Before 1937, firms have long been treated as a black box in economics. Economists were well aware of the differences between a firm and a person. People consumed, firms produced. People maximized utility, while firms maximized profits. The standard theory in economics laid foundations, so that economists can build models representing intricate details in their interactions, between people, between firms, or between people and firms. However, the literature on firms ends there. There were no investigations on the interactions within firms, or on contracts. Economists didn’t even ask why there were firms in the first place! Firms looked like ordinary ‘individuals’, except they produce instead of consume, and maximized profits instead of maximizing utility. That changed until Coase’s seminal paper in 1937.
Coase asked a simple question, which would send a ripple through economics. I say ripple, because it would take a little more than 30 years before his ideas caught fire. He asked why were there firms to begin with? In a world where Adam Smith’s invisible hand automatically guided resource allocation to their most optimal use, it seemed curious that some (or most) production had to be conducted within a firm. Why not just organize production within the market? Coase offered us a simple, yet intriguing answer to this question, so intriguing was the answer that it took more than 30 years for economists to take a serious consideration in Coase’s ideas. Coase told us that using the market entails a cost, he called a ‘the cost of using the market.’ It would be 30 years later, when Stiglitz named this cost ‘transaction cost.’
It didn’t take long after the 1960’s for transaction cost economics to catch a momentous boost in economic literature. Economists such as Oliver Williamson, Benjamin Klein directed their research towards finding formalizable theories of the firm. It would not take long after that for economists to finally study the interaction within firms, thanks to the advent of game theory, agency problems could be analyzed and optimal incentive contracts could be formulated. However, something was missing. Our theories seemed so alien to real managers in real firms that every working economists knew that the field is still in search for a realistic theory of the firm. In this chapter, we will discuss the classical agency problem framed in terms of the incentive – insurance tradeoff, and the new method in explaining agency problems, non - contractibles.
Also, in this chapter, we will discuss the existing theories on the boundary of the firm. This area is budding with research literature, which started with Oliver Williamson and Benjamin Klein, later advanced by Gene Grossman, Oliver Hart, and John Moore. We will discuss the similarities and the differences surrounding their theories, and briefly discuss the empirical work.
1.1 What are Firms?
Firm behavior can not be dissected until we can fully appreciate the complex relationship inside firms. Economists used to share the view that firms are ‘clean,’ ‘well organized,’ ‘powerful’ production entities. Decision and its relevant information will be gathered, analyzed, processed and finally utilized to their utmost value, producing output that can fully capture the firm’s underlying potential and maximize profits without any complications. However, this view of firms and organizations is wrong.
The description we gave above can certainly describe a single person. On the other hand firms are made of numerous employees, managers and owners. In other words, there are political games that go on inside firms. These potentially damaging behaviors inside and between firms will determine the boundary of firms, and the incentive contracts inside firms. Agency theory equips us with the knowledge to tackle and explain a wide ranging phenomenon exhibited by firms. But before we move on to the agency problem, we have to answer this question: If there are dirty politics and inefficient behavior within firms, why are there firms in the first place?
Coase introduced to us the concept of transaction costs. If transaction costs are high, the market system fails to allocate resources efficiently. In other words, the price system fails, as transaction difficulty rises. As a result, firms exist because operation with in an organization, in some cases, is less costly than operating in the market system. So even though empirical evidence shows us that firms are ‘systematically stupid,’ performing worse than markets efficiency wise, we could be merely witnessing a case of selection bias.
From the graph above, we can see that the firms we observe, operate in an environment where the transaction difficulty is greater than While the markets we observe, operate in an environment where the transaction difficulty is less than . More interestingly, we would find the markets operating on a higher efficiency level than the markets. But this is in no means evidence against the effectiveness of firms or organizations in general. Theory suggests a difficulty in comparing these two in an empirical setting since we would encounter a selection bias problem. To sum it up, firms deal with hard problems that the markets couldn’t handle. We are now ready to discuss the workings inside a firm.As you can see, I'm trying to organize my summary into maybe a small book.
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