Journal Des Economistes Et Des Etudes Humaines: Firm As A Nexus of Markets

Journal des Economistes et des Etudes Humaines
Volume 16, Number 1 2010 Article 3
Firm as a Nexus of Markets

Ivan Jankovic, University of Windsor
Recommended Citation: Jankovic, Ivan (2010) "Firm as a Nexus of Markets," Journal des Economistes et des Etudes Humaines: Vol. 16: No. 1, Article 3. Available at: http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241 2010 Berkeley Electronic Press and IES-Europe. All rights reserved.
Firm as a Nexus of Markets

Ivan Jankovic
Abstract
The Austrian School's conventional theory of the firm is based on an attempt to synthesize Coase's concept of the firm as a centrally planned hierarchy with the Austrian theory of entrepreneurship and monetary calculation. This paper is a critique of that program as well as an attempt to outline the alternative theory of the firm, one based on the synthesis of the contractual agency theory of the firm (Alchian-Demsetz, Jensen-Meckling) with the same Austrian arguments about entrepreneurship and calculation. The firm in this paper is defined as a nexus of various markets for goods as well as for labor and managerial services rather than as a hierarchy or organization. Both the neoclassical and Austrian critiques of the latter concept are utilized to prove that a clear distinction between the market and the firm cannot be established. That distinction is based on the misunderstanding of the firm's dynamics as exclusively tied to the managing/transaction costs ratio as well as on the mischaracterization of inter-firm relations as commanding ones (Demsetz-Alchian, Jensen, Meckling, Fama, Cheung). On the other hand, the central planning view of the firm is equally at odds with the key Mises's argument that rational economic planning is impossible in the absence of market prices (Mises, 1990). If this is so, the firm, as understood in a Coasian paradigm, would not have any reason to exist, or any reason to contribute positively to economic efficiency, because it would simply represent a centrally planned island of incalculability in a wider market setting (Rothbard, 2004). Since the firm is a nexus of various markets, its operation is contrary to the Coaseian assumptions led by the price signals. Only insofar as the internal firm's operation is driven by the price signals can the firm be efficient. KEYWORDS: praxeology, firm, transaction costs, contractual agency theory, entrepreneurship, monetary calculation, nexus of markets Author Notes: I want to thank Jason Crooks, Cynthia Tran, Jason Boose and two anonymous referees for the useful suggestions that helped me to improve the paper. All possible remaining errors or omissions are solely mine.
Jankovic: Firm as a Nexus of Markets
Introduction My aim in this paper is to outline the heterodox Austrian theory of the firm. What I call here an orthodox or mainstream Austrian theory of the firm is an attempt to reshape a Coasian notion of the firm as a centrally planned hierarchy, by merging it with general Austrian theory of the market process and entrepreneurship. The principal Austrians of the present (Klein and Foss, 2005, Foss 1994, Langlois and Foss, 1997) developed a theory of the firm by trying to synthesize this Coasian notion of the firm as a hierarchical entity dominated by commands and orders, with a distinct Misesian theory of entrepreneurship and monetary calculation as preconditions of rational economic planning. This approach is entirely rejected in this paper and the contractual "agency" theory of Alchian-Demsetz, Jensen-Meckling, Fama is accepted instead as a basis for the Austrian-neoclassical synthesis. Although this approach has been hinted at by some Austrian scholars (Mathews 1996, Salin 2002, Boudreaux and Holcombe, 1989) its full implications have never been spelled out. In the section 1, after explaining the basics of Coase's theory of the firm, I will proceed with my critique of it, focusing specifically on its central assumptions of the explanatory power of the category of transaction cost and its definition of the firm by using the relationship between the managerial and transaction costs as a criterion. In the section 2, I will explore the assumptions of the ''orthodox'' Austrian concept of the firm, and then evaluate it, proving that the same objections against the orthodox Coasianism apply equally to Austrian Coasianism. In outlining the nexus of market theory of the firm in section 3, I will rely upon the Austrian heterodox theory (Schumpeter, Kirzner, Mathews, Salin), as well as on some neoclassical mainstream contributions (Alchian and Demsetz, Jensen and Meckling, Fama, Cheung), to undermine a sharp division between the firm and the market, and specifically to challenge the notion of entrepreneurship as being absent from the firm. I will also try to show that any theory, in which the firm is understood as a basic unit of analysis violates one of the fundamental methodological tenets of sound economic theory methodological individualism. Apart from that, I will use Mises/Rothbard's argument regarding the relative inefficiency of non/price allocation of capital goods to question the idea of the firm as a centrally planned entity. In the fourth and the final section, I will further refine the nexus of markets theory by questioning the idea of a firm as a unit of analysis by introducing the problems of cartels and vertical integration, and showing that it is very difficult to give a satisfying theory what the firm is, as opposed to cartels and diverse types of contracts, such as hive rental or service contracts. In concluding, I will briefly summarize the results.
