The Nature of the Firm
Stephen C. Mooney
July 2006 (minor corrections 2010)
It is doubtful if there is yet general agreement among economists on the subject matter
designated by the title „theory of the firm‟. (Archibald 1987)
It is important to realize that there is no new „theory of the firm‟ waiting to replace the
traditional neoclassical theory of the firm. (Furubotn/Richter 1997)
What is a firm? The answer depends largely on who‟s asking and why. For early classical
economists (Smith, Hume, Say, Ricardo), a firm was a landed estate, a small-scale, family-owned/operated manufacture or a joint-stock trading company. For late classical economists (J.S. Mill, Marx, Cairnes), a firm was predominantly a large-scale industrial manufacture.
For neoclassical economists, particularly early neoclassical economists (Cournot, Marshall, Jevons, Walras), a firm is an abstract unit of analysis (one of a set of such units that includes the „individual‟, „household‟, „industry‟ and „economy‟); it is an organization engaged in
production or supply whose internal structure and motivation are assumed for the purposes of
analysis to be „owner-operator‟ and „profit maximization‟ respectively. Within the
neoclassical framework, human beings are assumed to be rational (narrowly defined);
information is assumed to be complete, perfect and costless; the economy is assumed to be
completely decentralized; and the institutional environment in which the firm operates is ignored. These assumptions were made to simplify the problem domain within an as-yet incomplete 200-year research program.
For economic historians (Berle and Means 1932, Chandler 1977, North 1990, Spulber 2002), Austrian economists (Schumpeter 1934, Hayek 1945) and late neoclassical economists (Knight 1921, Coase 1937, 1960, Alchian and Demsetz 1972, Williamson 1975, Demsetz 1990, Hart 1995), the internal structure and dynamics of the firm, particularly the public, limited-liability corporation, warrant investigation. The current view is that a firm is a nexus of contracts designed to specify property rights and/or reduce opportunistic behavior arising from bounded rationality and incomplete/asymmetric information, but there is no standard model.
In practical terms, a firm is essentially a team-machine. It is a self-selecting society with an institutional structure (set of formal and informal rules) brought into existence for the purpose of creating goods and services and selling them to the wider society outside of itself.
To understand the firm, one must first understand the lever. Anyone who has used a claw hammer to withdraw a nail from a board or a crowbar to pry up a rock from the ground is familiar with the lever. It is a tool that amplifies physical human strength and thereby, in the jargon of economists, increases labor productivity. Whereas it might be impossible to withdraw a nail with one‟s fingers, the leverage of a claw hammer accomplishes the task
easily. Whereas it might take five men one day to remove a large rock from a field with their bare hands, one man with a crowbar might accomplish the task in an hour. Moreover, while one man alone might lever the rock out of the ground in an hour, three men with levers acting
in concert might do it in fifteen minutes. That is because tools, knowledge and teamwork can multiply rather than sum human capabilities.
The advantages which are derived from machinery and manufactures seem to arise principally from
three sources: The addition which they make to human power. – The economy they produce of human
time. – The conversion of substances apparently common and worthless into valuable products.
(Charles Babbage 1835, in Babbage 1986, 6)
Not only can a firm do things far more efficiently than a disorganized collection of individuals, but the benefits from team productivity are so great that the team may choose to keep the firm together over the long term instead of disbanding and doing something else.
The eighth wonder of the world is this: two pounds of iron-stone purchased on the shores of lake
Superior and transported to Pittsburgh; two pounds of coal mined in Connellsville and manufactured
into coke and brought to Pittsburgh; one half pound of limestone mined east of the Alleghenies and
brought to Pittsburgh; a little manganese ore, mined in Virginia and brought to Pittsburgh. And these
four and one half pounds of material manufactured into one pound of solid steel and sold for one cent.
That‟s all that need be said about the steel business. (Andrew Carnegie c.1900, in Livesay 1975, 189)
A firm, therefore, embodies productive technologies in the form of a team-machine. In fact, within the neoclassical perspective, we can go so far as to visualize a firm as nothing more than an automatic, self-optimizing capital asset, literally a machine. This is why neoclassical economists model the entire economy in terms of static equilibrium. The human being is exogenous.
Viewing the firm as the nexus of a set of contracting relationships among individuals also serves to
make it clear that the personalization of the firm implied by asking questions such as “what should be
the objective function of the firm,” or “does the firm have a social responsibility” is seriously
misleading. The firm is not an individual. It is a legal fiction which serves as a focus for a complex
process in which the conflicting objectives of individuals...are brought into equilibrium within a
framework of contractual relations. In this sense the „behavior‟ of the firm is like the behavior of a
market.... We seldom fall into the trap of characterizing the wheat or stock market as an individual, but
we often make this error by thinking about organizations as if they were persons with motivations and
intentions. (Jensen and Meckling 1976, in Putterman and Kroszner 1996, 321-322)
It is also an error to confuse economics (an academic discipline concerned with the pursuit of
knowledge) with business (a commercial enterprise concerned with the prosecution of action). Not only politicians, but corporate executives themselves have come to believe that the goal of the firm is to maximize profits (“provide shareholder value”) within a framework of corporate social responsibility (“give something back”).
