Ch. 8, The Firm As a Market Institution

We saw in previous chapters how we can view the firm as the observable distinctiveness of an implementation of a productive innovation brought about by an entrepreneur or entrepreneurial team. The nature of the innovation means the tasks and intermediate goods produced by those tasks are purely interdependent; there are no (and can be no) markets for them. For this reason, the implementation falls outside the reach of the price mechanism and therefore takes place outside the limits of the extent of the existing market. In this sense, the firm is a separate phenomenon that is related to, functions with and depends on, yet is internally unique in the sense that its internal parts are not replaceable by the market. For an observer, the firm appears as a separate organisation or entity that is created by the entrepreneur. It also appears as a means to solve the problem of implementing innovation that is not supported by the market.

However, it is important to remember that the firm is not in itself an economic end or a purposefully created occurrence, as is oftentimes hypothesised in the theory of the firm literature, but the observable result of implementing a productive innovation in the form of an ‘island of specialisation’. It is separate from the market and utilises a division of labour that is different in kind and degree, but ‘it’ is not necessarily more than the implemented innovation: the ‘organisation’ is coordination of novel production but does not exist economically in addition to the specialised, coordinated production process. Chapter 7 above indirectly addressed this issue in terms of financing and ownership. An implication of that discussion is that the firm is not distinct and not distinguishable from other types of productive contracting in the market from an ownership point of view. Whether the firm is financed fully by one party, internal or external to the firm’s production process, or if it is financed collectively by those taking part in it, is rather irrelevant for our perception or identification of the firm as an economic phenomenon as well as for how it is implemented. It is the type of implementation itself, the fact that it is outside the reach of (rather than supersedes, as Coase has it) the price mechanism that characterises and defines the firm.

The firm is thereby the result of entrepreneurship’s endeavour to realise a type of production process that cannot be implemented through market-based exchange or contracting. But its function is not to provide a laboratory for entrepreneurs to engage in innovative experimentation, even though this may be a common type of activity taking place within the firm once it is formed.[i] As the firm is the observable result of entrepreneurs implementing innovation outside the extent of the existing market, the economic function cannot reasonably be to provide a means for innovative entrepreneurs to implement the imagined production process. Rather, the economic function of the firm can be found if we assume the perspective of a higher level of abstraction. The firm here serves as an explanation to the continuous flux of the market process through adaptive change and, especially, its progression toward increased productivity and prosperity—‘the firm’ is how the existing market structure is revolutionised by productive innovation and how production breaks free from the specialisation deadlock.

Competition as a discovery process

As the firm, as it is here conceived, necessarily is formed outside the extent of the market, there are and can be no market prices for the capital goods in their particular uses within the ‘island of specialisation’. Therefore, there is no guidance offered to the entrepreneur in terms of the efficient social allocation of productive resources within the production process. The firm is consequently blind to whether resources are used to their fullest extent from the point of view of consumer wants satisfaction. This uncertainty, which was discussed in chapter 7 above, is borne by the entrepreneur or entrepreneurs within the firm through their investments. It does not mean that the firm cannot make a profit, but, to the contrary, the firm can be highly profitable. What is necessary for profitability is not economic efficiency in the allocation of resources used, which assumes an equilibrium view, but that the firm produces greater value than existing competing uses of similar resources (primarily the market-traded inputs used in the production process). It is possible to outdo the market because of the productive innovation implemented through increased specialisation through the division of labour. Even if the market is fully arbitraged and all opportunities for profit within the extents of the market are exploited, the market is in a constrained maximum: it uses only the knowledge and the production processes that are known and traded, which does not include the productive innovations imagined by entrepreneurs. This is why the entrepreneur’s productive innovation takes place outside the extent of and so potentially revolutionises the structure of the existing market: it creates new knowledge of what can be achieved through production that was not previously considered in and even less was incorporated by the market. The market, as we discussed in chapter 3, is subject to and continuously improved through profit-incentivised reallocations within the specialisation deadlock, a limitation that is effectively circumvented by the innovator-entrepreneur. Even a fairly inefficient allocation of resources within the new production structure in the firm can potentially outdo a fully arbitraged market because of its use of more intensive but far from perfected specialisation.

