Why Do Firms Exist?

Kevin Bryan writes,

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organized as they are, why they persist over time, and why interfirm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational. Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many “resource” type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.) I believe that there are reasons why the costs of maintaining relationships – transaction costs – endogenously differ within and outside firms, and that Hart is correct is focusing our attention on how asset ownership and decision making authority affects incentives to invest, but these theories even in their most endogenous form cannot do everything we wanted a theory of the firm to accomplish. I think that somehow reputation – and hence relational contracts – must play a fundamental role, and that the nexus of conflicting incentives among agents within an organization, as described by Holmstrom, must as well. But we still lack the precise insight to clear up this muddle, and give us a straightforward explanation for why we seem to need “little Communist bureaucracies” to assist our otherwise decentralized and almost magical market system.

Read the whole post. Pointer from Tyler Cowen.

I still think that Alchian-Demsetz is the best place to start. Suppose that a bunch of computer programmers, loan officers, and bank tellers get together to start a bank. They cannot just bargain with one another on roles, responsibilities, and pay. You need a decision-maker. And that decision maker must serve a definitive owner. The owner is the “residual claimant” on the firm.

I think that this is similar to why we certain key components of infrastructure are centralized. Road systems, sanitation systems, communication wiring, and the electric grid, for example. Imagine a bunch of households get together and say, “Let’s have a road system.” They cannot just each decide to build roads in the vicinity of their homes and then bargain with one another on roles, responsibilities, and tolls to charge drivers. You need a decision-maker. etc.

I think that we know intuitively why firms exist. The challenge is to articulate that intuition.

12 thoughts on “Why Do Firms Exist?

  1. “I doubt the business model”

    Personally, from my perspective, the actual challenge is resolving this paradox…

    1. the owner being the decision maker
    2. consumers being the ultimate decision makers

    Uber made the decision to go driverless. But whether or not this is a good decision really isn’t up to Uber. It’s up to millions and millions and millions of consumers. Evidently we trust the decisions of consumers more than we trust the decisions of producers. But, if this is truly the case, then why didn’t Uber see the benefit of opening up its decision to public valuation? Each and every person would have had the opportunity to spend as much of their own money as they wanted on their preferred option…

    A. Yes driverless
    B. No driverless

    Then we would have seen which option was the most valuable. Would Uber have had to abide by the public’s valuation? Not necessarily. But would it really have hurt Uber to know the public’s valuation?

    “On the other hand, it is also a maxim of experience that in the multitude of counsellors there is wisdom; and that a man seldom judges right, even in his own concerns, still less in those of the public, when he makes habitual use of no knowledge but his own, or that of some single adviser.” – J. S. Mill, Considerations on Representative Government

  2. @Epiphyte

    Perhaps the issue is local knowledge. The consumers have local knowledge of their own problems, the firm owner of his proposed solution. This is part of the puzzle that asking a bunch of people what they want often results in total hooey; and providing options often results in unexpected uses for products.

    • BenK, what’s not quite clear in your response is how, exactly, the people answer the question of what they want. Imagine that the Nobel committee had asked people who they wanted to win the prize in economics. There are two mains ways that people could have answered the question…

      1. stated preference (voting, surveys, opinion polls, etc)
      2. demonstrated preference (willingness to pay (WTP))

      It’s one thing to simply say that Armen Alchian should win… it’s another thing to substantiate your preference with a sacrifice of $5000 dollars. The former is an opinion… the latter is a valuation. We see crowdfunding for products but I haven’t heard of crowdfunding decisions.

      • Actually, I think I’ve heard of crowdfunded decisions. I see them in many settings. One is local civic organizations where they have different projects and you donate to your favorite – the one with the highest donations when the total crosses a key line gets the pot and the project is executed.

  3. But we still lack the precise insight to clear up this muddle, and give us a straightforward explanation for why we seem to need “little Communist bureaucracies” to assist our otherwise decentralized and almost magical market system.

