Economic theories of the Firm

May 11, 2017
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Human Action: Pocket EditionWhat is a firm? This may not seem like a question in lack of an answer. In the United States, as in most other countries, it is a registered, regulated entity acting legally as a person. But economically, the legal definition is irrelevant: the economic function of the "firm" is not its legal status — if it were, then the law rather than the organization would provide the market with that function.

So could there be firms without corporate law? The answer is obvious: firms exist and are an important part of modern markets today just as they existed and provided a vital function before the law defined and certified such organizations. Indeed, one can easily argue that corporate law is primarily about government taxation and regulation of the market — and defines the firm only as a means toward these ends.

Consequently, the economic question remains, and it necessarily includes the "where, " "how, " and "why" of the business firm. How can one economically define what a firm is? What, from an economic point of view, is a business firm? A deeper question is, what is the firm's function in the market — and why are certain transactions integrated in organizations? And further: how can we distinguish this phenomenon in the market so that it can easily be studied? The questions may seem foreign, but economics has not been able to find very good answers to them, neither historically nor in contemporary theory.

The economic question of the firm is old. Adam Smith discussed firms in The Wealth of Nations (1776) and established that they, in the sense of "manufactures, " were more efficient in producing than individual, self-employed craftsmen and labor workers. (Cantillon, who wrote the world's first systematic economic treatise [1755], does not analyze the firm as much as he analyzes the entrepreneurial function.) Smith's explanation for the manufacture's efficiency is that it can utilize a different form of, or more intense, division of labor than can be coordinated through market exchange (or contracting). But he quickly moved on to discuss other economic issues instead of elaborating on this analysis (which, by the way, was heavily criticized by Rothbard).

Smith's view was however accepted by most classical economists and thus the firm was thought of in terms of its different kind of division of labor. Generations later, Karl Marx wrote in Das Kapital (1867) about the Smithian kind of manufactures and how they establish and exploit the more intense division of labor. Marx uses Smith's argument, but the discussion helps to clarify the view of the firm. Of course, he finds the manufacture and the division of labor highly problematic, since the individual worker is separated from the end product and therefore is "alienated" through work performed within the manufacture. Marx was obviously not very interested in the economic analysis — division of labor increases productivity and increases prosperity for all individuals involved as well as society as a whole — and so focuses solely on the problem he identifies.

A few decades later, the sociologist Emile Durkheim wrote a whole treatise on the division of labor (1892) and — characteristically difficult to read — defines its constitution and limitations. He also connects the division of labor to the structure of society and theorizes about its utilization and distinct types in towns and rural areas. The conclusion is that towns have greater density, which makes it easier to trade, because potential trading partners, as well as products to trade, are closer at hand.

Durkheim focuses on the limitations of the division of labor as it was famously defined by Smith in the phrase, "the division of labor is limited by the extent of the market." The market's "extent" is here identified as market density: the greater the density (closeness or ability to effectuate trade) the easier it is to divide work into smaller parts and thereby increase overall productivity through streamlining the carrying out of individual specialized tasks.

About the same time as Durkheim, Marshall authored his magnum opus, Principles of Economics (1890), which laid a foundation for neoclassical economics.
Marshall also talked abstractly about how industries and market structure can be analyzed in terms of

"representative firms, " which are simplified representations (ideal types) of firms. Adopting this perspective (or the common interpretation thereof) allows for analytical precision, but at the same time does away with existing differences between real firms. The representative firm can easily be described in terms of a profit/output maximizing "production function, " and this remains the neoclassical view of the firm to this day.

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