The combination of the firm’s highly intensive but underutilised, non-maximised specialisation and revealed profitability provides strong incentives for actors presently occupied in within-market trading positions to act as imitator-entrepreneurs in order to capture some of the new value created and revealed by the original firm. Not only will an imitator-entrepreneur have the chance to capture some of the profits that are captured by the original firm, but there are opportunities to increase the overall profitability of the productive innovation through maximising the production process. Imitator-entrepreneurs may see ways of emulating the original process while improving on it using their own specific skills, knowledge, and contacts. There is therefore a real chance for second-movers and late-comers to outdo the first-mover and capture the full profit potential of the innovation. This provides a strong incentive to follow the original firm into the new production space and compete with it head on.

On the other hand, as the original firm is automatically integrated through pure interdependence between its parts, the knowledge revealed to potential competitors through its implementation is likely to be incomplete. Whereas the implementation itself is not maximised, the knowledge used within the production process is only partially made available to anyone outside the firm. This suggests a possible problem for imitator-entrepreneurs, who cannot simply copy the original structure but must engage in innovative entrepreneurship themselves in order to implement a competing production structure; the partial knowledge available or appropriable must be completed by the imitator-entrepreneur. There is therefore entrepreneurial uncertainty-bearing also in being a second-mover, since innovations are necessary to fill the gaps and also must be fitted with what is known about the process and can be imitated. This may suggest a delay in the effectiveness of competitors to implement their competing structures, but also means competition will not arise between identical or very similar implementations of the original production structure. Rather, competition will initially emerge between full production processes that differ in various ways but essentially provide the same or perceived substitutable productive service.

None of the established competing production processes are guided by real market prices, and therefore neither the original nor the imitating entrepreneurs can be expected to immediately discover the efficient internal allocation of resources. Competition therefore takes place between imperfect implementations that differ in various ways, both in terms of how the overall production process is implemented and in the effectiveness of individual parts of it as well as their contribution to the value produced. These differences are a result of the entrepreneurs’ different skill sets and knowledge, their idiosyncrasies, and the types of resources—human and otherwise—that are available to them. As they attempt to implement production processes similar to (and that therefore compete directly with) the original process, they attempt to fill in gaps in the available knowledge while also playing on their strengths in attempting improvements to the process. They cannot be expected to produce identical solutions to the perceived problems.

This state of affairs suggests that entrepreneurs are collectively involved in a discovery process of which production processes are more effective and therefore produces the greater value or at the lower cost. It should be expected that the entrepreneurs, upon implementing their own versions of the production process, attempt to improve the process by imitating their competitors. As more entrepreneurs enter the production space, they add their own skills, ideas, and knowledge to the type of production implemented by the original entrepreneur. The new production space should therefore, from an aggregate point of view, see continuous improvement in effectiveness and efficient use of resources as more entrepreneurs enter to compete for profits. We should see both increased competition to capture the revealed profits and increased profitability of the production space overall, ceteris paribus, as the implemented processes are, over time, improved and perfected.

Whereas we would initially see complete implementations compete with each other, each suffering from pure interdependence of its internal parts, entrepreneurs are likely to also engage in competition for individual factors used within their individual ‘islands of specialisation’. An imitator-entrepreneur can find that it is potentially beneficial to attempt to overbid the original entrepreneur for labour workers employed within the original firm. This may be for the reason that this worker’s particular competence is highly productive, that it is very difficult to replace by other means, because this specific productive contribution falls outside the realm of this entrepreneur’s primary skillset, or because it appears easier than perceivable alternative courses of action. Competition for individual competences and resources specific to, and therefore purely interdependent within, the original firm loosens the grip of interdependence. Such bidding is made possible because the imitator-entrepreneur was able to produce a competing production process that implements a similar structure with similar interfaces between at least some of its internal tasks. It also means the specific resource is complementary to a lesser degree while potentially more substitutable, since it can be used in two competing production processes. With the imitator-entrepreneur engaging in bidding for resources previously used exclusively within the original entrepreneur’s productive innovation, an undeveloped market emerges between the two. As other entrepreneurs enter, the bidding generates a market price for the previously unpriced factors based on the entrepreneurs’ joint appraisement of their productive value. This further strengthens competing entrepreneurs’ ability to discover and implement improvements to the process and should therefore lead to rapid improvements in terms of both technical effectiveness and allocative efficiency. The original firm’s ability to absorb revealed improvements determines its continued profitability and therefore survival. It is by no means necessary that the original firm persists in the face of increasing competition; the original innovation leads the way and breaks the ground for a new kind of production, but whether it survives the competitive process depends on its entrepreneurial ability to make use of and implement improvements discovered by others.

