theory of the firm

The Economist notes Ronald Coase’s one hundredth birthday. I should not allow this to go uncommented upon. To me Coase asked one of the most simple yet subversive questions of all time in economics: why do firms exist?

To regular people outside the wonderland of orthodox economic theory, this question usually induces something between an indifferent yawn, and a totally indifferent shrug. Business firms are such a huge factor in our daily lives that we take them for granted. Most people work in one, or know plenty of others who do. So why ask such a dull and, frankly, obvious question? Surely economists have that one covered.

Umm, no.

I know this, because the “theory of the firm” was my entry point back into economics a decade or so ago. Having spent years in the business world I simply assumed that somewhere in the literature, maybe hidden from view, was a great deal of theorizing about the firm. I wanted to delve into it because I was convinced that said theory would guide me towards an answer to my own question, which was far more parochial: what will happen to the structure of the firm once information technology is fully embraced?

I came across Coase early in this search, and was happy to see he first posed his sly little enquiry in 1937. My search was immediately stalled. His question elicited no response. Economists were, and largely still are, totally uninterested in the firm and in the actual operations of business. Indeed in one paper two luminaries, Alchian and Demsetz, argued it was of no consequence, although I am happy to report they have backtracked subsequently.

How can this be?

Wonderland admits no organization other than the magic of markets. Ergo: no firms. If markets are so magical that they solve all the world’s economic coordination problems, which is what orthodox economists believe, then firms are an anomaly. Worse, they are an embarrassment.

I have a vague recollection of a character in Dickens called Podsnap, a bureaucrat who solves the unsolvable by waving his hand and dismissing the issue as a minor nuisance beneath his august attention. Maybe he was an economist because this is the standard method they adopt towards business. It is a mucky black box unworthy of their higher and more rarified examination.

That the black box is where stuff gets done is of no matter. Only business school people deal with earthly things like firms. True economists soar above, and grapple with important issues like revealed preferences, utility, marginal costs, Pareto efficiency, convex curves – how we love those – and other features of proper, albeit not real, economies. They leave real things to peons. The ugly paradox here is that business schools teach orthodox economics, apparently oblivious to the implied contradiction. No wonder business people hold economists in such low regard.

So Coase was ignored.

Of course I simplify, but the story is largely true.

Much later, only in the last two decades or so, has a true attempt been made to deal with the firm. Oliver Williamson, and his ilk, have developed the Coasian idea of transaction costs to allow the firm to be retrofitted onto orthodoxy without upending the entire sorry mess. The idea being that firms exist because there are costs of coordination that create efficacy in active, rather than passive,management. Remember the whole point of market worship is that its magic allows economies to be passively coordinated thus rendering the heavy, and altogether active, coordination of a government mute at best and harmful at worst. So active management simply doesn’t fit the orthodox narrative. It is a distinct no no.

Personally I reject Williamson as being an attempt to avoid answering the question correctly. The real answer, for me at any rate, is that firms exist because of uncertainty. And uncertainty is a dirty word in the lexicon of economics. A really bad, bad, dirty word.

You see, if uncertainty exists out there in the real world, then all that elegant math stuff economists rely upon to prove, yes prove, that markets possess magical powers, immune even to kryptonite, then uncertainty cannot be. It just cannot be.

So they don’t talk about it.

True, economists have spent vast amounts of energy trying to weasel a different view of what uncertainty is. Sometimes they call it risk. As in risk modeling. As in the financial crisis and risk management. Which turned out to be more risk than they could manage. That’s because they muddle risk and uncertainty. Risk is something we know enough about to mitigate. Uncertainty is something we simply don’t know. It is an ontological rather than epistemological problem. Not that learning doesn’t help.

Regular people are faced with uncertainty all the time. So they execute various strategies to fend off its consequences. They cooperate. They search to extend their known landscape. They move about. They listen and try to parse out meaning from noise. They organize. They build walls to protect themselves. They invent technologies so they can peer deeper into the dark. They design elaborate rituals to appease the spirits of gods. They speculate.

And they start business firms.

Firms themselves do many of these things too. Above all else they plan. They are centrally planned economies. They execute against a plan, which is an alternative reality they hope approximates the actual reality as it unfolds. If their plan and the real world are close enough, as history plays out, then the firm survives. No plan is ever accurate, but the point is that be accurate enough. Efficiency is not required. Sufficiency is. Perfection unnecessary, survival paramount. Redundancy is an virtue. Exactitude a luxury. Having some spare capacity to guard against forecasting error is useful. Having latitude and degrees of freedom are vital. Being supremely fit and lean are nice, but only if you know what’s going to happen. If you don’t, then its better to be a bit flabby, but versatile.

In other words it’s all about being able to hypothesize a direction, and being able to adapt as information flows in.

This is what firms do. It all sounds so utterly non-scientific and ordinary.

Firms are, in the words of Loasby, hedges against uncertainty.

They are thus a constant dagger pointed at the heart of orthodox economic theory. No wonder Coase went unanswered.

On a lighter note, here’s a neat question to pose all your CEO, MBA, and fervent right wing business friends: “Do you believe in free market theory?”. Probable answer: a resounding yes. Follow up question: “Then why is your company organized as a centrally planned economy a la the Soviet Union?”. Probable answer: blabbering, murmuring, and a change of topics.

There is not one CEO of a large business firm, that I know of, who truly believes in the magic of free markets. Otherwise one of them would have organized his or her firm to conform to that theory. So don’t listen to them. Further, since an enormous proportion of all economic activity in every country on earth takes place within the safe and centrally planned confines of a business firm, it is equally safe to say that the evidence is in. Markets suck at coordination. Planning rocks.

Now how we teach this basic economic reality to economists is another question.

Coase: you devil. Stop asking awkward questions!