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Journal des Economistes et des Etudes Humaines, Vol. 16 [2010], No. 1, Art. 3
1: Inception of modern theory of the firm: Ronald Coase and beyond Ronald Coase expressed his vision of the firm through his famous formula pertaining to the firm as a tool for minimizing the "cost of using the market mechanism". It implied that a firm existed as a way to provide an individual with the opportunity to carry out transactions on the open market. Within the transaction costs, Coase further differentiated the costs of obtaining the information about business opportunities costs of setting and monitoring the contract etc (Coase, 1937). Coase's primary assumption is that the firm shows up because of an imbalance between the cost of using the information from the open market and the cost of organizing and monitoring the production within the firm (costs of management). If transaction costs are higher than the costs of management the firm will appear, and if marginal transaction costs are rising compared to marginal management costs, the firm will tend to grow (Coase, ibid.). The boundary of the firm is defined by this point of equilibrium between the managerial and transaction costs. The principal innovation of this Coase's early paper was an idea of possibility to combine the impersonal, allocative mechanism of market prices with the hierarchical model for organizing activities within the firm. This puzzling dichotomy, however, came as both a discovery and a new problem; a discovery because none before him thought of the firm as an entity which is, in an organizational sense, competing with the market, and a problem because it was not clear how to apply a standard economic analysis in such a changed environment. Although Coase tended to transcend some basic features of a standard perfect competitive equilibrium analysis, his assumptions about transaction costs, as well as all subsequent attempts of his followers to give a sense to the notion, were nevertheless deeply rooted in that analysis. As Harold Demsetz has pointed out (Demsetz, 1988), all theoretical conceptualizations of the transaction cost paradigm rested on the idea that (at least some) information is complete, free and perfect, notably information about the comparative costs of production of the same item in the two separate firms. This idea represented a residue of the old perfect competitive equilibrium conception, which included perfect information as a crucial condition. According to Demsetz, the decision to "buy-or-make" (to carry out a transaction via open market or within the firm) in the framework of any paradigm of transaction costs is made only on the basis of the relation between the transaction and management costs. It is supposed implicitly that two firms must produce the same item at the same cost.1 In that way, the rejected
It seems that Coase himself was well aware of the inappropriateness of his analysis of the factors determining the nature of the firm and the extent of its operations, primarily due to ignoring the problem of production cost. In the article "Nature of the firm influence" he described his previous emphasizing of the dichotomy transaction vs. managerial costs, and the relative neglect
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assumption of free information appears in a residual mode as availability of information on relative production costs: "Although information is treated as being costly for transaction or management control purposes, it is implicitly presumed to be free for production purposes," (Demsetz, ibid., 148). However, this is a wrong assumption which distorts the picture of how a decision "buy-or-make" is made. A firm can continue with internal production even in the case that transaction costs are null and managerial costs positive, if the productive efficiency of the firm is sufficiently higher than the productive efficiency of the second-best firm. It can also continue to buy inputs on the market even if its managerial costs are null, if the productive efficiency of the supplying firm is much higher. If all firms disappear with null transaction costs (as one would expect), does that mean managerial costs in this situation also become null? Obviously not, because the individuals also have the costs of organizing production no matter how they are linked with the other individuals. Therefore, the real decisions of buying or making must be made on the basis of an assessment of the overall costs and benefits of the internal production versus the open market purchase. That assessment includes not only the ratio transaction/managerial costs, but also the relative production costs, the state of technology, innovations, etc. Thus, transaction costs/managerial costs ratio would be just one, and by no means the most important factor in the buy-or-make decision. When a firm buys the inputs from another firm, it thereby pays the managerial costs of that other firm. Also, by producing its own item from inputs bought on the open markets it pays the transaction costs of purchase of inputs. An open market purchase does not eliminate the managerial costs, just as internal production does not eliminate the transaction costs! The final conclusion could be that it is not possible to draw an analytically clear distinction between open market purchase and internal production, i.e. between the market and the firm as categories! In their famous paper, Klein, Crawford and Alchian confirmed the Demsetz-Alchian early finding, "Once we attempt to add empirical detail to Coase's fundamental insight that a systematic study of transaction costs is necessary to explain particular forms of economic organization, we find that his primary distinction between transactions made within a firm and transactions made in the marketplace may often be too simplistic. Many long-term contractual
of the production cost in his initial paper from 1937: "In that article, I did not explore factors that could lower the organization costs in one firm in relation to other firm. It is sufficient if the main goal is to explain why firms exist. But if one wishes to explain institutional structure of production in system as a whole, than it is necessary to unfold the reasons why costs of organizing certain activities across the firms are different," (Coase, 1937). But in in the work of the Coase's very influential disciple, Oliver Williamson, we can find a much sharper exclusion of the production cost from the analysis, and a complete rehabilitation of the traditional neoclassical conception of cost, (see, Langlois & Foss (1997)).
