What Are Firms For
"Let us recount what four key political economists had to say about the role and function of firms. This is how they answer the basic question: What are firms for?
Smith begins his Wealth of Nations (1776) with an account of how a pin-making firm manages to produce so many pins, i.e. efficiently, via the utilisation of a clever division of labour. Clearly, for Smith, firms are the locus of the division of labour. Firms are good for the purpose of creating economies of scale and thus of making it possible to reduce costs inexorably while boosting output geometrically. However, firms sees a threat to the Good Society because an inordinate success of one firm poses a threat to competition, the solvent of market (or monopoly) power that constantly undermines the invisible hand. For that reason, Smith was adamantly opposed to the idea of limited liability, to corporations in other words. In short, firms were essential as loci of divided and synchronised labour but their ultimate contribution to society was predicated upon being kept small, free of the division between ownership and control that is the feature of modern corporations and, lastly, engaged in constant, cut-throat competition with one another.
Marx posed a simple question: Where do firm profits come from? If Smith’s beloved competition works well, prices will crash to the level of per unit costs and profits will wither. So, is profit only possible when the market is insufficiently competitive? His answer was in the negative. He believed that firms can profit even when competition is as cut-throat as Smith had wanted. The key to his theory was the dual nature of labour: Employers hire labour time from selected employees (and pay a competitive wage for it – a standard price for labour time that is determined at the labour market) but, once production begins, firms receive from workers another kind of labour: the employees’ energy, work, ideas etc. Notice the ‘gap’: employers they pay for ‘labour time’, for which there is an established market and a market-determined price (the wage), but receive something different – labour’s fruits, which can and, indeed, must have a value in excess of that of the ‘labour time’ firms pay for. That difference, between the value of the type of labour received and the type of labour paid for, is the source of profit (and is known in the ‘trade’ as surplus value). In short, for Marx, firms operate as profit machines, through the generation of surplus value. Pure exchanges cannot sustainably generate profits since arbitrage is bound to eat into the latter. Firms are the realms of extractive power. It is where surplus is generated, before turning into rent and interest payments, with the residual equalling the firm’s profit.
Unlike Smith, Schumpeter thought that progress and social well-being could not result from cut-throat competition between small firms that squeezes their profits to zero. He thought, instead, that corporations wielding monopoly (or oligopoly) power were the true agents of progress. For if long term improvement, and ultimately much lower costs, require expensive R&D, only monopoly-oligopoly profits can finance it. Adopting an evolutionary perspective (one that he admits to having borrowed from Marx – even though the two men were politically at odds), he conceived of large corporations as dinosaurs struggling to survive. Most become extinct, victims of upstarts with brighter ideas, better management structures and fresher products. In turn, these upstarts grow large and unwieldy and are, in time, undermined by hungrier, leaner, more innovative competitors. And so on. In short, Schumpeter emphasised the importance of the corporations’ monopoly-oilogopoly power from the perspective of cost-destroying innovations. Firms, corporations in particular, are seen as case studies of central planning in a see of competitive markets. While Schumpeter would say that companies like GM or Microsoft were not much different to Soviet style planning operations, he hoped that the marketplace within which they functioned would impose upon them Darwinian pressures that would, eventually, push them into the list of extinct outfits, giving space for newer, fresher corporations. Then again, in his famous Capitalism, Socialism and Democracy, Schumpeter expressed grave doubts about a society whose future depends on a corporate culture that functions in hierarchical terms that are not so much different from the logic of the former Soviet Union’s Gosplan (the central planning agency).
Coase was the first economist to pose unequivocally the question that my title paraphrases: Why firms? What are they good for? Why should an entrepreneur want to hire employees rather than subcontract an activity or service to someone else? While both Marx and Schumpeter had already given interesting answers to this question, Coase’s own answer is interesting also. He pointed out simply and convincingly that the cost of subcontracting a good or service, through some market, may be much larger than the cost of producing that good or service internally. He attributed this difference to transactions costs and explained that they were due to the costs of bargaining (with contractors), of enforcing incomplete contracts (whose incompleteness is due to the fact that some activities and qualities cannot be fully described in a written contract), of imperfect monitoring and asymmetrically distributed information, of keeping trade secrets… secret, etc. In short, contractual obligations can never be perfectly stipulated or enforced, especially when information is scarce and unequally distributed, and this gives rise to transaction costs which can become debilitating unless joint production takes place within the hierarchically structured firm. Optimal corporation size corresponds, in Coase’s scheme of things, to a ‘point’ where the net marginal cost of contracting out a service or good (including transaction costs) tends to zero ." (http://blogs.valvesoftware.com/economics/why-valve-or-what-do-we-need-corporations-for-and-how-does-valves-management-structure-fit-into-todays-corporate-world/)