportunity costs within specific tasks in a productive innovation are unknown and unidentifiable as there are no existing alternative procedures to compare with or even alternative uses for the intermediate goods in the process. This suggests that the cost of uncertainty within production that takes place outside the extent of the market is of significant magnitude and can even be prohibitive. The question is then if the cost is avoidable, the answer to which depends on the time horizon considered.
The cost of uncertainty is initially unavoidable for the reason discussed above: the novel production structure suffers from incompleteness, strict interdependence between its parts, and lack of knowledge. As none of the tasks within a production process that is established through ‘splitting’ a market production task exists prior to the firm’s forming, there should be no question that the full uncertainty must be borne throughout the implementation, improvement, and completion of the process. This uncertainty is ultimately borne by those investing in the undertaking, who risk losing the principal investment. These investors or capitalist-entrepreneurs should wish to limit this cost of uncertainty, but as there is no social valuation through market pricing the uncertainty is unavoidable. The process can be improved technologically through adopting existing technological standards, choosing materials wisely, and so on. In terms of economic uncertainty, the only basis for making decisions is entrepreneurial judgement. This situation is unfavourable and costly, but inevitable. Entrepreneurs have a strong incentive to seek all means possible to reduce the uncertainty of the enterprise, which can possibly be achieved by relying to the greatest degree possible on market-tradable inputs and services.
As we saw in the previous chapter, the successful firm would soon be emulated by entrepreneurs seeking to capture part of the discovered profits. This may have a negative effect on profits for the original firm, but also relieves the entrepreneur of some of the burden of uncertainty. As other entrepreneurs enter the new production space, markets for factors emerge between the firms and therefore a limited market price mechanism that helps the entrepreneur determine the economic value of each task. The cost of uncertainty therefore decreases as competition for profits emerges and intensifies, since the entrepreneur is provided with real market data that reduce the uncertainty of the undertaking. The net effect of reduced cost of uncertainty and diminishing profits due to intensifying competition depends on the particular situation, but it is possible – at least in the face of initial competition – that the original firm’s economic situation is strengthened through the reduction in cost of uncertainty exceeding the reduction in earned profits. In any case, the market-making as competitors enter the production space created by the original entrepreneur reduces uncertainty.
As competition is further intensified, more opportunities to escape uncertainty may surface through the innovative actions of other entrepreneurs. Not only will the new markets for factors used specifically in the novel production process lead to increased quality and lower prices, competition also increases the chance for improving the tasks themselves through allowing cross-firm discovery of improvements. But as competition intensifies and factor markets stabilise and mature, it is reasonable to expect innovative entrepreneurs to imagine productive innovations that can replace tasks that were previously necessary to coordinate within the original firm. Such innovations would take advantage of the specific knowledge and judgement of innovative entrepreneurs to further ‘split’ tasks by producing sub processes utilising even more intensive divisions of labour. The original firm, which disrupted market production, is then at first subjected to uncertainty-reducing and profit-seeking competition through the entry of emulating and imitating entrepreneurs in the production space, and then subject to disruptive innovation through the formation of new firms outside the new extent of the market.
This process may in fact be to the original entrepreneur’s advantage, depending on which tasks are disrupted, since it could improve his or her ability to focus on the greatest value added and therefore competitive advantage. It is probable that the productive innovation that caused the original firm includes tasks that are both core and supportive, since it necessarily had to completely replace an existing market-traded production task. In other words, there may be tasks or functions that were part in the original composition of the firm’s production process that were neither core to the innovation nor of great value to it. These tasks, which may include coordinating functions across production tasks, tools maintenance, marketing, human resources, and other administrative functions, were however necessary for the firm to avoid incompleteness. At least as imagined by the entrepreneur. Without this type of functions, the original firm could not be successfully implemented. But as a factor market forms and innovative entrepreneurs follow suit and attempt to replace specific tasks carried out within firms in this market, these non-core supportive functions would be an easy target for innovation and new firm formation. When several competing firms carry out similar processes, they may all need the same types of administrative functions that are necessary but not core to the production process. As they are not core to production but supportive, it would be beneficial to these firms not to provide the services in-house but to procure them in the market as stand-alone services. Indeed, if entrepreneurs could outsource these functions or purchase them at competitive prices they would probably be happy to do so since it allows them to focus on the core innovation. The supportive functions are therefore in a sense low-hanging fruit for further extensions of the division of labour – opportunities for other entrepreneurs seeking to disrupt the newly created market.