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relationships (such as franchising) blur the line between the market and the firm." (Klein et al, 1978) In his later works, Harold Demsetz goes even further, denying any real explanatory power to the category of transaction cost. According to him, although transaction costs undoubtedly exist and have impact on economic activity, this is analytically useless for answering the questions on why and where the firm is more efficient than the market in resolving the problem of economic coordination between the individuals within the producing team and outside it. Demsetz explains that the role of transaction cost in explaining the manner in which organization responds to these problems is like the role of gravity in explaining chemical reactions; gravity influences chemical reactions, but seldom is it the key variable whose behavior importantly explains variations in the reactions observed," (Demsetz, 1988, p. 151). Gravity surely influences chemical reactions, but dozens of other phenomena also influence them, and gravity also influences dozens of other phenomena apart from the chemical reactions. By the same token, the genesis, extent and characteristics of the firm are certainly affected by transaction costs in some way, but they are also affected by the prices of commodities on the world market, by the productive efficiency of rival firms, by specific knowledge of firms' members and many other factors. On the other hand, transaction costs (uncertainty, incomplete knowledge) exert an influence apart from the firm and the market on a wide variety of activities of individuals outside the economic system. Any transaction includes the cost of acquiring the opportunity to carry it out. To speak about that cost as the key determinant of the genesis and structure of the firm deprives the notion of the transaction cost of any serious predictive power, or as Demsetz ironically notes means to come closer to definition of transaction costs as the costs of resolving problems, (ibid., p. 152). How do we, in spite of these theoretical weaknesses of Coase's concept of transaction cost, come to adopt the idea of the firm as a hierarchical rather than a contractual entity? The standard explanation says that the hierarchical nature of the firm can best be seen in how production is organized within it, because monitoring and issuance of orders are everyday practice, as well as the hiring and firing of the workforce. Bosses and subordinates do not cooperate via price mechanism, but rather give orders and comply with them; they make and carry out economic plans (Coase, 1937, Williamson, 1985). Yet, things could be seen from an entirely different perspective, in which the coordination within the firm has been explained as just one specific marketbased contractual arrangement (Alchian and Demsetz 1972, Jensen and Meckling 1976, Fama, 1980, Salin 2002). A market includes, among its other functions, a voluntary system of contracts between two or more parties. Decisions on making contracts are free and ex ante at least, efficient. They are useful for both parties, otherwise they would not have been made in the first place. In that connection, a
http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241
firm is only a specific and often a complicated nexus of contracts between the owners, managers, workers etc. To put it shortly, a firm is a nexus of contracts between the various individuals with different interests and different contributions to a joint business enterprise. An owner brings in capital and material resources. He hires managers to operate his plants and organize production processes. Managers hire workers and include them together in cooperative locus. Workers offer their services for the monetary and non-monetary remuneration, fixed or flexible. All of them meet each other on the various markets and negotiate in order to make arrangements which will allow them to improve their economic interests. If they reach an agreement, that does not mean anything more than an exchange of legitimately owned resources, whether those resources include physical capital, organization skills or working efforts. Methodologically speaking, there is nothing specific concerning firms that we cannot observe in the ordinary open market: "The firm does not own all its inputs. It has no power of fiat, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting between any two people. I can "punish" you only by withholding future business. That is exactly all that any employer can do. He can fire; I can fire my grocer by stopping to purchase from him. There is no other difference," (Alchian and Demsetz, 1972, 777). The impression that the firm is entirely specific, or even radically different in nature than other forms of voluntary contractual and spontaneous cooperation, stems from the fact that the entrepreneur and the worker have different costs related to the monitoring or maintaining the adherence to a contract. For an employee to monitor contractual adherence by his employer, it is sufficient to establish whether the contracted upon sum of money is paid to him, and to demand contract enforcement either via the court or an alternative avenue, if the obligations of an employer have not been met. On the other hand, the managers or owners of a firm often have to proceed through a much more complicated operation to estimate whether employees properly execute the duties they have undertaken by contract. Continuous, exhaustive, resource and time consuming monitoring is a part of contract enforcement on the side of the entrepreneur (Salin, 2002). Therefore, many theorists (including Coase) seem to believe that in the relationship between the owner, worker and the entrepreneur there is some asymmetry, or even that such a pattern of organization is not contractual whatsoever, but rather a hierarchical one. Asymmetric relationship between workers and managers in monitoring contract adherence gives a false impression of a hierarchical structure. But, as we have seen, the organizational pattern of the firm is purely contractual, just as in any other case of market cooperation.2 In
