An introduction to the theories of the firm

The business forms are almost as old as commerce itself. Though these informal and formal structures have existed for countless years, there was hardly any research on their need and function. It was only in the latter decades of the 20^th century that the need for business structures was questioned and investigated.

Such questioning initially started in the field of economics but its value was soon discovered by the management as well as legal thinkers. What developed out of this questioning can be called as ‘theories of the firm’. While discussing these theories, note that we are talking about any and every business form and structure and not just partnership firms as the word is commonly understood today.

Multiple uses of these theories range from designing effective laws, framing governance models, to finding practical solutions to economic problems like wealth inequality.

In this article, we are planning to introduce a select number of these theories. We are also planning a series of articles on these theories which will cover them in detail.

Emergence and classification of the theories of the firm

The economic theories of the firm dealt with the behaviour of the firm as an economic unit in a market. The earliest views dealt with the firm as only a black box (i.e. a sample representing homogeneous units) without focusing on the inner workings of the firm.

While profit maximisation was supposed to be the sole aim earlier, the later economic theories covered a varied field as the realities of the behaviour of firms was not adequately explained by the sole motive of profit.

One can broadly distinguish between theories of the existence of firms (why there should be a business form) and theories of the limits of the firm (what should be the limits on the size of the firm and how it should be organised internally). Another distinction is based on the core focus of the theory (either on the production of the firm or on the governance structures of the firm).

Production Function theories

The main proposition of these theories is that organising production within the firm is often more efficient than organising production through contracts between many independent parties.

Firms are primarily viewed from a technological perspective and described as production units that efficiently transform a series of homogeneous inputs into a series of outputs. This view treated the firm like an individual which is capable of having a well-defined set of goals and preferences independent of its members.

These economists considered that the nature of the firm is based on the organization of a bundle of contractual arrangements. The firm is equated with the contracts it consists of. A contract is the central modular mechanism that plays both a coordinating and an incentive-providing role within and between the firms.

The second theory, the modern theory of property rights, defines the firm as a collection of nonhuman assets and argues that firms arise where market contractual relationships fail. Such failure of market relationships can be an absolute breakdown or inefficiency in the transaction.

The collection of assets view explains the firm’s boundaries in terms of the optimal allocation of asset ownership. The holder of the residual rights of control over the nonhuman assets in a coalition has power over the human capital owners, who need nonhuman assets to be productive.

Generally, theories that describe the firm as a production function are not actually theories of the firm but rather theories of markets in which firms are important actors. They explain why firms exist but do not explain under what terms the firm is the superior form of organisation.

Firms as Governance structure or Organisational construction

Due to the above limitations of the production function theories, various theories emerged that studied the inner workings of the firm.

One of the key approaches was transaction cost economics. This approach defines the firm as a governance structure that is coordinated by hierarchical authority. While the initial theories simply focused on the difference between the hierarchies in the firm and the larger market (due to the employer/ employee relationship), the theory later on evolved to accommodate both the legal rules and normative private ordering to deal with the incompleteness of the contracts.

Recent advances in the theory

With respect to both the above categories, there are shortcomings as far as practical solutions to corporate governance problems are concerned. It must be conceded upfront that these theories never sought to solve the corporate governance problems. However, some recent advances hold some promising solutions.

These approaches have called for recognition of other incentive mechanisms aside from contracts and ownership. The concept of ‘power’ is also introduced in this analysis.

The firm in corporate law

The theories of firm have been explored by the legal scholarship as well. Two noteworthy approaches required to be considered are: legal theory of firm based on contract and features of the firm.

Corporate law permits a firm to negotiate and sign contracts by giving it the right to act as a single contracting party that is distinct from the individuals who own or operate the firm. Based on this, some scholars consider it more suitable to define the firm as a nexus for contracts rather than nexus of contracts.

The legal theory of corporations based on the features of the corporation describes the 5 core features of the corporations: legal personality, separate patrimony (or entity shielding), transferable shares, delegated management and investor ownership.

However, in both the cases, the real thrust is upon the law and its effects. Legal theories tend to be more descriptive rather than providing any genuine relief.

Synthesis

Further, there are certain Institutional theories of the firm which tend to encompass both these views as well as the prevailing social, cultural and moral norms and tend to focus on the residual autonomy of the firm.

In our next articles, we shall expound in detail the key premises, advantages, shortcomings, and uses of these theories.

• Team Efficax