Outsourcing these functions does not only allow the entrepreneur to focus on and streamline the firm’s processes around core tasks, but also relieves him or her from uncertainty. When supportive or other services can be purchased in the market, it is easier to estimate their worth and contribution to the firm’s bottom line. It also means the entrepreneurs focusing on supplying that specific service do so through first innovating and then under competitive pressures, which would push down costs, lower prices, incentivise innovation, and standardise service offerings. And as the services are provided in the market contractually, which means they are procured at the going market price while they are also no longer part of the coordination problem inside the firm, the entrepreneur’s uncertainty is reduced. The increased focus on core production activities leaves more resources for further development and improvements, and allows the entrepreneur to focus on improving the core innovation.
This process of firm formation followed by the emergence of factor markets and then outsourcing reinforces the argument in chapter 6: that the firm is a volatile, transient construct that temporarily provides a function. This conclusion is seldom drawn in the literature on the firm, perhaps due to the empirical observation that legal firms last for very long periods of time, but follows logically from the argument presented here. As the firm is not an end in itself, but a structure that is observable due to the distinct nature of implemented productive innovation, it serves only to overcome the problem of production. As the firm is subjected to competition and the competitive discovery process reveals more efficient configurations and better production structures, the rationale for and indeed the basis on which we identify the firm is undermined and eventually inexistent. It makes sense that the firm as an integrated production structure due to being firmly located outside the extent of the market eventually becomes part of the market – it is a starting point for market-making, not an escape from the market. As this happens, the specific tasks originally carried out within the firm may be better provided by specialised parties in a competitive market – at a market price. The innovation, which we identified as the implementation of a production process consisting of a highly intensive division of labour that is not supported on the existing market, is no longer novel or even a contribution to productivity as its ingenuity is copied and improved on by others. The market, in a sense, ‘catches up’ with the entrepreneur’s innovation as competitors adopt the new specialisation intensity and thereby extend the market to incorporate the new degree and kind of division of labour.
This is essentially a lifecycle of the transient firm, in which a revolutionising productive innovation is implemented outside the extent of the existing market. This requires an initial investment, likely one of significant magnitude, since the completion and outcome of the new production process are uncertain and the tasks have yet to be implemented. The firm is for this reason as extensive as need be at its founding, including supportive tasks and production of specific capital goods to be used in production. It is possible that the entrepreneur or those employed to carry out specific tasks within the new process identify better ways of achieving the imagined end, and such changes will be implemented to improve the outcome of the process. This suggests that the process is not fixed and a blueprint, as was discussed in previous chapters, but a process that facilitates discovery through implementation and experimentation. Yet the scope of the production process, as originally imagined, is the necessary scope. But it is too comprehensive in a competitive setting. The emergence of competition and therefore markets for factors allows for tweaks and improvements of the process that may include downsizing or even the termination of certain tasks that were believed to be necessary but proven to be superfluous. Necessary but non-core supportive, administrative, or coordinative tasks can then be outsourced as new entrepreneurs enter the market to offer these services efficiently at a market price. The firm, as a result, is further reduced in scope and size.
This does not mean that firms can never grow, only that the original scope is necessary to attain the original end. As should have been clear in the examples discussed in previous chapters, replacing a market-tradable production task with a new process has a specific scope: it needs to maintain compatibility with inputs as well as outputs. The roundaboutness of the process – the number of tasks that are carried out – depends on the entrepreneur’s imagined innovation, but the scope of what is achieved is fixed. This is not to say that there are no benefits achievable through increased scale. It may be the case that the tasks identified as part of the productive innovation are severely underutilised within the production process, but that they can be favourably used in other types of production. Depending on the anticipated cost and the availability of slack resources, it is conceivable that it is advantageous to increase the scale of the firm so that it contributes to several lines of production in the market simultaneously. This may be perceived at the outset prior to implementing the process, revealed during the implementation phase, or identified during production. The tasks implemented as part of the production process are resources to the firm, which are changed and improved over time to increase overall productivity and competitiveness. As individual tasks are highly specialised and therefore very effective at performing their specific productive activities, they could potentially be applied to different production processes. This is especially the case to the degree they remain underutilised within the firm, which provides the capitalist-entrepreneur with an incentive to expand the firm by increasing its scope. For this reason, there is certainly a resource-based story to be told about the firm’s evolution and growth.
