The Firm – A Note To Myself, Part One

I am thinking through my views on the business firm as an economic entity. My notes so far [no particular order]:

1. The modern business firm is a reaction to, and exist because of, uncertainty. Other rationales are subsidiary to this. For instance New Institutional Economics [NIE] explains firms in the tradition of Ronald Coase and focuses on transaction costs, agency issues, the potential for cheating, and asset specificity. But all these are symptoms of uncertainty. The problem with NIE is that it tries to hew close to the neoclassical line and thus avoids confronting uncertainty directly. Those symptoms are all useful to know and have to be dealt with, but are not the cause of a firm’s existence.
2. All firms have a great deal in common – structure, operations, purpose, attitude towards customers, relations with the environment etc – so can speak of each firm as being an “instance” of a general form. We are interested in that general form.
3. All firms enclose and occupy a logical and physical space in order to offset uncertainty. I call this space “operating space” [OS].
4. Within OS firms create an “alternative reality” that is more certain than the exterior real world. They do this by invoking strategic plans that substitute arbitrary or created “facts” for the unknowns in the environment. They then assume the reality of these facts and conduct their operations accordingly. The contradiction of the plans by unfolding actual reality puts a premium on adaptability and causes a constant need to update plans.
5. As an aspect of that alternative reality, firms set prices – in a variety of arbitrary ways – in order to impose some sense of certainty on their immediate future. Such prices are modified as the firm learns about unfolding reality. This sets in motion an iterative feedback loop tying the firm’s planning to the environment – which includes other firms. So firms try to set prices, which end being modified as information is revealed. The dominant force in pricing is their initial determination which is institutional in character.
6. OS is extensive and thus expensive. This imposes a cost on consumers who tolerate OS provided that it is socially beneficial.
7. The social benefit of OS is that it allows productive processes that are fragile with respect to uncertainty to take place. The management cost of OS is therefore acceptable depending on that fragility, which in turn depends upon the complexity of the product and the time it takes to produce.
8. Management cost is not that associated with production, but is – more importantly – that associated with creating, monitoring, adjusting, and executing plans. Management not only manages production, but in conforms that production to the firm’s planned reality.
9. Any phenomenon that reduces endemic environmental uncertainty diminishes the need for firms – the Internet is an example.
10. This is because consumers have access to more information and thus causing the cost of creating and maintaining OS to exceed its social value. Consumers then have the ability to “dis-intermediate” OS. This puts pressure on management to eliminate costs.
11. Enclosed within OS are a set of “processes” that encompass production.
12. Each process is composed of a mix of “roles” and “routines” that embody the firm’s knowledge.
13. Roles, consist in main, of “secondary knowledge”, which is the capacity to learn, adapt, and modify actions. It is responsive to the environment, to error, to mutation, and thus is the center of the ability to change.
14. Routines consist, in the main, of “primary knowledge”, which is the codified, and thus less expensive and more easily replicated, form of knowledge. Routines are specific to a task and require less skill to execute. They are more easily automated. Firms prefer primary knowledge because it is predictable and can thus be built into a plan more comfortably – the output is also predictable, reducing uncertainty with respect to product.
15. Routines are preferred because of this reduction in uncertainty, but are flawed – perhaps fatally so – with respect to a sharp contradiction not plans by unfolding reality. Primary knowledge is useful only insofar as the future mimics the past, which given endemic uncertainty degrades its use inevitably. Thus the need for the learning capacity of secondary knowledge and its ability to identify the need for and subsequently develop new primary knowledge.
16. Production itself consist of the imposition of order on hitherto disordered raw material substrate. Thus production is a creative force temporarily offsetting the tendency towards disorder in the environment. Order is imposed by the elimination of information from the substrate. Of all the potential states for that substrate only one is chosen – the others are removed or prohibited. The raw material is thus rendered into a specific state for a single or limited range of uses.
17. The imposition of order requires energy, which is thus part of the production “function” along with raw material, the knowledge of the required order, the knowledge of how to impose order, and the labor and equipment needed to execute the roles and routines embodying the process.
18. The production process can be viewed as a lengthy algorithm being applied against the substrate. The longer the algorithm the more information content the end product possesses.
19. There is a tendency towards greater information content as the accretion of knowledge within an economy enables exploration of more intractable areas of “product space”.
20. Potential product space has no bounds. Possible product pace is bounded by the constraints of the economy’s “basis”. Actual product space is that part of the possible subject to the plans established within the total set of firms’ OS.
21. An economy’s basis consists of its state of knowledge [all forms]; its institutional structures; its geographic [resource] limits; its available technology; its cultural constitution; and its available networks through which communication [access to information, contacts etc] and logistics [transport etc] are enabled.
22. The more complex the basis the more able an economy is to access product space. In particular as economy’s learn there is an increase in complexity in the economy. Rising complexity places a greater premium on OS within which to manage creative processes. Hence the increasing dominance of large OS spaces and rising management cost in general. For society to benefit from the production of complex products it has to tolerate this rise in management cost.
23. But the emphasis is on tolerance. Consumers would prefer lower costs and smaller OS.
24. Realizing this, and yet faced with increasing complexity, managements execute a variety of approaches to reduce overall cost. There are two generic approaches: greater emphasis on primary knowledge – lower production cost, but less adaptability; and reducing management cost itself by automating semi-skilled or even skilled activities [converting roles into routines], de-layering, and relying less on internally generated “know-how” and more on externally provided “know-how”.
25. From this we can understand that business firms – because of their desire to maintain an OS – are in confrontation or competition with consumers. For consumers firms are both desirable [production of complex products] and undesirable [imposition of intolerable management costs]

Part Two next week …