ECON 378 - Lecture Eight - The Theory of the Firm

ECON 378

Lecture Eight: The Theory of the Firm

Sources: Coase, “The Nature of the Firm,” in Economica; Klein, The Capitalist and the Entrepreneur: Essays on Organizations & Markets; Williamson, Markets and Hierarchies: Analysis and Antitrust Implications, Alchian and Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review; Klein, Crawford and Alchian,"Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics.

Economic Textbooks:

Firm is a Black Box:

Basically becomes a calculus problem.

The Literature:

Why do firms exist?

What determines their size and scope?

But we should also ask and the literature is not clear on this:

What is a firm?

How distinctive are firms as organizing modes (i.e., how sharp are the boundaries between them and the environment in which they operate?)

It pretty much starts with Ronald Coase – 1937 article “The Nature of the Firm”.

Ignored for many years but since the 70s or so it has been the starting point for many economists to build upon when discussing the firm.

He basically asked why firms exist and gave a theory as to what a firm is:

"A firm undertakes those activities which are cheaper to organize internally rather than acquiring them from the marketplace."

Transactions Costs are important:

A "set of contracts" theory emerges - arguing that a firm is simply a set of contracts but internally organized.

Two means (modes) of organizing resources into an output:

1. Market contract mode:

(relationship between independent contractors -- no employees)

2. Internal organization mode:

(relationship would be employee, not contractor)

This is a firm. So when more than one input is owned by the same owner or owners – we see a firm exist. Asset ownership theory.

Gets fuzzy - some see the employee relationship as a contract relationship, for example. But we will discuss this later when we talk about some of the “Austrian” contributions.

So the question Coase asked? Why do we observe one mode and not the other - or more generally, when should we expect to observe one mode and when the other (what is it in the structure of transacting that makes one form less costly than the other?)

Coase on Transaction Costs: "The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of 'organising' production through the price mechanism is that of discovering what the relevant prices are. . . . The costs of negotiation and concluding a separate contract for each exchange transaction which takes place must also be taken into account." (my emphasis) -

So he is talking about not having perfect information about prices.

Dahlman’s translation of the above – Transactions costs are either:

So, "It is true that contracts are not eliminated when there is a firm but they are greatly reduced." - and therefore, so are transaction costs.

Note the following about what Coase said – an Austrian economist would pay special attention to the following:

Coase on Uncertainty: "The question of uncertainty is one which is often considered to be very relevant to the study of the equilibrium of the firm. It seems improbable that a firm would emerge without the existence of uncertainty." (my emphasis)

Uncertainty and Transaction Costs:

Coase on the Entrepreneur: "A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur."

That is, instead of the price system (although -- the entrepreneur is guided by the price system to some extent as well). Note that the entrepreneur though is not an entrepreneur is the Austrian sense – he or she basically directs resources within the firm. Remember, Mises talked about the entrepreneur being a resource allocator – but he meant in the market generally. Not within a firm.

A criticism that some Austrians make of Coase is that he seems to see the firm as an island of planning – somewhat separate from the dynamic, spontaneous order of the market. Klein (your reading) disagrees with that though and says he is not saying that.

So let’s sum up Coase:

After Coase - different economists tried to either disagree with Coase (offer another theory as to why firms exist) or build upon Coase. Let’s look at a couple of the most popular – including Williamson’s work.

Alchian and Demsetz ("Production, Information Costs and Economic Organization"): They offer a different theory of why firms exist.

Team production:

But the problem:

Therefore shirking:

Therefore there is a need for:

The problem though –

The answer:

So we have internalization again -- ownership of the means of production by a central party - but for a different reason – monitoring or agency costs.

Klein, Crawford and Alchian ("Vertical Integration, Appropriable Rents, and the Competitive Contracting Process") and Williamson (Transaction Costs Economics): Basically they offer further explanations for why we might see vertical integration. So they are extending Coase, not so much disagreeing with him. This has been extended considerably and has become pretty important in microeconomics and the theory of the firm. Some Austrian economists feel that Williamson offers “Austrian “ insights to the theory of the firm. At least – very compatible. Peter Klein (the author of your reading) is one of them. So we will spend some time on it and see what you think.

Transaction Cost Economics - Mostly Williamson (see your reading)

According to transaction cost economics, how we study economic organization (how resources are organized into outputs) depends upon two important behavioral assumptions:

1. Humans are subject to "bounded rationality"

2. Humans are given to opportunism –

Also - important, if not the most critical dimension for describing transactions is the condition of

3. Asset specificity:

Williamson - Given all three , we should: "organize transactions so as to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism."

In other words -- try to decrease uncertainty regarding contingent events about what others might do -- by decreasing the incentive or likelihood of opportunism.

So assume we want to produce something and we need an input in order to do it. We have three options:

1) short term contract -

2) long term contract –

3) make the input ourselves –

Which one do we do? This will depend upon our circumstances. Are there specific assets involved, for example. If there are specific assets -- opportunism becomes a real possibility and we will have to think about that when we make our decision about our input.

