The Competitiveness of Nations in a Global Knowledge-Based Economy
Harold Demsetz
The Firm in Economic Theory: A Quiet
Revolution
American Economic
Review, 87 (2)
May, 1997,
426-429.
Content
I. The Existence and Importance of Firms
II.
Abandoning the Presumptions of Neoclassical Theory
Neoclassical theory’s objective is to understand
price-guided, not management-guided, resource allocation. The firm does not play a central role in
the theory. It is that well known
“black-box” into which resources go and out of which goods come, with little
attention paid to how this transformation is accomplished. In the theory’s core model, perfect
competition, the transformation accords with the dictates of known technology
and prices. Management has no real
influence. Nonetheless, the firm in
this theory, and the household too, serve an important objective, that of
conceptualizing an economy in which there is extreme dependency. Production takes place in firms. Consumption and resource supply take
place in households. People must
depend on each other, and self-sufficiency is thus barred. Multi-person firms (and households) are
not needed to play this role. A
farm is a firm, whether owned and worked by a single person or by many, if its
crop is produced for the market rather than for those who have produced
it.
This is quite different from the firm in R. H. Coase’s
1937 classic on the nature of the firm in which managed coordination, presumably
involving more than one person, defines the firm. Prime objectives of his article are to
explain the existence of firms and their importance, relative to the price
system, in the allocation of resources. The difference between these views may be
examined in regard to these objectives.
I. The Existence and Importance of
Firms
In Coase’s (1937) analysis, firms come into existence
when the cost of consciously managing inputs (to achieve a given outcome) is
less than the cost of using the price system. The cost of using the price system is not
clearly described by Coase, although he refers to the costs of acquiring price
information, negotiating, and exchanging. To interpret Coase in a manner consistent
with his objectives, these costs should be interpreted as those of any
activity undertaken to use the price system. Analogously, management cost should be
interpreted as those of any activity undertaken to manage consciously the
use of resources. The cost of a
telephone call can be a cost of using the market in some circumstances or, in
others, a cost of managing; so can the cost of transacting or of contracting.
Negotiating to purchase a good from
another firm gives rise to a cost of using the price system; negotiating to set
the limits of employee work assignments gives rise to a cost of managing. This interpretation is consistent with
contemporary discussions of governance and contracting, but to avoid the
confusion that accompanies terms such as these and “transacting,” I henceforth
refer to PSC and MSC as the costs, respectively, of using a price system and of
using a management system.
In the perfect-competition model, PSC and MSC are both
zero. This is because prices,
goods, and technology are all freely known. Therefore, the comparison that Coase
makes in judging the relative importance of managed and price-guided resource
allocation cannot be relevant to firms and markets in the perfect-competition
model. Yet, in that model, there
are firms and markets. They
complement each other rather than, as in the views of Coase and contemporary
theory, competing with each other. Firms, the sole producers of goods and
services for sale to others, require conceptual “places” (i.e., markets) in
which entitlements to these goods and services are exchanged, but even the
service of exchanging is produced by firms. Markets reveal exchange opportunities but
do not produce goods or services; they can not substitute for firms in this
respect. The implicit substitute
for the firm in this theory is self-sufficient production.
Coase seeks the bright line that separates managed
coordination from price-guided coordination. Neoclassical theory, were it
to
search for an analogous bright line, would seek that
which separates production for others from self-sufficient production, or in
more conventional terminology, that which separates specialization from
self-sufficiency. The relative
importance of these turns on the advantages that come from scale economies,
economies of repetitive task performance, comparative advantage, and so
on.
If one now lets PSC be positive, the neoclassical
comparison responds quite differently from the way Coase’s comparison responds.
Neoclassical theory must view PSC
as an impediment to specialization and as a cause of diminution in
its importance to the economy. This
means diminution in the importance of firms and the price system (i.e., the
market). Specialized production is
sold to others across a PSC barrier, so its advantage over self-sufficiency is
diminished the larger is PSC; the hypothetical lower limit of PSC, zero,
maximizes the range of activities in which specialized production (i.e., the
firm) dominates self-sufficiency. For neoclassical theory, positive MSC, on
the other hand, only provides an incentive to favor single-person firms over
multi-person firms.
Coase’s view, and contemporary theory’s also, must be
the opposite of this. Zero PSC eliminates the need for managed
coordination, at least if there is positive MSC (or if management provides
weaker incentives than do market prices), and price-guided organization
dominates managed organization; the importance of firms is diminished. Positive PSC, on the other hand,
increases the relative importance of firms (i.e., of managed coordination).