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In their famous paper, Alchian and Demsetz identify the relation employer/employee with the relation consumer/producer: "Telling an employee to to type this letter rather than to file that document is like my telling a grocer to sell me this brand of tuna rather than that brand of bread"
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transaction cost theories we are expected to visualize the firm as a micro-state within the market, with its own managerial military and police to issue orders and monitor their execution. In such an analytical environment, individualist perspective is basically lost. A significant contribution of Alchian-Demsetzs new perspective was the emphasis on methodological individualism through the concept of the firm as a legal facet of various sets of contracts. In Alchian and Demsetz's work the concept of the firm is related to resolving the moral hazard problem occurring in team work, essential to the firm's operations. The firm is not an instrument of minimizing the transaction costs, but of measuring the marginal contribution of the team members to the value of its output. It is an instrument of resolving the principal-agent problem (Achian and Demsetz, 1972). The individualist concept of the firm can survive in such an environment, unlike in the Coasean framework. Generalizing the Demsetz-Alchians findings, Jensen and Meckling widen the scope of agency theory to apply it to all forms of institutions in which the principal-agent problem is present. That way, the theory of the firm as a unique entity disappears, that is, it becomes a part of a wider program of explaining how in the framework of various contractual systems the costs and benefits of principal-agent relations are distributed. The concept of a firm that has some essence ("nature") that is first discovered by careful analysis and then differentiated from the "market, is finally abandoned. Jensen and Meckling clearly describe this changed notion of the firm: "it makes little or no sense to try to distinguish those things that are inside the firm (or any other organization) from those things that are outside of it. There is in a very real sense only a multitude of complex relationships (i.e., contracts) between the legal fiction (the firm) and the owners of labor, material and capital inputs and the consumers of output," (Jensen and Meckling, 1976, 10). Simply, a firm is a changing and flexible net of contractual relationships between individuals that have their own separate interests, motivations and goals. Therefore, according to Jensen and Meckling it is besides the point to question what the "objective function of the firm" is, and whether or not the firm could possibly have some "social responsibility", outside their drive for making profit. Even maximization of profit strictu sensu could not be taken as a firm's objective function, not because something else is its objective function, or because people in the firm do not make the profit, but because they also do a lot of other things (work for salaries, pay interests, sell products, gain prestige, etc.). Different individuals within the firm have different objectives to achieve and thus, they all have different objective functions. Only individuals have objective functions, not collectives. I. Therefore, a firm does not have neither the profit nor "social" functions, since it does not
(Alchian, Demsetz, 1972, s.779)
have any subjectivity whatsoever. Firm is a fiction, it does not really exist3 Jensen and Meckling define a firm as "legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may represent other organizations) are brought into equilibrium within a framework of contractual relations " (Jensen and Meckling, ibid.,11). If so, the concept of ownership of the firm also must be redefined. The ownership over capital is ownership over just one of the possible sets of inputs, the others being managerial or working services, all assembled within the "firm" by a nexus of contracts. A firm cannot be owned because a set of contracts cannot be owned. As Fama says: "Ownership over capital should not be confused with ownership of the firm. Each factor in a firm is owned by somebody. The firm is just set of contracts covering the way inputs are joined to create outputs and the way receipts from outputs are shared among inputs," (Fama, 1980). This also means that a firm cannot plan, because only individuals can plan. Although all of this is essential for the Austrian theory of the firm as well (and will be included in our proposal of how to remodel it), the theory in its neoclassical form has serious problems. One of the basic weaknesses of the neoclassical contractual notion of the firm was the absence