Market-making and the dissolution of the firm

What follows from the original implementation of the productive innovation as the first imitator-entrepreneur enters the production space is a discovery process through productive competition between firms.[ii] The firms attempt to implement improvements in order to capture as large share as possible of profits. These improvements are produced both internally to the individual firm, through continuous experimentation and innovation, and externally through copying from other firms. This is what also facilitates the bidding for competing firms’ resources, since the overall effectiveness of an internal production process is revealed through profitability. Discovery of how to improve one’s internal production process can therefore be brought about through bidding for and winning over other firms’ core competencies (primarily labour workers). As the discovery process is directed toward specific tasks and factors within firms, the market price for these factors is determined. This facilitates more precise valuation of factor use and thereby provides a means to estimate the firm’s internal effectiveness and allocative efficiency through calculation. Competition makes internal discovery possible by loosening and ultimately undoing the pure interdependence between factors within firms, which makes further improvements possible. It is conceivable that many firms at their founding, even though they may be profitable, incorporate tasks that are found to be either inefficiently implemented, are of little value, or even contribute no real value to the firm’s output. Such tasks are promptly improved in or jettisoned from surviving firms under competitive pressure.

The bidding for internal factors determines their market value and establishes market prices, and therefore produces a market in the production space that was previously outside the extent of the market. A successful and imitated productive innovation therefore sets in motion a process in which the existing market structure is challenged: the more intensive specialisation in the new market space, as originally created by the productive innovation and attempts to imitate, constitutes an improvement over the existing market, and therefore requires market actors to adjust their activities. Previously marketed production that the productive innovation effectively replaces is outcompeted and the resources used in these marketed tasks released. As competing firms in the new production space engage in cross-process bidding for factors and, consequently, market-making, they effectively bring about a shift in the limits of the extent of the market per se. The new extent of the market incorporates the kind and degree of specialisation originally implemented outside the market in the productive innovation, which effectuates changes within the previous extent of the market. The creation of market between firms ultimately exposes the existing market to the new division of labour, which has repercussions for the existing allocation of resources as well as market prices for substitutes. The innovation has ripple effects that reallocates resources toward what are now revealed to be their better uses, and prices change as an effect. As the market adopts the new state of production, and consequently the new knowledge discovered by the original and imitating firms, the firms tend to dissolve into market trade. The original ‘island of specialisation’, where it demonstrably earns a profit, therefore serves as an incentive for its own dissolution through imitative competition.

This process may be anything but instantaneous. Before market prices are determined and accepted, the entrepreneur who decides to rely on the undeveloped market faces extensive uncertainty of the kind necessitating the ‘island of specialisation’. Failure to procure factors in the very limited factor markets between competitors leads to incompleteness, and it is easy to understand how entrepreneurs may resist the temptation for this reason alone. This does not preclude bidding for factors perceived of higher value currently located within competing firms, however. If they can be won over, it is to the winning firm’s benefit and at the same time the competitor’s loss. The latter may under certain circumstances be sufficient to start a bidding war between entrepreneurs in the new production space.

Entrepreneurs are incentivised to use the price mechanism. As we saw in previous chapters, the uncertainty within the ‘island of specialisation’ is very costly, but necessary since the implementation of the productive innovation is impossible through market means. If entrepreneurs could rely on the price mechanism instead of bearing the full uncertainty of the enterprise, there is reason for them to do so. Indeed, they will always choose reliance on the price mechanism over other means of coordination wherever it is feasible.

