The Economic Theory of the Firm

What is a firm? This may not seem like a question in lack of an answer. In the United States, as in most other countries, it is a registered, regulated entity acting legally as a person. But economically, the legal definition is irrelevant: the economic function of the “firm” is not its legal status – if it were, then the law rather than the organization would provide the market with that function.

So could there be firms without corporate law? The answer is obvious: firms exist and are an important part of modern markets today just as they existed and provided a vital function before the law defined and certified such organizations. Indeed, one can easily argue that corporate law is primarily about government taxation and regulation of the market – and defines the firm only as a means toward these ends.

Consequently, the economic question remains, and it necessarily includes the “where,” “how,” and “why” of the business firm. How can one economically define what a firm is? What, from an economic point of view, is a business firm? A deeper question is, what is the firm’s function in the market – and why are certain transactions integrated in organizations? And further: how can we distinguish this phenomenon in the market so that it can easily be studied? The questions may seem foreign, but economics has not been able to find very good answers to them, neither historically nor in contemporary theory.

The economic question of the firm is old. Adam Smith discussed firms in The Wealth of Nations(1776) and established that they, in the sense of “manufactures,” were more efficient in producing than individual, self-employed craftsmen and labor workers. (Cantillon, who wrote the world’s first systematic economic treatise [1755], does not analyze the firm as much as he analyzes the entrepreneurial function.) Smith’s explanation for the manufacture’s efficiency is that it can utilize a different form of, or more intense, division of labor than can be coordinated through market exchange (or contracting). But he quickly moved on to discuss other economic issues instead of elaborating on this analysis (which, by the way, was heavily criticized by Rothbard).

Smith’s view was however accepted by most classical economists and thus the firm was thought of in terms of its different kind of division of labor. Generations later, Karl Marx wrote in Das Kapital (1867) about the Smithian kind of manufactures and how they establish and exploit the more intense division of labor. Marx uses Smith’s argument, but the discussion helps to clarify the view of the firm. Of course, he finds the manufacture and the division of labor highly problematic, since the individual worker is separated from the end product and therefore is “alienated” through work performed within the manufacture. Marx was obviously not very interested in the economic analysis – division of labor increases productivity and increases prosperity for all individuals involved as well as society as a whole – and so focuses solely on the problem he identifies.

A few decades later, the sociologist Emile Durkheim wrote a whole treatise on the division of labor (1892) and – characteristically difficult to read – defines its constitution and limitations. He also connects the division of labor to the structure of society and theorizes about its utilization and distinct types in towns and rural areas. The conclusion is that towns have greater density, which makes it easier to trade, because potential trading partners, as well as products to trade, are closer at hand.

Durkheim focuses on the limitations of the division of labor as it was famously defined by Smith in the phrase, “the division of labor is limited by the extent of the market.” The market’s “extent” is here identified as market density: the greater the density (closeness or ability to effectuate trade) the easier it is to divide work into smaller parts and thereby increase overall productivity through streamlining the carrying out of individual specialized tasks.

About the same time as Durkheim, Marshall authored his magnum opus, Principles of Economics(1890), which laid a foundation for neoclassical economics. Marshall also talked abstractly about how industries and market structure can be analyzed in terms of “representative firms,” which are simplified representations (ideal types) of firms. Adopting this perspective (or the common interpretation thereof) allows for analytical precision, but at the same time does away with existing differences between real firms. The representative firm can easily be described in terms of a profit/output maximizing “production function,” and this remains the neoclassical view of the firm to this day.

In direct contrast to the Marshallian analysis, E.A.G. Robinson analyzed the firm in terms of the division of labor in his book The Structure of Competitive Industry (1931). Robinson continued the Smithian analysis of firms as constituting a more intense division of labor, and attempted to identify the “optimal size” of firms in the market. He recognized that small firms tend to have a single general manager, while larger firms often employ an increased division of labor even within management. In this way, he wrote, firms can grow in terms of both scope and scale through internal divisions of labor.