    The person who wrote this has probably never ever worked in a firm. The “bureaucracy” of a firm is due almost entirely to comparative advantage among its workers due to diversity of competence and interest.

    In order to maximize its success, a firm should maximize its comparative advantage with respect to its outputs relative to other firms. In order to maximize its productivity, a firm should maximize the comparative advantages of its individual members. Any time spent by the firm’s members that isn’t in their respective comparative advantages reduces the firm’s productivity and hence its comparative advantage.

    That includes the fact that some people are better at strategy, some people are better at tactics, some people are better at executive execution, some people are better at managing people, some people are better at focused intellectual work, some people are better at just doing a job. Lo and behold, you can predict the “bureaucracy” — more properly called delegated decision making — from those competencies and interests.

    The bottom line: The vast majority of members of a firm do not want to be its leader. Each would rather focus on what he or she does best, and that means a limited decision-making role and probably zero strategic decision making. Fortunately for the firm, that’s what maximizes the firm’s productivity. If a firm did not have a bureaucracy figuring out strategy and turning it into product, it would have to invent one.

  4. You need a decision-maker. And that decision maker must serve a definitive owner.

    I think this gives too much credit to the owner. It is more accurate to say that the owner serves the firm and its decision maker than that the decision maker and the firm serve the owner.

    In the cases of both venture capital and public stock markets, owners seek out firms that have good comparative advantage, a strategy to carry it to product, and leadership to execute the strategy. The capital seeks out the firm because both the capital and the leadership recognize the opportunity the firm has and the capital believes the leadership can achieve it with some probability and some gain to the capital. If the firm or its decision makers serve the owners rather than the best interests of the firm, its successes will be impaired, and the owners will get less out of their investment than otherwise and will on the margin move their capital to some other opportunity.

    Even if a venture capitalist believes she can execute a firm’s strategy better than the firm’s decision makers, she will recognize that her comparative advantage is in selecting firms that have good opportunity and leadership and advising them and otherwise assisting them. In that way she can operate in many firms rather than only one and can maximize her and her fund’s product. She does not want the firm’s decision makers to serve her or her fund. She wants them to serve the firm.

  5. I can leave a firm whenever I want, or start my own. Communists frown on such actions.

  6. I believe that the next phase in this aspect of economics will come in when the various hybridizations of crowd funding, blockchain , prediction markets, gig economy, microservices, etc. become more important in our day to day existence.

    crowd funding – risk assessment and investment
    blockchain – mostly proof of stake blockchains – common source of truth and the coin itself is a direct substitute for equity and residual claim
    gig economy – scheduling of daily work of employees, contractors
    prediction markets – taking a bet on what may work
    microservices – simplifying interfaces with simple and complex systems (which may internally have any shape – you don’t know , you don’t care)

    You will actually have people testing the various theories of corporate formation and governance by trying to leverage these technologies more. We may see some unowned networks develop the kind of innovative agility that we associated only with firms before, or we may not. Either way, we will have more empirical evidence towards which theory is truer.

  7. I believe that the next phase in this aspect of economics will come in when the various hybridizations of crowd funding, blockchain , prediction markets, gig economy, microservices, etc. become more important in our day to day existence.

    While those may change how firms relate to the larger economy on the margin, how they are funded, and how many workers must be members inside the firm versus providing inputs from outside the firm, none of them address the greatest scarcities that firms satisfy: strategy and commitment.

    Having a firm decide day-to-day how a worker should spend his time in order to maximize his value to the society at large simply yields the most economically efficient use of his scarce time. Granted, there are exceptions where individual contributions can be efficiently supplied from outside the firm — think Uber drivers or freelance writers — but those examples of contributions that demonstrate limited requirements, limited interfaces, and limited commitment prove the rule. If what a worker does does not have clean external requirements with strictly limited touchpoints, he is better off mutually committing with others who can complement his skills under a common strategy. He is better off in a firm. And on average the more he wants to exercise his comparative advantage — the more he wants to maximize his economic value — the more better off he is in a firm.

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