One reason for this is the flexibility that comes with independence, since access to more than one supplier of a necessary input or service lessens the risk of incompleteness. Another reason is the calculability that market prices facilitate, since they offer a social appraisal of the means and factors used in production. Furthermore, procuring necessary factors, inputs, and services in the market can reveal that imperfect substitutes are available as back-up solutions in the face of temporary incompleteness. It also suggests that the entrepreneur can limit the time between investment and payment, since inputs procurable in the market are their own, separate projects. Moreover, the firm avoids development costs as well as costs of controlling, monitoring, and managing the sub production process, which is another entrepreneur’s project. There may also be opportunities to lower input costs by letting suppliers compete for the order, which also suggests any costs of price discovery are effectively assigned to suppliers as they advertise their prices and qualities as part of the competitive process.

The entrepreneur, as we have already seen, does not choose to form a firm, but it is the inevitable result (whether or not it is intended or favourable) of implementing the productive innovation outside the extent of the market. There is for this reason, as well as the specific cost reasons noted above, little economic reason for the entrepreneur to maintain the firm as it was originally constituted beyond the emergence of factor markets between the firm and its competitors.[iii] Indeed, the emergence of markets relieves the entrepreneur of the burden of uncertainty since time, effort, and other productive means can be focused on a limited set of the production process rather than distributed across the tasks in the production process. The boundaries of the firm therefore shift with the emergence of markets for the factors necessary for the completion of the production process. The primary tendency should not be toward and expanding scope of the firm, but the very opposite: the entrepreneur – as well as labour workers employed in the firm – benefit from consistently transferring previously internal tasks to emerging and maturing markets.[iv] We can then see that the bounded rationality of the entrepreneur or entrepreneurs in the firm is an important factor for the effective and economic scope of the firm, but that it plays little role in determining the firm’s boundaries. Indeed, the firm needs to be complete – at least in terms of its scope – at its formation, or it will fail due to incompleteness. The bounded rationality of those involved in the firm can be a reason to not form the firm, since the productive innovation will then seem impossible to implement. Bounded rationality can also affect the costs within the firm and thereby increase the incentive to outsource initially internal tasks. But it cannot determine the boundaries of the firm, which are set by the existence of markets: the firm itself is non-market, and dissolves as markets form or expand to encompass tasks previously organised in the firm. The primary tendency of already formed firms is consequently the reduction of their scope through increasing adoption of market means for coordinating

production – outsourcing of tasks and functions supplied in the market.

The firm and the market

With the scope of the firm being reduced, and more as time passes, the original entrepreneur can focus more intently on what is (to him or her) the firm’s original and core contribution to society’s overall production structure. Outsourcing, therefore, has the effect not only of expanding the market’s reach through allowing market prices of previously internal production tasks to be determined through bidding, but also facilitates continued improvement and, possibly, innovation within the original firm. In general, the firm can outsource tasks carried out within the productive innovation following one of two changes in the firm’s production space. As competitors enter and bid for intra-firm factors, the task’s market price is determined and its originality undermined through the firms’ competitive actions; it can therefore eventually, in a standardised form, be provided by independent producers in the market. This commodification of the task makes it easily procurable through simple market trade, and there is consequently no reason for the firm to dedicate resources to organise the task in-house. For supportive tasks or tasks that are already partially compatible with the market, as for example the first and last tasks in a serial multi-task process, there should be comparatively limited costs involved with outsourcing. Alternatively, entrepreneurs who enter the production space as the competitive discovery process is already well underway may identify that there is a profit opportunity in innovating to replace a recently priced task. These entrepreneurs provide the same function as the original firm by establishing a novel, innovative way of carrying out a function that can replace an existing production task – only they do so before the task has been fully overtaken by the market and commodified. As this new firm is formed, it offers to carry out and replace a task carried out within already existing firms.

The effect is in both cases a reduction of the outsourcing firm’s scope and therefore increased possibility to focus on the remaining tasks. It is likely the entrepreneur most eagerly welcomes outsourcing of supportive functions and those tasks that are not core to the innovation, that is those tasks that were necessary at the inception to maintain the firm’s productive completeness but are no longer so. The reduced scope accelerates possibilities for productive improvement and the firm’s ability to identify and experiment with opportunities for further innovation. Such innovations can include the further splitting of an already implemented task (that is, a task that is the result of previous, firm-forming task-splitting), which were this to take place in the market (when the firm has dissolved into the market’s price mechanism) would constitute a new firm. While the entrepreneur can engage in productive innovation and task-splitting at any point within the firm, doing so before competitors relieve the entrepreneur of some of the uncertainty is risky. As the efficiency of tasks cannot be known and economic improvement of tasks do not take place until a competitive discovery process has begun, the entrepreneur is to a significant extent blind to whether the task to be further split is of sufficient quality to be viable in the market. Splitting such a task into a sub process may therefore have the effect that existing errors or mistakes, primarily of economic rather than technical nature, are cemented or amplified. This can risk the profitability of the enterprise, whereas awaiting competitive discovery can substantially lessen this risk.