It should be noted, however, that the development of resources generally precedes expansion of the firm’s scope. This is partly due to uncertainty, since the outcome of the original productive innovation is unknowable until it has been implemented and tested. The entrepreneur could believe that there are several uses for tasks to be performed within the production process, and therefore speculate about expanding the firm’s scope, but this greatly increases the uncertainty of the endeavour. As the imagined task has not been implemented, details about its performance and conditions cannot be exactly known. It is possible that the task, when implemented, needs restructuring or even be replaced by some other task or function. Basing two or more production processes on the specific contribution imagined from one task the processes have in common creates a bottle neck and single point of failure. As the processes are already subject to incompleteness, the uncertainty of the endeavour should increase dramatically if it includes more than one process. This doesn’t mean that entrepreneurs will not attempt to do this, only that the cost of uncertainty should in many cases be a reason to postpone expansion of scope until the first process has been fully and successfully implemented. The particular conditions of the situation in which the entrepreneur undertakes to implement the productive innovation are likely to provide guidance in specific cases.
The underutilisation of tasks within the newly implemented production process should be a reason to consider expansion for increased profitability. But expansion is also a means to deal with the risk of competitive entry, since evidence or perception of underutilisation or slack resources provide an incentive for other entrepreneurs to enter the new production space with somewhat altered processes that improve resource utilisation. The original firm could therefore choose to expand even before competitors emerge in order to get the full benefit of the developed and implemented productive tasks. In rare cases, overall profitability of the productive innovation may depend on finding ways to increase the use of highly specialised tasks through expanding the firm’s scope. This would be the case to, for example, a task is so highly specialised that it becomes prohibitively costly not achieve a certain degree of utilisation. Where the anticipated production volume is insufficient to reach minimum utilisation, making the task part of more than one specialised process would solve the problem. Though it would be done at the cost of increased uncertainty and incompleteness problems.
As a process has been implemented, improved, and found workable, the real effectiveness and utilisation of its parts is discovered. At this point, the entrepreneur may find it advantageous to expand the business into other types of production that could make use of one or more of these tasks (unchanged or with slight modifications). So while the scope of the productive innovation is fixed, though could potentially be improved through inserting further innovations and thereby make the process even more specialised and roundabout, the scope of the business is not. The firm is a first implementation of a new specialisation intensity that relies on a new degree and kind of division of labour, and to the extent that it is successful (that is, effective and efficient) it will be able to replace existing production processes. A successful firm can in this sense take advantage of ‘internal’ innovations in specific tasks by expanding the scope; that is, by going into other lines of business, other types of production, and other industries. The successful firm can thus grow in size and influence until the innovation is fully disseminated through competitive imitation or replaced by superior productive innovations.
The scope of the firm can also be expanded within the existing production process by attempting to replace adjacent, market-based production stages to ‘integrate’ vertically. There may be synergies from co-locating the productive innovation or sharing its supportive resources with either upstream or downstream stages, which from the market’s point of view could resemble vertical integration. But as we have pointed out in previous chapters, contracting specifics are insufficient for distinguishing between the market and the firm as different means of organising production. A firm, located outside the extent of the present market, can find value in owning or in other ways controlling a provider of a market-traded production stage (that is, production placed within the market), but this in itself doesn’t move that provider to a location outside the market – and therefore isn’t placed inside the firm. Rather, the transaction establishing ownership between the firm and the provider of a marketable production stage is a simple market contract. Buying a producer in the market will make it a subsidiary, but not an integrated part of the original firm. There is one exception to this, however, and that is if it is acquired in order to obtain a specific resource, competence or experience that is to be modified, altered or redirected toward a highly specialised task within the firm. This latter case may be a proper response to identifying weaknesses or other possibilities for improvements in the implemented process. Insourcing and expansion of the firm’s scope after its forming raise the question of what we mean by ownership of an ‘island of specialisation’ and how acquisition of market-based production stages affects its boundaries.