Only years after Robinson’s treatise on the firm’s optimal size was published, a young Ronald Coase wrote an article espousing the formal analysis of economics while being inspired by Robinson’s approach. Coase’s article “The Nature of the Firm” (1937) introduced the concept of transaction costs(even though the term was not coined until much later) to explain why some production is organized in hierarchies (firms) while some is spontaneously coordinated through the price mechanism. Coase knew from economic theory that the price mechanism is efficient in resource allocation, which should mean that firms by definition must be suboptimal. So, he asked, why are so many transactions in the market organized within or between firms?

Coase answered his own question, stating that firms must aim to “reproduce” the price mechanism’s efficient resource allocation. By directing labor workers, who are bound in open-ended employment contracts, rather than contracting with labor providers in the market, firms can avoid the costs of using the price mechanism. The way Coase sees it, the market is efficient in its resource allocation but it is very costly to bring about this efficient allocation due to frictions such as search and marketing costs and negotiations over contract terms. These costs can be avoided by sidestepping workers’ autonomy under “atomistic competition” and instead having them follow orders within islands of planning. (Coase quotes Robertson [1923] in saying that firms are “islands of conscious power.”)

Nobody paid attention to his article, however, until Oliver Williamson rediscovered its core thesis some three decades later. At this time, economics had already adopted the production-function view of the firm – it was considered a “black box” that transforms inputs into outputs. In this sense, Coase and Williamson’s emphasis on the firm’s internal organization challenged the established analysis of economic organization.

Outside of economics, however, theoretical developments in management and organization theory are based on the Robinsonian (or Smithian) theory rather than that of Marshall and Coase. Robinson had great influence on Edith Penrose (one of Fritz Machlup’s students), who wrote the still very influential book The Theory of the Growth of the Firm (1959) a couple of decades after Coase’s award-winning article. This tradition has evolved almost exclusively within business schools and has lost much of its basis in economic theory; it therefore appears quite eclectic in terms of approach, analysis, and method.

The economic theory of the firm has not made much headway in the more than seven decades since Coase’s article was published (and four decades since Williamson’s rediscovery). Some discoveries have been made within the Coasean framework, but research primarily focuses on applications of Coasean reasoning as well as on (re)defining and measuring transaction costs.

But what about the Austrian School? The answer is that we sadly do not have a theory of the firm. Mises did not theorize much on firm organizing, and Rothbard finds it sufficient to briefly discuss the natural limit to firm size due to the calculation problem in Man, Economy, and State(1962). More recently, we have seen several attempts to draft an Austrian theory of the firm, but they generally remain drafts rather than developed theories. Frederic Sautet has attempted to formulate a theory of the firm based on Kirzner’s entrepreneur in An Entrepreneurial Theory of the Firm (2000), but does not make a thoroughly convincing case, and Peter Lewin has developed a Lachmann-inspired capital-based view of the firm. Similarly, Peter G. Klein has made some progress in integrating the transaction-cost approach with Austrian capital theory and Misesian entrepreneurship (see his The Capitalist and the Entrepreneur [2010] and the forthcoming Organizing Entrepreneurial Judgment: A New Approach to the Firm [2011]).

While these approaches are predominantly Austrian in both flavor and substance, they all tend to disregard the traditional, “older” view of the firm as a different type of division of labor; instead, they focus more narrowly on several distinctly Austrian insights. Furthermore, the firm tends to be analytically separated from the overall market process due to the emphasis put on its internal organization and boundaries. But should the firm be analyzed as a creature distinct from the market – or is it an integral part of the market’s process and its evolution toward more extensive or intense division of labor and greatly increased prosperity?

There is good reason to put the firm at center stage, rather than making it a marginally important phenomenon in the market. Indeed, I attempt in an article for the Quarterly Journal of Austrian Economics to show that the firm not only provides a function in the market place but could be an essential part of the wealth-creating market process as well as an essential part of civilized society. Indeed, the firm is much more than a legal entity – it is a cornerstone of the market and instrumental to entrepreneurial profits.