of the theory of monetary calculation and entrepreneurship and although indirect, the adoption of an assumption of perfect knowledge via completeness of contract, certainty and rationality of economic actors (Zingales, 1998). It is correct to say that both transaction costs and contractual theories were in various ways rooted in neoclassical assumptions about information, knowledge and competition. Also, that is the reason to believe that the conventional agency theory of the firm needs the Austrian concepts of monetary calculation, entrepreneurship and plan coordination in order to be better founded. The choice of the mainstream Austrian theory of the firm was to try salvaging Coase's theory by incorporating it into Austrian framework. I think a much better approach would be to salvage the contractual agency theory by incorporating it, in a similar way, into the Austrian argumentative setting of calculation and entrepreneurship. In what follows I will try to outline some basic avenues along which that can be achieved.
As far as profit mazimization is concerned it is possible to posit it as a supreme end of those who have a property eployed for investment purposes, but they are just one of the contracting parties within the firm. In this (methaphorical) sense promoting the "social" function of the firm only could mean that the owners should stop striving to achieve profit, but accept to work to achieve other goals, such as "fairness", other people's well being and so on. It would imply that someone should be an owner, bear the cost and risk of conducting business, and let someone else reap the gains of his effort, that is, decide on how residual income is to be divided. For the classical analysis of why a firm has no social responsibility of any kind, see Friedman (1970)
2. The standard Austrian view of the firm The basic categories, missing in both the contractual and Coasian paradigm of the firm are, according to the Austrian critique, entrepreneurship, monetary calculation and inter-temporal allocation of productive factors. Entrepreneurship in the wider sense is a consistent part of the human action, actually its synonym. Man acts in various ways (not only as an economic actor-entrepreneur), using certain means to achieve ends. He undertakes actions in order to achieve the state of affairs which he anticipates as desirable compared with the present one. If there were no gap between the present and desirable states of affairs there would not be any room for entrepreneurship in this wider sense of the word. At the same time, entrepreneurship means accepting and coping with uncertainty concerning the future. If we knew what the future would be, no one would undertake any action whatsoever. The overall behavior of man has built in itself the implicit assumption of dealing with uncertainty. Therefore, entrepreneurship as a way of dealing with the uncertainty is a universal phenomenon of human action. It is, as Mises puts it, a praxeological fact (Mises, 2004). It is clear that, according to this wider praxeological definition, every economic actor would be an entrepreneur at the same time (for he is facing uncertainty, unavoidable opportunity cost and incomplete information about the world and future). The economic entrepreneurship is a somewhat narrower notion, it does not include every actor, but only those that use the material means to achieve the material ends (profit, earnings). The economic entrepreneurship means praxeological entrepreneurship plus monetary calculation on the basis of price mechanism. An entrepreneur is the one who risks material assets in order to organize a production process he believes could result in products that can bring him financial gain. He acts on the basis of the prices of production factors (labor, capital, raw materials) which he purchases on the open market and uses according to his plans, guided by anticipation of future earnings from the particular use of those factors, compared with the (hypothetical, opportunity) costs of that use. Also, he, just like any other entrepreneur, faces uncertainty concerning the future. If his anticipation of the future consumer demand turns out to be correct, he will gain profit. Accordingly, if his anticipation was misdirected, he will incur financial loss, and possibly, bankruptcy. At the same time, an entrepreneur must take into account (to estimate ex ante) both what the most viable way of production will be and where on the preference scale of the consuming public a particular product is. He must calculate an outcome on the basis of uncertain knowledge about the unknown magnitude and take the risk with his own or delegated money for those calculations: "The business of the entrepreneur is not merely to experiment with