Ownership and boundaries of the firm
As the discussion above shows, the boundaries of the firm can change over time. Absent additional innovation, the scope of the firm should diminish over time as the production process is improved and supportive services are outsourced. Part of the reason for this is the cost of uncertainty, which can be avoided by adopting market-provided solutions instead of relying on in-house provision. Part of it is also that competition is expected to emerge and then intensify for as long as the firm is profitable, which will eventually bring division of labour in the market to par with the productive innovation and thereby subsume it. As the process of increasing competition eats away the rationale and function of the firm, it will eventually dissolve into the market as the price mechanism is a more efficient means to coordinate production tasks. The interdependence of tasks within the firm is then loosened with the entry of the first competitor and then more so as other entrepreneurs enter the production space until the tasks are fully or primarily traded and tradable in the market. This relieves the entrepreneurs within the firm from the uncertainty that it entails.
The firm can continue to exist beyond its ‘natural’ longevity only if there are specific barriers to entry for competitors or if it successfully engages in continued innovation. The former can emerge as a result of relatively far-reaching resource scarcity, which is in essence a limitation of rather than to the market. Scarcity is a precondition for trade and market as abundant supply makes allocation of resources to their better uses completely unnecessary, but trade-deterring scarcity arises because the market has not provided the production apparatus with sufficient supply of the good or satisfactory substitutes. This may be a result of production’s reliance on a (presumably natural) resource that either sees very little or prohibitively expensive substitutes – or if the resource is so little understood that no substitutes have been invented. These are all problems that will be solved with the passage of time and the continuation of economic and market progress through competitive discovery. Regulation has similar effects but poses a different problem since it is persistent and unrelated to the economic use of resources. The effects of regulation on the firm will be discussed in chapter 10.
The changing boundaries of the firm are indicative of the problem of ownership that the firm as an ‘island of specialisation’ causes. Legal entities such as the empirical firms in our modern economies can own and deal with resources, and whoever is the legal owner of the firm entity enjoys ownership of its resources. In our analysis, however, the firm is not an entity but the implementation of a productive innovation outside the extent of the market. This is done through establishing a more intensive specialisation within the process, as compared to the market, through a greater degree of division of labour. Whereas it may be useful to assume that the originator of this innovation is a single person, this may not be the case. We have already found that the implementation process entails discovering necessary changes and tweaks to the imagined process, and that the exact nature of the individual tasks as well as the outcome of the process is unknown and unknowable. Whereas the original entrepreneur initiates the implementation process and has the basic idea, the nature of each task, their coordination, and thus the functioning of the full process is discovered as the tasks are performed. Those carrying out the work will be best positioned to identify problems and weaknesses, and also figure out how to overcome or solve them. In this sense, each person involved in implementing the productive innovation is an innovator, however within the realm of the original purpose. This process, as we saw above, is very costly and requires a substantial capital investment. We therefore have a number of parties that could potentially be denoted owners of the firm: innovators at different level of abstraction (primarily the original entrepreneur and those specialising to carry out specific tasks within the new process), and investors. All of them bear the uncertainty of the undertaking, but perhaps to differing degrees.
This discussion is however beside the point for the same reason as when we discussed authority in chapter 5. Whereas we as observers can identify the firm as seemingly distinct from the wheeling and dealing in the market, where factors actively bid for inputs and seek the highest possible bids for their outputs, it is not an entity in itself. It is outside the limits of the extent of the market and its parts and totality are subject to strict interdependence that keep the parts together. But there is no ‘it’ in the sense that there are only productive tasks carried out by labour factors specialised to those very tasks. What allows us to distinguish the firm from the market is the fact that the tasks carried out within its boundaries are unique – they are, when implemented, completely without redundancy. This is why there is no (and can be no) market for the individual tasks carried out within the firm, which translates to their strict interdependence and subjection to the incompleteness problem. And this is the only reason we can recognise the firm as something distinct.
