The Nature of the Firm

Economic theory has suffered in the past from a failure to state clearly its assumptions. Economists in building up a theory have often omitted to examine the foundations on which it was erected. This examination is, however, essential not only to prevent the misunderstanding and needless controversy which arise from a lack of knowledge of the assumptions on which a theory is based, but also because of the extreme importance for economics of good judgment in choosing between rival sets of assumptions. For instance, it is suggested that the use of the word “firm” in economics may be different from the use of the term by the “plain man.”11 Joan Robinson, Economics is a Serious Subject, p. 12. Since there is apparently a trend in economic theory towards starting analysis with the individual firm and not with the industry,22 See N. Kaldor, “The Equilibrium of the Firm,”Economic Journal, March, 1934. it is all the more necessary not only that a clear definition of the word “firm” should be given but that its difference from a firm in the “real world,” if it exists, should be made clear. Mrs. Robinson has said that “the two questions to be asked of a set of assumptions in economics are : Are they tractable? and : Do they correspond with the real world?”33 Op. cit., p. 6. Though, as Mrs. Robinson points out, “more often one set will be manageable and the other realistic,” yet there may well be branches of theory where assumptions may be both manageable and realistic. It is hoped to show in the following paper that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall, the idea of the margin and that of substitution, together giving the idea of substitution at the margin.11 J. M. Keynes, Essays in Biography, pp. 223–4. Our definition must, of course, “relate to formal relations which are capable of being conceived exactly.”22 L. Robbins, Nature and Significance of Economic Science, p. 63. It is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist. Let us consider the description of the economic system given by Sir Arthur Salter.33 This description is quoted with approval by D. H. Robertson, Control of Industry, p. 85, and by Professor Arnold Plant, “Trends in Business Administration,” Economica, February, 1932. It appears in Allied Shipping Control, pp. 16–17. “The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive.” An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.44 See F. A. Hayek, “The Trend of Economic Thinking,” Economica, May, 1933. The economic system “works itself.” This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives. This is necessarily so if there is to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.55 See F. A. Hayek, op. cit. Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except in so far as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning. The example given above is typical of a large sphere in our modern economic system. Of course, this fact has not been ignored by economists. Marshall introduces organisation as a fourth factor of production; J. B. Clark gives the co-ordinating function to the entrepreneur; Professor Knight introduces managers who co-ordinate. As D. H. Robertson points out, we find “islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”11 Op. cit., p. 85. But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation necessary? Why are there these “islands of conscious power”? Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.22 In the rest of this paper I shall use the term entrepreneur to refer to the person or persons who, in a competitive system, take the place of the price mechanism in the direction of resources. It is clear that these are alternative methods of co-ordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all, well might we ask, why is there any organisation? Of course, the degree to which the price mechanism is superseded varies greatly. In a department store, the allocation of the different sections to the various locations in the building may be done by the controlling authority or it may be the result of competitive price bidding for space. In the Lancashire cotton industry, a weaver can rent power and shop-room and can obtain looms and yarn on credit.33 Survey of Textile Industries, p. 26. This co-ordination of the various factors of production is, however, normally carried out without the intervention of the price mechanism. As is evident, the amount of “vertical” integration, involving as it does the supersession of the price mechanism, varies greatly from industry to industry and from firm to firm. It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism. It is, of course, as Professor Robbins points out, “related to an outside network of relative prices and costs,”11 Op. cit., p. 71. but it is important to discover the exact nature of this relationship. This distinction between the allocation of resources in a firm and the allocation in the economic system has been very vividly described by Mr. Maurice Dobb when discussing Adam Smith's conception of the capitalist: “It began to be seen that there was something more important than the relations inside each factory or unit captained by an undertaker; there were the relations of the undertaker with the rest of the economic world outside his immediate sphere…. the undertaker busies himself with the division of labour inside each firm and he plans and organises consciously,” but “he is related to the much larger economic specialisation, of which he himself is merely one specialised unit. Here, he plays his part as a single cell in a larger organism, mainly unconscious of the wider rôle he fills.”22 Capitalist Enterprise and Social Progress, p. 20. Cf., also, Henderson, Supply and Demand, pp. 3–5. In view of the fact that while economists treat the price mechanism as a co-ordinating instrument, they also admit the co-ordinating function of the “entrepreneur,” it is surely important to enquire why co-ordination is the work of the price mechanism