new technological methods, but to select from the multitude of technologically feasible methods those which are best fit to supply the public in the cheapest way with the things they are asking for most urgently, " (Mises, 1951, p.110). To achieve this end, it is not at all sufficient for an entrepreneur to execute the tasks that the neoclassical school acknowledges the "manager" should execute, namely to organize the production within the cooperative unit called a firm, according to the plan adopted in advance by someone else. Such a view of the entrepreneur's role reduces his activities to the horizon of an ordinary clerk who takes the overall outer structure of the market as a given framework to which he must adjust. On the contrary, the real entrepreneur works on the capital markets in uncertain conditions, where he tries to use incomplete information to gain the profit. His job is quite different from that of an ordinary bureaucratic clerk who acts in the given informational framework in which he just executes his assigned task of achieving the technical optimum known in advance. Creativity of the market process lies in an entrepreneur's changing of the circumstances, in his ability to adapt to changing consumer choices, by devising and adopting better production techniques and less expensive ways of producing, distributing and advertising products. He is an instrument of adaptation of the market process to the unpredictable consumer demand. In Mises' writings, the firm is not in focus of analysis, but the entrepreneurial function a feature of a businessman that he operates in the capital markets to provide inter-temporal allocation of scarce goods between the various branches of industries: "The market of the capitalist society also performs all those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; they buy and sell the shares and bonds of already existing and of new corporations; they grant, withdraw, and recover credits; in short they perform all those acts the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way," (Mises, 2004, pp. 707-708). The famous debate on economic calculation in socialism between the Austrian school of economics (Mises and Hayek) and their socialist opponents (Neurath, Lange, Lerner and others) was the main theoretical battlefield where we can discern the significance of monetary calculation for the theory of the firm. Without reviewing the debate more in depth, it would be sufficient to refer to Mises' famous argument for the impossibility of socialism: if there is no private property, there is no supply and demand for goods, services and production factors. If in some society there would not be supply and demand, there also would not be the prices of consumption and capital goods. If there wouldn't be prices, there is no economic calculation (economic planning) whatsoever, because
the planner (entrepreneur or the government "manager", nevermind) cannot know, even if properly motivated to work and make plans, neither what has to be produced, nor in what quantity, by combination of what specific factors etc, so socialism necessarily leads to economic chaos and wasting of resources (Mises, 1990). One of the Mises foremost disciples, Murray Rothbard, employed this classical calculation argument to resolve the issue, which even today put in trouble the orthodox theory of the firm, both in its transactional and agency variety. This is the question set by Coase himself in his seminal paper: why is all production not located in the one single firm, or cartel, that is: where lies the upper boundary of the vertical integration? Rothbard's answer goes as follows: one big firm cannot exist because independent profit centers within it could not know in the absence of an external market to calculate the transfer prices, i.e. prices of intermediary production factors which they exchange, and production would be increasingly inefficient (Rothbard, 1962). Therefore, for him, just like for Mises, in order for a firm to be able to calculate its cost and profit, it is not sufficient to have a market-based prices for the consumption goods; it is by far more important to have market prices for the capital goods. If one firm swallows the external markets, then the transfer prices within that big firm would cease to reflect the real availability and opportunity costs of goods anymore and would become as artificial and arbitrary as prices set by the socialist central planner.4 Automatically, the Misesian signal that too expensive production factor sends to an investor - get out of me - would not function anymore. Entrepreneurs would start to waste the resources increasingly, investing in the wrong projects. Thus, according to Rothbard, the upper boundary of the firm's growth is a boundary of survival of independently existing markets for its production factors. The full-blown socialism could be best described as one big firm that swallowed an entire market in all goods and services, both final and intermediate ones. The majority of authors who write in the Austrian tradition conceive the firm along this Mises/Rotbard broadly set model: they assume the firm is a
The fact is that socialist countries could economically survive only because they compared relative prices in the West and adopted them home. In the absence of information based on a capitalist economy in the outside world, socialism would colapse within the few months, resulting in mass famine, shortages and teror (just like it really happened each time when some pure sort of socialism was launched in compete isolation from the capitalist world, such as Stalin's in some phases, Mao's china or Pol Pots' Cambodia). Nikita Khruschev himself should not have to read Mises in order to understand that "if the whole world would became socialist, we still should leave Switzerland to be a capitalist state, to find out the structure of prices for a socialist world. In a position similar to Khruchev's, a director of state enterprise would be caught in a situation that would "swallow" markets for all production goods. He would be forced to demand the creation of at least one additional firm to find his own transfer prices.
