THEORIES OF THE FIRM

The central issue

Why do firms (in general 1) exist? This question is one that has preoccupied many scholars of

organisations. However, it is probably true that economists, rather than those interested in

management or business, have spent a greater amount of time (and paper) investigating the

twin questions of ‚Why do firms exist? Why isn’t everything done by the market‛ (The

Economist, 2010, para. 1).

One view—presented by Kantarelis, an economist— argues that a firm is

… a needs-satisfying machine; it is an entity invented and employed by

society to better satisfy the society’s interests. A society is better off

when properly regulated business firms are allowed to carry the bulk of

economic activity than when they are not allowed to exist or are severely

regulated by the state. And, as history has documented, societies fare

better when they are dependent on such business firms than when they

are dependent on central planning (2010, p. 3).

You might like to reflect on Kantarelis’s statement, especially in the light of the discussions

around corporate social responsibility.

In the classic book The wealth of nations, Adam Smith (1776) describes how the division of

labour—the splitting up of jobs into small parts—can produce significant increases in

productivity. The example he uses is of pin making:

… a workman not educated to this business … could scarce, perhaps, with

his utmost industry, make one pin in a day, and certainly could not make

twenty. But in the way in which this business is now carried on .. it is

divided into a number of branches. … One man draws out the wire;

another straights it; a third cuts it; a fourth points it; a fifth grinds it at

the top for receiving the head; to make the head requires two or three

distinct operations; to put it on is a peculiar business; to whiten the pins

is another; … to put them into the paper; and the important business of

making a pin is, in this manner, divided into about eighteen distinct

operations …. I have seen a small manufactory of this kind … make

among them [the ten persons in the factory] about twelve pounds of

pins in a day. There are in a pound upwards of four thousand pins of a

middling size. Those ten persons, therefore, could make among them

upwards of forty-eight thousand pins in a day. Each person, therefore,

making a tenth part of forty-eight thousand pins, might be considered as

making four thousand eight hundred pins in a day. (Smith, 1776, pp. 11-12,

italics added).

In other words, by dividing the work in to small tasks, in which people can become very

efficient, productivity rose from 20 pins to around 40,000 pins per person per day. However,

is productivity alone the explanation as to why firms exist?

1 This is a different question to asking why does a particular firm exist.

Theories of the firm

2

The perspectives from economics

Since Adam Smith’s time, four main theories have emerged that seek to explain why firms

exist. These main theories are the Transaction Cost Theory of the Firm, the Principal-Agent

Theory of the Firm, and the Evolutionary Theory of the Firm.

The Transactions Cost Theory of the Firm is attributed to Coase (1937) and more recently to

Williamson (1975). TCE, as it is sometimes called, focuses on problems that arise during

transactions because of asymmetric information; that is to say, the seller and buyer know

different things. The fundamental argument behind TCE is that it is sometimes cheaper to

do things inside the firm rather than incurring the expense of going to market. In particular,

Coase argues that the more specific the inputs required by the firm, the more likely it is that

the firm would do or produce them internally rather than going to the market to buy them.

This theory explains the rise of the highly diversified business (The Economist, 2010), but it

does not account well for how firms utilise their advantages, or how they evolve over time.

The Principal–Agent Theory of the Firm, sometimes called agency theory, extends the TCE by

considering the impact of information asymmetry again. But instead of differences in the

information known between the buyer and the seller, agency theory is concerned with the

differences in information between the principal (say, the owner) and the agent (say, the

manager to whom the owner has delegated authority and responsibility). In particular it

looks at:

… resolving two problems that can occur in agency relationships. The

first is the agency problem that arises when (a) the desires or goals of the

principal and agent conflict and (b) it is difficult or expensive for the

principal to verify what the agent is actually doing (Eisenhardt, 1989, p.

58).

How does one ensure that the agent is doing what the principal wants them to do (in the

face of information asymmetry between them). Principal-agent theory goes beyond the

owner-manager situation and considers all relationships where there might be such an

asymmetry. Agency theories weakness is the challenges of structuring incentive

mechanisms. It often relies on complicated—and sometime incomplete or unenforceable—

contracts. Furthermore, while sharing some of the same routes as TCE, it doesn’t address

some of the problems as effectively as ‘pure TCE’, neither does it explain the evolution of

firms.

The Evolutionary Theory of the Firm (Nelson & Winter, 1982), unlike neo-classical theories

(such as TCE) which focus on equilibrium and stability, is a dynamic theory that seeks to

address how and why change happens. According to Kantarelis (2010, p. 6), the

evolutionary theory of the firm:

… emphasis on production capabilities and process as well as product

innovation. The firm, according to this theory, possesses unique

resources, tied semi-permanently to the firm, and capabilities; the firm’s

resources can be classified into four categories: financial, physical,

human and organisational. The theory sees the firm as a reactor to

change and a creator of change for competitive advantage. The firm, as a

creator of change, may cause creative destruction, which in turn may

Theories of the firm

3

give birth to new industries and enable sectors of, or entire, economies

to grow‛.

A more managerial perspective

These three theories of the firm are grounded in economics. However, outside of economics

there are a number of other theories of the firm, but the most notable is the Behavourial

Theory of the Firm. This approach, associated with Cyert and March (1963), emphasises the

behavioural nature of decision-making in firms. Such decisions are made in situations of

uncertainty, a situation that arises because ‚rational actors are significantly constrained by

limitations of information and calculation‛ (1963, p. 214) and so they have ‘bounded

rationality’. As a result, individuals and groups tend to ‘satisfice’ (Augier & March, 2008),

rather than maximise the outcome of their decisions. The notions of ‘bounded rationality’

and ‘satisficing’ are very important ideas in the management arena.

Further reading

If you want to know more about the Behaviour Theory of the Firm, rather than jumping in

and reading the book, you might begin with the retrospective review written by Augier and

March (2008).

References

Augier, M., & March, J. G. (2008). A retrospective look at A Behavioral Theory of the Firm.

Journal of Economic Behavior & Organization, 66(1), 1-6. doi:10.1016/j.jebo.2008.01.005

Coase, R. H. (1937). The nature of the firm. Economica, 4(16), 386-405. doi:10.1111/j.1468-

0335.1937.tb00002.x

Cyert, R. M., & March, J. G. (1963). A behavioral theory of the firm. Englewood Cliffs, NJ:

Prentice-Hall.

Eisenhardt, K. M. (1989). Agency theory: An assessment and review. The Academy of

Management Review, 14(1), 57-74. doi:10.2307/258191

Kantarelis, D. (2010). Theories of the firm (3rd ed.). Geneva: Inderscience Enterprises.

Nelson, R. R., & Winter, S. G. (1982). An evolutionary theory of economic change. Cambridge,

MA: Harvard University Press.

Smith, A. (1776). An inquiry into the nature and causes of the wealth of nations (Vol. 1). Chicago:

Chicago University Press.

The Economist. (2010, December 16). Why do firms exist? The Economist. Retrieved from

http://www.economist.com/node/17730360/print

Williamson, O. E. (1975). Markets and hierarchies, analysis and antitrust implications: A study in

the economics of internal organization. New York: Free Press.