So let's specify clearly what specific assets are. There are four types (as per Williamson):

1) Site specificity:

2) Physical asset specificity:

3) Human asset specificity:

4) Dedicated assets:

When there is a specific asset -- there is more of an incentive for opportunism.

So let's get back to our input decision. What we should do, according to transaction cost economics, depends upon our circumstances.

How do we obtain our input? When will we use each?

1) Short-term (spot) contract

2) Long-term contract

3) Vertical integration - make it ourselves

If we have all three: bounded rationality, opportunism and specific assets.

This is when, according to transaction cost economics, we need to figure out how to "organize transactions so as to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism."

Will a short-term contract work? If we didn't have asset specificity, we could enter into a short-term (spot market) contract and basically we are just faced with finding the best deal in a competitive market.

We wouldn't have to worry about the fact that we have transaction-specific assets (the value of which is contingent upon us dealing with a specific party). But we do -- so this option will not do.

For example, let's say that the input that we need is specific to a machine that we already own. We need a very specific input produced -- or it will not work with our existing machine. Most likely the party we deal with will also have to invest in specific assets to produce our input. This involves a long term relationship with a particular party.

Will a long-term contract work? Maybe -- it depends -- as the costs of incomplete long-term contracts increase, and as the likelihood of opportunism increases, long-term contracts become less attractive and we might have to turn to our third option.

Will vertical integration be the best option? If transaction costs are high enough -- yes -- we make it ourselves! And this is what the firm does.

In other words -- different means of contracting (or not contracting) come about because of this situation.

Firms come up with their own private solutions to contracting problems -- different business practices that have been seen in the past as being "inefficient" and even illegal are now seen as ways of dealing with contracting costs.

For example: exclusive dealings contracts -- I will agree to sell to you exclusively in a specific area if you agree to make investments in specific assets. Levi Jeans agreeing to sell to only one store in a mall in exchange for the store investing in promotion material specifically designed to sell Levi Jeans.

Real World Case Example: The Fisher Body-GM Case

GM wanted Fisher brothers to produce their metal bodes (for cars).

But that would mean that Fisher brothers had to invest in specific machinery to make the specific bodies for GM (stamping machines and dies)

In 1919 they engaged in a long-term exclusive dealing contract. Since GM could potentially "hold up" Fisher brothers after the specific asset investment was made and either reducing their demand for the bodies or end the contract with them if the price was not adjusted downward.

The exclusive dealings clause in the contract required GM over a 10 year period to buy all their closed metal bodes from Fisher -- this limited the potential for GM to hold up Fisher.

But this created the potential for Fisher to hold up GM. Fisher could take advantage of the requirement that GM not purchase elsewhere by increasing the price or decreasing quality.

So pricing clause: Fisher's VC + 17.6% (designed to cover labor and transportation costs + anticipated capital costs - including opportunity cost of the capital or profit)

Also: most favored nation provision - price could not be greater than what they charged for similar bodies elsewhere.

So what happened?

What about a Self-Enforcing Range - (relying on reputation):

Another example: Alanson P. Minkler and Timothy A. Park, "Asset specificity and Vertical Integration in Franchising" in the Review of Industrial Organization, 2005.

"We employ measures of the proportion of company-owned outlets for the degree of integration and brand name capital for the degree of asset specificity. The results suggest that for the sampled firms the degree of asset specificity is positively related to the degree of vertical integration".

So the more brand name capital invested - the more vertically integrated the franchise operation was.

Next: Some “Austrian” Contributions – are Coase, Williamson, etc. compatible or not?

Some Ideas: Creating an Austrian Theory of the Firm

Sources: Kirzner; Rothbard; Hayek; Lachman; Klein, The Capitalist and the Entrepreneur; Langlois, “The Austrian Theory of the Firm: Retrospect and Prospect.”

In a sense, Austrians – including Hayek – have addressed the same problem as Coase did:

What are the limits of the market and of the firm?

But most Austrians would say that incentive issues tend to override coordination issues in most of the explanations of the firm. Coordination issues, of course, have to do with knowledge issues and issues arising from change.

So the question is can we enhance Coase’s story with a more comprehensive account of coordination in the face of uncertainty and to extend that knowledge and coordination approach that the Austrians have used to explain markets (the price system) into the internal structure of the firm?

Here are a couple of quotations from leading Austrians about Coase and the limits to a firm – Kirzner on Coase:

“In a free market, any advantages that may be derived from ‘central planning’ . . . are purchased at the price of an enhanced knowledge problem. We may expect firms to spontaneously expand to the point where additional advantages of ‘central’ planning are just offset by the incremental knowledge difficulties that stem from dispersed information.”