in one case and of the entrepreneur in another. The purpose of this paper is to bridge what appears to be a gap in economic theory between the assumption (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on the entrepreneur-co-ordinator. We have to explain the basis on which, in practice, this choice between alternatives is effected.33 It is easy to see when the State takes over the direction of an industry that, in planning it, it is doing something which was previously done by the price mechanism. What is usually not realised is that any business man in organising the relations between his departments is also doing something which could be organised through the price mechanism. There is therefore point in Mr. Durbin's answer to those who emphasise the problems involved in economic planning that the same problems have to be solved by business men in the competitive system. (See “Economic Calculus in a Planned Economy,”Economic Journal, December, 1936.) The important difference between these two cases is that economic planning is imposed on industry while firms arise voluntarily because they represent a more efficient method of organising production. In a competitive system, there is an “optimum” amount of planning! Our task is to attempt to discover why a firm emerges at all in a specialised exchange economy. The price mechanism (considered purely from the side of the direction of resources) might be superseded if the relationship which replaced it was desired for its own sake. This would be the case, for example, if some people preferred to work under the direction of some other person. Such individuals would accept less in order to work under someone, and firms would arise naturally from this. But it would appear that this cannot be a very important reason, for it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of “being one's own master.”11 Cf. Harry Dawes, “Labour Mobility in the Steel Industry,”Economic Journal, March, 1934, who instances “the trek to retail shopkeeping and insurance work by the better paid of skilled men due to the desire (often the main aim in life of a worker) to be independent” (p. 86). Of course, if the desire was not to be controlled but to control, to exercise power over others, then people might be willing to give up something in order to direct others; that is, they would be willing to pay others more than they could get under the price mechanism in order to be able to direct them. But this implies that those who direct pay in order to be able to do this and are not paid to direct, which is clearly not true in the majority of cases.22 None the less, this is not altogether fanciful. Some small shopkeepers are said to earn less than their assistants. Firms might also exist if purchasers preferred commodities which are produced by firms to those not so produced; but even in spheres where one would expect such preferences (if they exist) to be of negligible importance, firms are to be found in the real world.33 G. F. Shove, “The Imperfection of the Market: a Further Note,”Economic Journal, March, 1933, p. 116, note 1, points out that such preferences may exist, although the example he gives is almost the reverse of the instance given in the text. Therefore there must be other elements involved. The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organising” production through the price mechanism is that of discovering what the relevant prices are.44 According to N. Kaldor, “A Classificatory Note of the Determinateness of Equilibrium,”Review of Economic Studies, February, 1934, it is one of the assumptions of static theory that “All the relevant prices are known to all individuals.” But this is clearly not true of the real world. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.11 This influence was noted by Professor Usher when discussing the development of capitalism. He says: “The successive buying and selling of partly finished products were sheer waste of energy.” (Introduction to the Industrial History of England, p. 13). But he does not develop the idea nor consider why it is that buying and selling operations still exist. Again, in certain markets, e.g., produce exchanges, a technique is devised for minimising these contract costs; but they are not eliminated. It is true that contracts are not eliminated when there is a firm but they are greatly reduced. A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm, as would be necessary, of course, if this co-operation were as a direct result of the working of the price mechanism. For this series of contracts is substituted one. At this stage, it is important to note the character of the contract into which a factor enters that is employed within a firm. The contract is one whereby the factor, for a certain remuneration (which may be fixed or fluctuating), agrees to obey the directions of an entrepreneur within certain limits.22 It would be possible for no limits to the powers of the entrepreneur to be fixed. This would be voluntary slavery. According to Professor Batt, The Law of Master and Servant, p. 18, such a contract would be void and unenforceable. The essence of the contract is that it should only state the limits to the powers of the entrepreneur. Within these limits, he can therefore direct the other factors of production. There are, however, other disadvantages—or costs—of using the price mechanism. It may be desired to make a long-term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period, instead of several shorter ones, then certain costs of making each contract will be avoided. Or, owing to the risk attitude of the people concerned, they may prefer to make a long rather than a short-term contract. Now, owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do. It may well be a matter of indifference to the person supplying the service or commodity which of several courses of action is taken, but not to the purchaser of that service or commodity. But the purchaser will not know which of these several