The Firm: A Revised Definition

The private sector is divided by economists into two subsectors: households and business. We designate the subsector of business as that area in which economically productive activity and exchanges take place. Within this (conceptual non-spatial) area we distinguish certain groupings of productive factors as 'firms'. Why is it that we draw this distinction? We may note that this aggregation, the firm, engages in some sort of productive activity. This however does not really answer the question. We are still left with the problem of determining where one firm ends and another begins. What is the criterion on the basis of which we recognize this subset? What is a firm? I will endeavor to establish that 'firm' is a word which we use to distinguish those organizations which sell goods or services in exchange for what we judge to be an accurate approximation of their actual worth to the purchaser. This approximation is judged to be reasonably accurate because the purchaser is making payment for units of something which is relatively close to what he hopes to receive from the vendor. This is in contrast to other exchanges which take place within the firm between the owner(s) and the suppliers of other productive resources, which we judge to involve a payment on the basis of a less accurate measure of the worth of the service being rendered, i.e., the purchaser is paying for units of something which is quite dissimilar from that which he actually hopes and plans to receive. The significance of this assertion if correct, is that if the supplier is paid on the basis of an inaccurate measure of the value of his service, there is little reason to think that efficient allocation will prevail. The nature of the reward structure is fundamental to the identification and definition of the firm.