This confusion arises partly from the separation of ownership and control within very large public corporations and partly from the marriage of science and management at the executive level in both government and industry since World War II. The common perception that big business and big government have merged into a national corporatist technocracy was captured eloquently by Charles Wilson in 1953. When asked if there was any conflict of interest between his position as President of General Motors and his appointment as Secretary of Defense, he replied, “I cannot conceive of one because for years I thought that what was
good for our country was good for General Motors, and vice versa.”
Before we fall into the trap of imagining a world governed by big business, remember that less than three percent of employer firms in the US earn $10 million or more, 0.3 percent have more than 500 employees, 10 percent have more than 20 employees and 75 percent have
no employees at all (USBoC). Meanwhile, government spending represents a whopping one third of the entire US economy.
Returning, then, to the firm as a commercial enterprise, it produces that which would not otherwise be produced, it reduces the cost of production so greatly that all share in the benefit (except in certain situations where property rights are held in common or jointly entangled) and it engenders further enterprise through capital accumulation (intellectual, physical, monetary). One might say its very existence attests to its social responsibility.
Business on a money-making basis is most insecure. It is a touch-and-go affair, moving irregularly and
rarely over a term of years amounting to much. It is the function of business to produce for
consumption and not for money or speculation. Producing for consumption implies that the quality of
the article produced will be high and that the price will be low - that the article be one which serves the
people and not merely the producer. If the money feature is twisted out of its proper perspective, then
the production will be twisted to serve the producer. The producer depends for his prosperity upon
serving the people. He may get by for a while serving himself, but if he does, it will be purely
accidental, and when the people wake up to the fact that they are not being served, the end of that
producer is in sight. (Henry Ford 1922, in Ford 1973, 12)
In addition to being a nexus of contracts, a modern firm has become a nexus of images, emotions and ethical values with an overarching identity - an icon - recognizable to the market and the community at large in the form of reputation. While it is fashionable now for a firm to mirror the ethical values and social norms of the day, at the end of that day, its reputation depends solely upon providing goods and customer services to the community of which it is a subset. A firm, therefore, has always been and will always be a commercial rather than political organization. The bottom line is that a firm is what it does.
Alchian and Demsetz 1972: “Production, Information Costs and Economic Organization” in
Alchian, Armen A. 1977: Economic Forces at Work: Selected Works by Armen A. Alchian.
Liberty Fund, Indianapolis, Indiana
Archibald 1987: “Firm, theory of the” in PDE 1998, II-357-362
Babbage, Charles (1835) 1986: On the Economy of Machinery and Manufactures, 4th edition.
Reprint by August M. Kelly Publishers, Fairfield, New Jersey
Berle and Means (1932) 1991: The Modern Corporation and Private Property. Transaction
Publishers, New York
Chandler, Alfred D., Jr. 1977: The Visible Hand: the Managerial Revolution in American
Business. Belknap, Harvard University Press, Cambridge, Massachusetts
Coase, Ronald 1937: “The Nature of the Firm” in Coase 1990 or Putterman and Kroszner
Coase, Ronald 1960: “The Problem of Social Cost” in Coase 1990
Coase, Ronald H. 1990: The Firm, the Market and the Law. University of Chicago Press,
Demsetz, Harold 1990: “The Theory of the Firm Revisited” in Williamson and Winter 1993
Ford, Henry (1922) 1973: My Life and Work. Big Business: Economic Power in a Free
Society, series edited by Leon Stein, Stuart Bruchey and Thomas C. Cochran. Arno
Press, New York Times, New York
Furubotn, Eirik G. and Rudolf Richter 1997: Institutions and Economic Theory: The
Contributions of the New Institutional Economics. Michigan University Press, Ann
Hart, Oliver 1995: Firms, Contracts and Financial Structure. Clarendon Lectures in
Economics, Oxford University Press, New York Hayek 1945: “The Use of Knowledge in Society” in Hayek 1980 or Putterman and Kroszner
Hayek, Friedrich A. (1948) 1980: Individualism and Economic Order. University of Chicago
Jensen, Michael and William Meckling 1976: “Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure” in Putterman and Kroszner 1996
Knight, Frank (1921) 2006: Risk, Uncertainty and Profit. Dover Publications, Mineola, New
North, Douglass 1990: Institutions, Institutional Change and Economic Performance.
Cambridge University Press
PDE 1998: The New Palgrave: a Dictionary of Economics, in four volumes, edited by John
Eatwell, Murray Milgate and Peter Newman. Macmillan Reference, London
Putterman, Louis and Randall S. Kroszner (Eds.) 1996: The Economic Nature of the Firm: A
Reader, 2nd edition. Cambridge University Press, Cambridge Schumpeter, Joseph (1934) 1983: The Theory of Economic Development: an Inquiry into
Profits, Capital, Credit, Interest, and the Business Cycle (translated by Redvers Opie).
Transaction Publishers, Rutgers - The State University, New Brunswick, New Jersey
Spulber, Daniel F. (Ed.) 2002: Famous Fables of Economics: Myths of Market Failure.
USBoC: http://www.census.gov/epcd/www/smallbus.html Williamson, Oliver E. (1975) 1983: Markets and Hierarchies: Analysis and Antitrust
Implications. The Free Press, Macmillan Publishing, New York Williamson, Oliver E. and Sidney G. Winter (Eds.) 1993: The Nature of the Firm: Origins,
Evolution and Development. Oxford University Press, New York