These conclusions clash with those
of neoclassical theory because managed coordination increases as the vertical
depth of the firm increases. The
firm manages the production of more of what it uses. But this can also be accompanied by
horizontal shrinkage in the size of the firm. This will normally happen if PSC
increases. This horizontal
shrinkage means less specialized production for others, and it is this that is
interpreted by neoclassical theory as a diminution in the importance of firms.
And so it is. Coase’s theory
correctly deduces that an increase in PSC leads to vertical integration and
correctly sees this as a reduction in the scope of market activity in terms of
the “make or buy” decision, but it neglects the impact of a larger PSC on the
importance of specialization in the economy. If PSC is made prohibitively high, ending
all transactions with others, the firm will have vertically integrated with the
household and become self-sufficient. For neoclassical theory, the
self-sufficient unit is the “non-firm,” whereas Coase and contemporary theory
see reliance on prices as the non-firm or as the market-based contractual
form.
But what does use of the price system mean? It would seem to mean self-interested
owner allocation of resources in accordance with market prices offered and not
in accordance with directions given by other persons. Direction by others would constitute
managed coordination. So the
non-firm for Coase and contemporary theory is really self-direction of one’s
resources in response to prices.
However, in the view of neoclassical theory,
self-direction in response to prices does not create self-sufficiency, which is
its non-firm. Self-sufficiency
means production obtained from one’s own resources but not offered to others
and, therefore, not undertaken in response to price signals. The one-person firm entails no management
of the activities of others, so it is a non-firm for Coase and contemporary
theory, but the one-person production unit can sell to others. This it does to the fullest possible
extent if PSC is zero, and if it does this, it qualifies as a firm in the view
of neoclassical theory. If PSC is
prohibitively high, self-sufficiency reigns supreme, and firms and prices have
no role to play in the economy.
The different views I have been discussing are directed
toward understanding different phenomena. Neoclassical theory is focused on
specialization, not on managed coordination. Coase’s theory is focused on managed
coordination, not on specialization. Contemporary theory has a still different
emphasis. Its concern is mainly
with agency problems, but, it is more closely related to Coase’ s theory than to
neoclassical theory because its focus is on optimal mixtures of market-based
incentives and management-based controls. Nonetheless, both have propositions
concerning the existence and importance of firms and firm-like contracts. In regard to these propositions, the
neoclassical view seems to me to be superior to the views of Coase and
contemporary theory.
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II. Abandoning the Presumptions of
Neoclassical Theory
If contemporary theorizing about firms shares the
weakness of Coase’s views on the existence and importance of firms, it has
nonetheless improved knowledge of institutional arrangements in other respects.
This it has done by rejecting the
assumptions used by neoclassical theory in its core model of the competitive
firm: (i) markets function freely, (ii) prices and technology are known by all
interested parties, and (iii) owners are effective in controlling the use of
their assets. In their place,
contemporary theory substitutes positive information cost. This creates a productive role for
management where none exists in neoclassical theory. The firm in neoclassical theory reflects
the imperatives of the price system, not those of management; if the price
system works well, resources are allocated well. Imperfect information, in contrast, makes
the judgment of managers and owners a source of productivity enhancement. The main source of management’s
productivity in contemporary theory has been in its response to agency problems.
Shirking, opportunism, and
reputation are brought to the fore. Understanding of these, and of business
practices responding to them, has improved rapidly during the last quarter
century. This is properly a source
of pride for those who have worked on these topics.
However, the focus in this effort has led to the neglect
of information problems that do not involve agency relationships. These are associated with planning in a
world in which the future is highly uncertain, and they include problems of
product choice, investment and marketing policies, and scope of operations.
Agency problems often intertwine
with these but are not central to them. Neglect of this class of problems is
unfortunate. Their solutions offer
different explanations of business practices than those derived from agency
relationships. Should agency
problems be the primary guide to understanding vertical integration? Perhaps, but consider, for example, the
role of “expertise.” Specialization
is productive in regard to acquiring knowledge. Forsaking reliance on a specialized body
of knowledge and using multiple kinds of knowledge instead raises the cost per
unit of knowledge acquired. The
manufacturer of commercial aircraft possesses specialized knowledge that can be
extended at little cost into the business of maintaining older aircraft. Vertical integration of these two
businesses is, therefore, a practical possibility. Vertical integration of aircraft
manufacturing and airline transportation, on the other hand, is more difficult.
Effective vending of airline
transportation to the general public requires operational and marketing know-how
not normally part of the knowledge needed to manufacture aircraft. The difficulty this poses does not depend
on agency problems. This is readily
seen by supposing that the firm comprises but a single person, or if composed of
many persons, by supposing that no one engages in opportunistic behavior. Agency problems are absent, but the
advantages of avoiding operations requiring different kinds of knowledge
remain.
