Why do firms exist?

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This is a question we constantly ask ourselves and our clients at TomorrowToday. The firm is a relatively new model in society and with the growth of multi-national corporations over the past fifty years, the firm has become the business model of efficiency and effectiveness. There is no denying that as a model, “firms” are able to attract, allocate and direct huge resources targeted at willing and accepting markets. Since the days on Ford’s production line people have come to accept and even champion the firm. Laws are passed in support of firms, education systems are designed to fill firms with bright corporate beings. Firms do a lot of good, they also do a lot of bad, but there is no denying they have been responsible as a social structure for an enormous rise in the standard of living. Something though is not quiet right, following the collapse of Lehman Brothers in September 2008 and the ensuing financial collapse the spot light has focused on the people who run firms and the firms themselves. This is a good thing because even though the nature of work has changed significantly over the past eighty years, the structures of work, including the office itself have remained stubornly old-fashioned. Never before have people had the ability and the technology to change the way we work, live and play. Yet most of us cling to the old way of work, fearful of what a more networked, fluid, self-managed business model may look like. It’s not that we don’t have the ability to change the way firms are run and operated, we do, it perhaps that we lack the imagination. We’ve been so indoctrinated with a centralised command on control model that we struggle to see outside of the firm’s constraining walls.

That is why I’m pleased to see The Economist Schumpeter asking the question “Why do firms exist?” this is a great question and will be one of the key themes I will be trying to answer this year. Are firms hero machines, fighters of poverty and champions of increasing standard of living, or are they antiquated dinosaurs destined to become part of the dust pile of corporate history as a new breed of social models arise out of the wiki and Web 2.0 driven eco-networked, self managed organisations ?

The battle lines are being drawn and 2011 will be an interesting year to challenge: Why do firms exist, in the form they do

You can read the Schumpeter’s article below or visit the economist

Why do firms exist?
Ronald Coase, the author of “The Nature of the Firm” (1937), turns 100 on December 29th
Schumpeter Dec 16th 2010 | from PRINT EDITION

FOR philosophers the great existential question is: “Why is there something rather than nothing?” For management theorists the more mundane equivalent is: “Why do firms exist? Why isn’t everything done by the market?”

Today most people live in a market economy, and central planning is remembered as the greatest economic disaster of the 20th century. Yet most people also spend their working lives in centrally planned bureaucracies called firms. They stick with the same employer for years, rather than regularly returning to the jobs market. They labour to fulfil the “strategic plans” of their corporate commissars. John Jacob Astor’s American Fur Company made him the richest man in America in the 1840s. But it never consisted of more than a handful of people. Today Astor’s company would not register as a blip on the corporate horizon. Firms routinely employ thousands of workers and move billions of dollars-worth of goods and services within their borders.

Why have these “islands of conscious power” survived in the surrounding “ocean of unconscious co-operation”, to borrow a phrase from D.H. Robertson, an economist? Classical economics had little to say about this question. Adam Smith opened “The Wealth of Nations” with a wonderful description of the division of labour in a pin factory, but he said nothing about the bosses who hired the pin-makers or the managers who organised them. Smith’s successors said even less, either ignoring the pin factory entirely or treating it as a tedious black box. They preferred to focus on the sea rather than the islands.

Who knows the secret of the black box?

The man who restored the pin factory to its rightful place at the heart of economic theory celebrates his 100th birthday on December 29th. The economics profession was slow to recognise Ronald Coase’s genius. He first expounded his thinking about the firm in a lecture in Dundee in 1932, when he was just 21 years old. Nobody much listened. He published “The Nature of the Firm” five years later. It went largely unread.

But Mr Coase laboured on regardless: a second seminal article on “The Problem of Social Cost” laid the intellectual foundations of the deregulation revolution of the 1980s. Eventually, Mr Coase acquired an army of followers, such as Oliver Williamson, who fleshed out his ideas. In 1991, aged 80, he was awarded a Nobel prize. Far from resting on his laurels, Mr Coase will publish a new book in 2011, with Ning Wang of Arizona State University, on “How China Became Capitalist”.

His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.

How much light does “The Nature of the Firm” throw on today’s corporate landscape? The young Mr Coase first grew interested in the workings of firms when he travelled around America’s industrial heartland on a scholarship in 1931-32. He abandoned his textbooks and asked businessmen why they did what they did. He has long chided his fellow economists for scrawling hieroglyphics on blackboards rather than looking at what it actually takes to run a business. So it seems reasonable to test his ideas by the same empirical standards.

Mr Coase’s theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India’s Tata group and Turkey’s Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists.

But Mr Coase’s narrow focus on transaction costs nevertheless provides only a partial explanation of the power of firms. The rise of the neo-Coasian school of economists has led to a fierce backlash among management theorists who champion the “resource-based theory” of the firm. They argue that activities are conducted within firms not only because markets fail, but also because firms succeed: they can marshal a wide range of resources—particularly nebulous ones such as “corporate culture” and “collective knowledge”—that markets cannot access. Companies can organise production and create knowledge in unique ways. They can also make long-term bets on innovations that will redefine markets rather than merely satisfy demand. Mr Coase’s theory of “market failure” needs to be complemented by a theory of “organisational advantages”.

All this undoubtedly complicates “The Nature of the Firm”. But it also vindicates the twin decisions that Mr Coase made all those years ago as a young student at the London School of Economics: to look inside the black box rather than simply ignoring it, and to examine businesses, not just fiddle with theories. Is it too much to hope that other practitioners of the dismal science will follow his example and study the real world?

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0 thoughts on “Why do firms exist?”

  1. mike says:

    This made for some interesting reading. I do believe though that firms are going to be around forever or certainly for as long as Capitalism exists. Fundamental principles of wealth creation mean that those with the ideas and resources will always dominate the landascape. The “firm” provides the means for the these people to secure this wealth. This is a good thing, in my view anyway.

    As long as there is a desire to grow one’s success then there will be a need for firms. A satisfied entrepreneur that says I am big enough I do not need more effectively saying I am able to derive everything I need out of my own labour will stop and he/she will be a firm of one. But if there is desire to grow, then the co-opting of additional resources will naturally follow. This additional skill requires a form, it requires a firm. For all of the old antiquated theory about a firm, it remains the most effective way of collaboration. The difference between those that succeed and fail, in my opinion anyway, comes down to continued renewal of the collaborative effort.

    Changing and growing the skills will be important, understanding the drivers of the members of the firm is critical. You have said this time and time again.

    So why do they exist? I think because they are the most effectivel way to collaborate and grow wealth.

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