A New/Old Theory of the Firm, Put to Use

There are two dominant theories of the firm in modern economics, one centered on transaction costs, the other viewing the firm as a nexus of contracts.  Both are premised on the notion that, absent any frictions, and especially those due to incentive problems, market coordination would always be superior to the coordination supplied by firms.  Hence firms are anomalies, and in the benchmark utopia of competitive general equilibrium they don’t exist at all except as accounting units.

There is a longstanding tradition that attempts to explain the existence and extent of firms according to their efficiencies rather than flaws in the market.  Such a view is implicit in Schumpeter, for whom entrepreneurship was a creative force that could not arise in markets composed of infinitely small players.  Chandler similarly tried to argue for efficiencies in coordination, especially in continuous process systems.  Neither succeeded in providing a formal explanation of what it was about the mechanisms that concerned them that indicated that firms rather than markets would house them, and their views have been largely banished from economic theorizing.  Nonetheless, the field of management, where questions of firm capacity and strategy are paramount, continues to draw on a conception of the firm in which administrative organization is capable of coordination that markets cannot supply.

In fact, there is a theory of the firm based on a single and, once it is laid out, rather obvious concept that provides a formal underpinning for management-centered approaches: the role of interactive nonconvexity in production systems.  Here are two explanations, one formal, the other intuitive.

Formal: The mono-equilibrium property of decentralized allocative methods depends on (quasi-) convex preference and production sets.  There are two potential sources of nonconvexity.  One is “wrongly” signed elements along the principal diagonal of matrices of cross-partial derivatives, especially as resulting from increasing returns in production.  The other is the presence of off-diagonal elements whose absolute value is sufficiently large to offset the effect of principal diagonal elements in determining the sign of the matrix of cross-partials.  The number of equilibria (local optima of an objective function encompassing this structure) is given by the degree of the underlying function.  Firms are instruments for selecting among (local) optima by direct specification of detailed quantities or processes.

Intuitive: Markets proceed through an adding-up process, where the collective result is the sum of many small transactions undertaken separately.  There exist situations, however, in which the outcome of taking an action depends on the action taken by others—this is the central problem in cooperative game theory, for instance.  Markets accommodate just one such interaction effect, the role that cumulative offers (demand and supply) plays in determining prices.  But there are many other types of interactions that markets are unable to coordinate.  Many arise in production, the effect that one person’s productive activity has on the productivity of another.  It is because of such interaction effects that it is necessary to draw up and implement a plan, a set of coordinated activities.  The firm is the organizational structure with the capacity to do this.

This view of the firm is based on an understanding of the limits of markets, but not on a presumption of market failure, as that term is understood by economists.  Specifically, the presence of externalities (missing markets) is neither necessary nor sufficient for the presence of interactive nonconvexities.  Thus there is no policy fix that can render the coordination of activities by firms unnecessary.  Also, the make-or-buy decision, which is central to any theory of the firm, is not governed solely by efficiency but depends also on the advantages of implementing plans that cannot be accomplished through contracting externally.

The value of this theory is demonstrated in a practical application: how do we explain the difference in the roles played by worker problem-solving in different kinds of firms?  In a recent paper, written with my coauthor Heike Nolte, we show that arguments based on nonconvex profit sets, along with institutional factors that influence strategic choice, can do this.

The central idea that links our coordinated activity theory of the firm to strategic differentiation is the profit landscape, as seen here, with an arbitrary starting point A.

In fact, this kind of landscape is familiar from evolutionary biology, where it is commonplace.  In biology the horizontal axes represent two particular traits genetically available to an organism, while the vertical axis represents evolutionary fitness.  The point is that natural selection, being nonpurposive, optimizes only locally, and there is no guarantee that organisms can adapt successfully as the landscape changes.  In our context, however, the horizontal axes represent a pair of activities the firm might undertake, and the vertical axis is profit.  Of course, this three-dimensional landscape is an immense simplification of the large-dimensional relationships analyzed by biologists or students of business.

The firm can navigate its profit landscape purposively, but it does so under conditions of uncertainty: the true hills and valleys are not known and can only be inferred.  The core tradeoff is between strategies that emphasize the generation and use of local knowledge to move readily toward hills adjacent to the one currently occupied, versus strategies that seek to minimize encumbrances that might interfere with movements toward more distant hills, less knowable but potentially more profitable.  The first is flexible in its existing operations, the second in its ability to exit and enter different operations.

In categorizing firms, we use two related distinctions, between stakeholder and shareholder enterprise models and between coordinated and liberal market environments.  The polar cases are stakeholder/coordinated and shareholder/liberal, but we are also interested in hybrids.  Our key assumption is that the shareholder firm seeks to maximize the present value of its profit stream, while the stakeholder firm wishes to maximize the likelihood of being profitable over a given time horizon.  Logically, this means that the shareholder firm is a “prospector” in the profit landscape, willing to take greater risks in order to maximize potential returns.  It makes fewer commitments, including fewer commitments to its workforce, that might interfere with its freedom to shed existing assets and acquire new ones.  The stakeholder firm, for which profit outliers are of less value, prefers to specialize in its local production space, taking less risk and maintaining its viability through operational flexibility.  The liberal/coordinated market distinction enters by altering the costs or feasibility of pursuing one strategy or the other.

These imputed preferences have implications for the role of workers within the firm.  The shareholder firm in a liberal environment will tend to recruit less qualified workers for routine tasks, make fewer commitments to them, invest less in their acquisition of new skills, accord them less autonomy in workplace decision-making, and utilize monetary incentives for performance.  It acquires less value from the locally-specific learning of workers who have the capacity and freedom to investigate their own operations.  The stakeholder firm in a coordinated environment will tend to recruit more qualified workers on the basis of long-term commitments, provide opportunities for skill-upgrading, permit much greater decision-making autonomy (as well as greater scope for autonomy), while relying to a greater extent on normative approaches to motivation.  It will implement more micro-innovations which can form the basis for navigation to adjacent profit hills.  If this schema is correct, we should observe these proclivities in the role of worker problem-solving in these different types of firms.

We have thus far conducted three intensive case studies, one with a stakeholder firm in a coordinated environment (Germany), another with a stakeholder firm in a liberal environment (the US), and a third with a shareholder firm in a coordinated environment (Germany again).  What we found are the patterns in worker problem-solving suggested by our theory, and informants describe institutional features, motivations and activities to which our theoretical explanations seem to apply.

We intend to continue case study research in worker problem-solving at additional firms.  The theoretical apparatus also lends itself to many other questions in economics and business.