courses he will want the supplier to take. Therefore, the service which is being provided is expressed in general terms, the exact details being left until a later date. All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser. When the direction of resources (within the limits of the contract) becomes dependent on the buyer in this way, that relationship which I term a “firm” may be obtained.11 Of course, it is not possible to draw a hard and fast line which determines whether there is a firm or not. There may be more or less direction. It is similar to the legal question of whether there is the relationship of master and servant or principal and agent. See the discussion of this problem below. A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory. It is obviously of more importance in the case of services—labour—than it is in the case of the buying of commodities. In the case of commodities, the main items can be stated in advance and the details which will be decided later will be of minor significance. We may sum up this section of the argument by saying that the operation of a market costs something and by forming an organisation and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this. The question of uncertainty is one which is often considered to be very relevant to the study of the equilibrium of the firm. It seems improbable that a firm would emerge without the existence of uncertainty. But those, for instance, Professor Knight, who make the mode of payment the distinguishing mark of the firm—fixed incomes being guaranteed to some of those engaged in production by a person who takes the residual, and fluctuating, income—would appear to be introducing a point which is irrelevant to the problem we are considering. One entrepreneur may sell his services to another for a certain sum of money, while the payment to his employees may be mainly or wholly a share in profits.22 The views of Professor Knight are examined below in more detail. The significant question would appear to be why the allocation of resources is not done directly by the price mechanism. Another factor that should be noted is that exchange transactions on a market and the same transactions organised within a firm are often treated differently by Governments or other bodies with regulatory powers. If we consider the operation of a sales tax, it is clear that it is a tax on market transactions and not on the same transactions organised within the firm. Now since these are alternative methods of “organisation”—by the price mechanism or by the entrepreneur—such a regulation would bring into existence firms which otherwise would have no raison d'être. It would furnish a reason for the emergence of a firm in a specialised exchange economy. Of course, to the extent that firms already exist, such a measure as a sales tax would merely tend to make them larger than they would otherwise be. Similarly, quota schemes, and methods of price control which imply that there is rationing, and which do not apply to firms producing such products for themselves, by allowing advantages to those who organise within the firm and not through the market, necessarily encourage the growth of firms. But it is difficult to believe that it is measures such as have been mentioned in this paragraph which have brought firms into existence. Such measures would, however, tend to have this result if they did not exist for other reasons. These, then, are the reasons why organisations such as firms exist in a specialised exchange economy in which it is generally assumed that the distribution of resources is “organised” by the price mechanism. A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur. The approach which has just been sketched would appear to offer an advantage in that it is possible to give a scientific meaning to what is meant by saying that a firm gets larger or smaller. A firm becomes larger as additional transactions (which could be exchange transactions co-ordinated through the price mechanism) are organised by the entrepreneur and becomes smaller as he abandons the organisation of such transactions. The question which arises is whether it is possible to study the forces which determine the size of the firm. Why does the entrepreneur not organise one less transaction or one more? It is interesting to note that Professor Knight considers that: “the relation between efficiency and size is one of the most serious problems of theory, being, in contrast with the relation for a plant, largely a matter of personality and historical accident rather than of intelligible general principles. But the question is peculiarly vital because the possibility of monopoly gain offers a powerful incentive to continuous and unlimited expansion of the firm, which force must be offset by some equally powerful one making for decreased efficiency (in the production of money income) with growth in size, if even boundary competition is to exist.”11 Risk, Uncertainty and Profit, Preface to the Re-issue, London School of Economics Series of Reprints, No. 16, 1933. Professor Knight would appear to consider that it is impossible to treat scientifically the determinants of the size of the firm. On the basis of the concept of the firm developed above, this task will now be attempted. It was suggested that the introduction of the firm was due primarily to the existence of marketing costs. A pertinent question to ask would appear to be (quite apart from the monopoly considerations raised by Professor Knight), why, if by organising one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all?22 There are certain marketing costs which could only be eliminated by the abolition of “consumers' choice” and these are the costs of retailing. It is conceivable that these costs might be so high that people would be willing to accept rations because the extra product obtained was worth the loss of their choice. Why is not all production carried on by one big firm? There would appear to be certain