The focus on agency relationships has also led to
neglect of some useful neoclassical theorizing. The successive-monopoly problem, price
discrimination, and price controls, as examples, offer motives for vertical
integration not involving agency problems. Of more general importance to business
organization, is the neglect of the impact of prices themselves. No firm can long survive a management
that persists in using capital-intensive methods of production and of monitoring
behavior if the price of capital keeps rising relative to the price of labor.
How much of the variation in
management techniques or contractual form is explained by agency problems and
how much by relative prices? The
work of contemporary theorists suggests that they believe agency problems are
the important source of variation, but I wonder if this is
so.
Neoclassical theory has no serious treatment of business
ownership. This is not surprising
in a theory whose core model presumes full knowledge and, therefore, no risk.
Risk becomes relevant if
information is imperfect. A problem
arises for would-be controlling owners, that of having “too many eggs in one
basket,” or of bearing too much firm-specific risk. The problem is more severe if a firm must
be large to compete effectively, but it can be ameliorated by acquiring equity
capital from many persons rather than from a few. Joint ownership, with its panoply of
control problems, re-
428
sults. The
ownership structure of the firm and the ownership of assets by the firm become
phenomena in search of explanation.
The relationship between diffuseness in the ownership of
the firm and variables such as firm size and regulation has been and is being
studied. There is no need to refer
to these studies here, but behind their logic lies productive roles for both
management and ownership. There are
two primary sources of ownership’s productivity. One is to provide and guide the flow of
equity capital. The other is to
control the activities of management. These involve a control-risk trade-off.
A “tighter” ownership structure
increases control of professional management but raises the firm-specific risk
borne by suppliers of equity. This
trade-off depends not only on the variables currently being studied, but also on
a society’s wealth and the distribution of same. A wealthy person can take a large
position in a firm’s ownership structure, yet enjoy diversification of his total
wealth. An egalitarian distribution
of wealth, precisely because it deprives a society of wealthy people, undermines
even a wealthy society’s ability to put owners in effective control of
professional management. No single
family or group of, say, five families would possess enough wealth to own a
substantial fraction of the equity of a firm that must be large to compete
effectively. An extremely unequal
distribution of wealth also exacerbates the entrenched management problem. The time and expertise available to those
few who are very wealthy are too limited to allow them to control effectively
the many enterprises they own. Between these extremes is a wealth
distribution that is best suited to accommodate the control-risk trade-off
problem; the wealthier is a society, the more moderate can be the inequality in
this distribution.
Contemporary theorizing about the firm indicates that
wealth and its distribution matter to society’s productivity because of the
constraints these put on the ownership structure of firms; in this new way, they
have an impact on the effectiveness with which business assets are managed.
Barring foreign equity capital, a
poor nation that follows an egalitarian income policy cannot have firms that are
effectively controlled if they operate in markets where large size is important
to competitive success. Equity for
such firms can be supplied only through a diffuse private-ownership structure or
through an even more diffuse public-ownership structure. Both make the control problem more severe
than it would be if resources had gone into markets in which large size is not a
competitive advantage. The
implications of this for economic growth are already reflected in recent work
(D. Lal and H.Myint, 1996).
Consider now the firm’s ownership of assets. If a firm can be small and compete, its
assets can be owned by a single person or by very few. In this case, the firm’s operations
impinge directly on the reputation of the owner(s). The ownership structure of a large firm,
however, must be more diffuse in order to ameliorate the firm-specific risk
problem. If each of many owners of
a small share of equity could insist on the return of his pro rata share of the
firm’s assets, as he can, for example, in dealing with an open-end mutual fund,
the firm could be forced to disgorge assets. This would create a great deal of
uncertainty for customers and suppliers if these were to find that long-term
relationships with the firm are important, for the overhang of the threat to the
firm’s assets makes the firm’s ability to honor such relationships problematic.
Shareholder reputation cannot play
as large a role here in assuring customers and suppliers as it does in the small
firm, because no single shareholder is undermining the firm’s ability to honor
long-term agreements when asking the firm to repurchase his relatively small
share of the firm’s assets. To
prevent disgorgement of assets, it is desirable for the firm itself to own the
assets once they are acquired with equity provided by shareholders. Accordingly, under present corporate law,
shareholders in the general case have a claim on dividends, can sell their
shares to others, and can vote on important corporate matters, but they cannot
insist on a pro rata return of the value of a going firm’s
assets.
Coase, R. H. “The Nature of the Firm.” Economica,
November 1937, 4(16), pp. 386-405.
Lal, D. and Myint, H. The political economy of
poverty, equity, and growth.
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