He is seeing the firm as an organization of planning. Therefore, although Coase might be right that it might be “cheaper” to bypass the market sometimes (due to transaction costs) – and to produce internally – there is a limit to that because of knowledge problems. There are no market prices within firms!! Therefore, the market generates knowledge that can’t be generated and utilized within a firm. This limits how far planning within the firm will be productive vs. market.

Rothbard on Coase:

“Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource.”

Again – need the market to generate prices in capital goods so that we know where they should be utilized generally. Internalizing = no market prices. Therefore, this lack of knowledge will keep the firm from continuously growing.

According to Langlois there are two essential components of an Austrian theory of the boundaries of the firm:

The literature on capabilities is large (Penrose, Richardson, Nelson & Winter, Teece, etc.).

What are they?

Since knowledge is local, individualized, and perhaps sometimes “tacit” – then firms. as well as individuals, are likely to have different sets of “knowledge, experience, and skills” (Richardson).

Such capabilities are what enable production in the first place (knowing how to produce something, for example) – but their limits also bound by what, and how much, individuals and firms are able to do.

These capabilities take advantage of localized knowledge (Hayek’s knowledge of time and circumstances)– but they can’t take advantage of the knowledge that markets generate because they don’t have that knowledge and aren’t able to create it. Therefore:

Managerial capabilities limit the size of the firm!

So another question – why are capabilities organized within firms, sometimes decentralized into markets, and sometimes coordinated by all kinds of different contractual relationships?

Langlois answers with what he calls “Dynamic Transaction Costs” –

“Are these costs of informing, teaching, and persuading others in order to create and redeploy capabilities in the face of change.” (Langlois)

So Langlois (and other Austrian economists) would say that the traditional way of looking at transactions costs is too static. There are transaction costs that arise out of change.

At any historical instant, relevant capabilities (the ones needed for the job at hand) may be located predominantly in markets or predominantly in firms. So one might be superior to the other in one case/time and not in another case/time.

Example: If seizing an entrepreneurial opportunity requires capabilities that do not yet exist – a firm might be best. People within the firm have the relevant knowledge and won’t have to transfer that knowledge to contractors, for example.

And there might be costs of adapting capabilities in the face of change.

If technological change is happening at a very rapid pace – may need to organize within a firm to produce the technology needed by the particular production process. Can’t count on an outsider to supply it.

Example: It might be costly to persuade otherwise capable outside suppliers of the profitability of one’s vision – cheaper to do it yourself!

So change – coming from the visions of entrepreneurs – can create costs to using the market (contractors). Change, then becomes another reason for the existence of the firm – not just uncertainty.

So this version also includes the entrepreneur as the person who discovers ways to deploy the capabilities that lead to profit opportunities.

Austrian Capital Structure and the Firm

But what about Klein’s (and others) claim that Williamson’s specific asset theory can be compared to Austrian capital theory?

Do we have other ideas about the firm if we look down this path?

Austrian Capital theory includes these ideas:

Asset Specificity –

Austrian Capital Theory –

There is substitution among capital goods but the degree of substitution is limited. Some substitution is possible, but typically at a cost.

“The real economic significance of the heterogeneity of capital lies in the fact that each capital good can only be used for a limited number of purposes.” (Lachmann)

Example: a specific kind of cement can be used to produce a sidewalk – but cannot be used to hold bricks together.

But the point is – since capital is not seen as a blob of homogeneous goods – coordination becomes necessary. How do we make sure we get the right kind of cement to the sidewalk guy and not the wrong kind? How do we make sure we utilize other capital goods to produce the right amount of each kind of cement?

Austrians have always emphasized how we need market prices to coordination capital goods as well as consumer goods. So why are some capital goods coordinated inside of the firm?

According to Langlois – due to dynamic transaction costs again. With high levels of change, the internal plan of the entrepreneur may have advantages over the market in coordinating heterogeneous capital.

Example: laying out the floor plan of a plant – with specific capabilities and specific pieces of capital. The specific knowledge capability is a clear advantage in knowing how specific pieces of capital that the plant uses should be placed within the plant to best take advantage of them. This is especially true if the plant floor plan needs to change on a regular basis.

Instead of contracting an outsider to lay out the plant each time it needs to change.

Summary

So let’s sum up these ideas:

We have extended Coase. Remember under Coase we have:

Uncertainty – transaction costs – internalizing – the firm – entrepreneur directs resources within the firm.

With these new ideas:

Uncertainty and Change– transaction costs and dynamic transaction costs – the entrepreneur deciding the “best” deployment of capabilities (which includes individualized knowledge) in order to coordinate heterogeneous pieces of capital – the firm (if the capabilities are better utilized within the boundaries of a firm – to deal with the uncertainty, change and the need for coordination of specific assets).

And all of this is limited by the fact that the knowledge inside of firms is limited knowledge (capabilities are limited) – it does not include knowledge that the price/market system generates and spreads.

This limits the size (creates the boundaries) of the firm.