The productive scope of the firm, by which we mean the extent of the overall production stages necessary to bring a specific product or product line into the hands of consumers that is integrated within a firm, should therefore decrease over time, but the number of tasks, the resources and factors tied up in production, and ‘size’ of the organisation may increase through further innovation. The firm’s scope will only increase by including more of the existent productive stages, which is of little use unless there are significant synergies in co-location or the added stage is split into a novel production process. Synergies should be available only under particular circumstances, including for example abnormal scarcity, or as a step toward innovation. For instance, the firm can offer employment to a factor engaged in the previous (upstream) or following (downstream) stage for the purpose of tweaking the task or otherwise changing the way this task works together with the intra-firm tasks. Without innovation, the addition of a production stage does not change the boundary of the firm as an ‘island of specialisation’ simply because it involves no specialisation; the firm’s employment of upstream producers is akin to exclusive contracting with a supplier but not a merger.

We have until this point argued that the firm is integrated simply for the reason that it makes use of and constitutes a division of labour that is more intensive and therefore of a different kind and degree than that traded in the market. The market does not support the splitting of tasks and the coordination of those tasks through market contracting or pricing, and therefore the firm is and must be established outside the extent of the market. As it is and real profit opportunities are revealed, other entrepreneurs will be incentivised to follow suit and compete with the original innovation, which leads to a competitive discovery and ‘maximisation’ of the innovation’s economic value – and eventually the dissolution of the firm through explicit outsourcing of tasks to other entrepreneurs or shifting toward market procurement as the market adopts the new intensity of specialisation and therefore determines the market price of specific tasks. The emergence of competitors, competitive discovery, and the dissolution of the firm are part of the process toward re-equilibration of the market. Whether or not the market was in equilibrium prior to the original productive innovation, the establishment of the firm and competing firms constitute a process of disequilibration from the point of view of the market order. The original firm disrupts the prevailing market structure by implementing an imagined productive innovation, and the ‘creative destruction’ of the innovation is brought about through the competitive discovery process as entrepreneurs enter the production space and, inadvertently, generate markets for factors used within firms. Imitating entrepreneurs amplify and bring to a close the change that was facilitated by the original entrepreneur’s implementation. Differences are evened out, unnecessary tasks are abandoned, and inefficiencies are solved as the productive arbitrage between firms that is the competitive discovery process proceeds; this process concludes with market standardisation of production where firms are neither necessary nor possible unless they introduce innovations that disrupt the new order. The competitive discovery process following the implementation of a successful and hence profitable productive innovation brings about the shift from a prior equilibrium to the new equilibrium revealed by the entrepreneur’s innovation. The firm in this sense explains what causes and brings about the shift from one equilibrium to another that Schumpeter originally hypothesised. It is a story about production and value creation, disequilibrium and entrepreneurship, and not one of cost avoidance.


[i] A core function of the firm is to provide the entrepreneur with a means to conduct controlled experiments with heterogeneous capital goods, argue N. J. Foss and P. G. Klein, Organizing Entrepreneurial Judgment: A New Approach to the Firm (Cambridge, UK: Cambridge University Press, 2012).

[ii] See F. A. v. Hayek, ‘Competition as a Discovery Process’, New Studies in Philosophy, Politics, Economics, and the History of Ideas, (1978), pp. 179-190.

[iii] See P. L. Bylund and R. Wuebker, Where Do Factor Markets Come From? Toward A Resource-Based Theory of the Entrepreneurial Firm (Keystone CO: 2014).

[iv] This reinforces the main point made in G. J. Stigler, ‘The Division of Labor is Limited by the Extent of the Market’, Journal of Political Economy, 59:3 (1951), pp. 185-193.