Yet what we have is a contractually based attempt at producing outside the limits of what is supported by the market. Within the firm, just as Coase originally identified, there is not a ‘series of contracts’ between any pair of parties. Instead, at least according to Coase, there is a single, long-term contract between the factor and the employer, who is awarded the authority to direct the resource. But we saw in chapter 5 that there is no basis for authority within the firm – based on Coase’s insight about the reciprocal nature of market action (including contracts). As for the numbers of contracts, it would be impossible to contract on details before the process has already been implemented – since the details are fundamentally unknown. Even so, upon implementation there is still no good reason for parties to contract on all details since there are no alternatives: due to incompleteness and interdependence there is no reason to establish contracts that specify all possible details. All parties to the novel production process are at the mercy of all others: if any one fails (or even misunderstands expectations) the whole process is left incomplete and therefore will not earn returns. Also, as the exact nature of the tasks and how they relate to each other cannot be known, it is impossible to contractually regulate to such detail. All contracts within the firm should therefore at least during its formation and the improvement and implementation phase be open-ended.
What matters in terms of ownership within the firm as an ‘island of specialisation’ is who owns the resources used: capital goods or tools, inputs, and so on. In the words of Hart and Moore, we can indeed ‘identify a firm with the assets it possesses and take the position that ownership confers residual rights of control over the firm’s assets: the right to decide how these assets are to be used except to the extent that particular usages have been specified in an initial contract’. Whereas those involved in the implementation process, whether as labourers specialising to perform specific tasks or in some other capacity, may choose to contract with each other to minimise the risk of opportunistic behaviour at some future time, such contracts are not necessary to form a firm. What matters is the capital investment and thus ownership of the resources that are used within the firm. This can be easily seen if we consider the whole process of firm formation. To implement the idea, there is capital needed to cover the outlays for development and purchase of tools, machinery, and inputs. To attract labour factors to partake in the undertaking and specialise to specific tasks in the process, payment or promise of payment or a share of the return must be made. The need for capital investment was discussed above.
It is not obvious, however, that a capital investment to implement the imagined production structure and thus form a firm must be made by one party. It could, and it may be likely that the entrepreneur has access to funds of his or her own or indirectly through a willing capitalist investor or by taking a loan. If this is the case, then the entrepreneur is the owner of the capital resources to the extent ownership has not been offered to the capitalist investor or lender and established contractually. To the degree these funds are used to pay labourers for their service, the labourers are not owners of the firm (they are essentially suppliers or subcontractors); to the degree labourers contract with the entrepreneur or investor about ownership, they are owners. As the firm itself cannot own resources, the resources used within the firm must be owned by someone. As the firm itself does not exist as a separate entity, no one can own ‘it’; what remains is ownership of resources and contractual commitments between parties. Centralised ownership is not a requirement for there to be a firm.
Coase’s point about the single contract is valid, however, since it would make sense for the entrepreneur or capitalist investor to contractually regulate the expectations of the parties to the firm. The firm is a contractual construct between the parties partaking in the endeavour. This may be done in a myriad different ways, but the nature of contracting doesn’t change the fact that the firm, as an ‘island of specialisation’, is, in a sense, its resources and that ownership consists only of those resources. The nature and coordination of production is outside the extent of the market, but this in itself does not require a particular form or nature of ownership.
D. Hart and J. Moore, ‘Property Rights and the Nature of the Firm’, Journal of political economy, 98:6 (1990), pp. 1119-1158.
T. Penrose, The Theory of the Growth of the Firm (New York: John Wiley and Sons, 1959).
 See E. T. Penrose, The Theory of the Growth of the Firm (New York: John Wiley and Sons, 1959).
 O. D. Hart and J. Moore, ‘Property Rights and the Nature of the Firm’, Journal of political economy, 98:6 (1990), pp. 1119-1158, p. 1120.