possible explanations. First, as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organising additional transactions within the firm may rise.33 This argument assumes that exchange transactions on a market can be considered as homogeneous; which is clearly untrue in fact. This complication is taken into account below. Naturally, a point must be reached where the costs of organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market, or, to the costs of organising by another entrepreneur. Secondly, it may be that as the transactions which are organised increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production. Again, a point must be reached where the loss through the waste of resources is equal to the marketing costs of the exchange transaction in the open market or to the loss if the transaction was organised by another entrepreneur. Finally, the supply price of one or more of the factors of production may rise, because the “other advantages” of a small firm are greater than those of a large firm.11 For a discussion of the variation of the supply price of factors of production to firms of varying size, see E. A. G. Robinson, The Structure of Competitive Industry. It is sometimes said that the supply price of organising ability increases as the size of the firm increases because men prefer to be the heads of small independent businesses rather than the heads of departments in a large business. See Jones, The Trust Problem, p. 531, and Macgregor, Industrial Combination, p. 63. This is a common argument of those who advocate Rational-sation. It is said that larger units would be more efficient, but owing to the individualistic spirit of the smaller entrepreneurs, they prefer to remain independent, apparently in spite of the higher income which their increased efficiency under Rationalisation makes possible. Of course, the actual point where the expansion of the firm ceases might be determined by a combination of the factors mentioned above. The first two reasons given most probably correspond to the economists' phrase of “diminishing returns to management.”22 This discussion is, of course, brief and incomplete. For a more thorough discussion of this particular problem, see N. Kaldor, “The Equilibrium of the Firm,”Economic Journal, March, 1934, and E. A. G. Robinson, “The Problem of Management and the Size of the Firm,”Economic Journal, June, 1934. The point has been made in the previous paragraph that a firm will tend to expand until the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm. But if the firm stops its expansion at a point below the costs of marketing in the open market and at a point equal to the costs of organising in another firm, in most cases (excluding the case of “combination”3), this will imply that there is a market transaction between these two producers, each of whom could organise it at less than the actual marketing costs. How is the paradox to be resolved? If we consider an example the reason for this will become clear. Suppose A is buying a product from B and that both A and B could organise this marketing transaction at less than its present cost. B, we can assume, is not organising one process or stage of production, but several. If A therefore wishes to avoid a market transaction, he will have to take over all the processes of production controlled by B. Unless A takes over all the processes of production, a market transaction will still remain, although it is a different product that is bought. But we have previously assumed that as each producer expands he becomes less efficient; the additional costs of organising extra transactions increase. It is probable that A's cost of organising the transactions previously organised by B will be greater than B's cost of doing the same thing. A therefore will take over the whole of B's organisation only if his cost of organising B's work is not greater than B's cost by an amount equal to the costs of carrying out an exchange transaction on the open market. But once it becomes economical to have a market transaction, it also pays to divide production in such a way that the cost of organising an extra transaction in each firm is the same. Up to now it has been assumed that the exchange transactions which take place through the price mechanism are homogeneous. In fact, nothing could be more diverse than the actual transactions which take place in our modern world. This would seem to imply that the costs of carrying out exchange transactions through the price mechanism will vary considerably as will also the costs of organising these transactions within the firm. It seems therefore possible that quite apart from the question of diminishing returns the costs of organising certain transactions within the firm may be greater than the costs of carrying out the exchange transactions in the open market. This would necessarily imply that there were exchange transactions carried out through the price mechanism, but would it mean that there would have to be more than one firm? Clearly not, for all those areas in the economic system where the direction of resources was not dependent directly on the price mechanism could be organised within one firm. The factors which were discussed earlier would seem to be the important ones, though it is difficult to say whether “diminishing returns to management” or the rising supply price of factors is likely to be the more important. Other things being equal, therefore, a firm will tend to be larger: the less the costs of organising and the slower these costs rise with an increase in the transactions organised. the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised. the greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size. Apart from variations in the supply price of factors of production to firms of different sizes, it would appear that the costs of organising and the losses through mistakes will increase with an increase in the spatial distribution of the transactions organised, in the diss