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Coasian central planning entity which operates in a broader market setting. They emphasize the role of the entrepreneur or financial speculator, as opposed to a manager within the firm, the role of uncertainty and risk-taking with physical assets when it comes to entrepreneurship, and treat the firm as an instrument of entrepreneurial judgment in a quest for profit opportunities (Foss and Klein, 2005, Foss 1994, Langlois and Foss,1997, Klein 1996, Klein and Klein, 2001). However, I think this perspective is headed the wrong way. 3. Firm as a nexus of markets This standard Austrian theory of the firm inspired by Mises's and Rothbard's analyses, consists broadly speaking of three parts: a Coasean central planning unit, an entrepreneur/speculator, and an independently existing market. Our contention is that the first part of the equation (the firm as the central planning entity) should be completely removed, and replaced by the theory of the firm as a nexus of various markets. First off, if we accept Mises's previously considered idea about the strong distinction between an entrepreneur/speculator and mere manager or worker, we have no basis for the concept of the ''firm'' as an entity that represents a unit of analysis at all. Specifically, we are bound to reject Mises's own strong insistence (echoed by Klein and Foss and other orthodox Austrian theorists of the firm) that an entrepreneur controls the factors of production' in the sense that he exerts the authority and central planning control over those factors of production, including the workforce. If the key role belongs to the entrepreneur, and not to the firm, it is then from a praxeological point of view much more appropriate to analyze the ''firm's'' operation in terms of multiple contracts and the buying/selling arrangements of the entrepreneur with the outside providers of services to him (members of his firm), than in terms of the firm's commanding authority over its assets and its joint planning of activities within the outer market framework. The emphasis on the firm seems to be a form of confusion stemming form the imprecise and metaphorical use of language. We do not have any straightforward explanation as to why we have to resort to the concept of the firm as a central planning ''island'', in order to describe the voluntary arrangements among the free individuals. Secondly, the general concept of the firm as a central planning entity operating in the environment characterized by the presence of free market prices is even more problematic when we confront it with the basic Misesian paradigm of the economic calculation. Mises's iconic argument against socialism was that in the absence of market prices, rational economic planning would not be possible at all. Market prices are indispensable analytical and cognitive tools for entrepreneurial speculation with privately owned capital, without which,
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according to Mises everything would be a leap in the dark (Mises, 1990, p.). However, if this is so, how then can the very same absence of monetary price coordination of economic plans within the firm suddenly become a virtue? If the very possibility of rational economic planning critically depends upon the presence of market prices, how then can the firm, understood as a central planning and hierarchical island in the ocean of the market transactions, represent a contribution to the economic efficiency rather than an obstacle to it, or, for that matter, to exist at all? By accepting the Coasiean notion of the firm as central planning minimizer of the market transaction costs, the Austrians ironically accepted the notion of central planning as a solution for the shortcomings of the market. This problem, a failure of the orthodox Austrian analysis of the firm to even notice this blatant inconsistency between the general Misesian calculation argument and the Coasean theory of the firm, is painfully obvious when we read both Rothbard and younger Austrian theorists of the firm. Rothbard generalizes the Mises's calculation argument by pointing out that if a part of economic activity guided by central planning grows at the expense of market basedtransactions via prices, the overall economic efficiency diminishes that way: "islands of non-calculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater" (Rothbard, 2004). Therefore, as more and more of the economic activity falls under the firm's central planning mode of coordination, "incalculability chaos" increases. If we accept this Rothbard's argument, it would follow that every firm by its own existence hampers to some extent the overall economic performance of the economy. What this Rothbardian logic does imply is that the firm is basically a problem and an anomaly. The shrinkage of the area covered by market price coordination, which is replaced by the central planning commands, diminishes ipso facto the possibility of entrepreneurs to calculate the real opportunity costs of resources and their capacity to know what efficient production and investment is. The optimal industrial structure according to this perspective would be the one without any firms altogether (without those "islands of incalculability"), and with a multitude of individual entrepreneurs that are buying and selling products on the open market. However, this is plainly wrong most advanced economies have a myriad of firms, and in some cases very large or even monopolistic firms are the most efficient ones at the same time. So, the conventional Rothbardian analysis of calculation is a brilliant (although non-intentional) critique of the Austrian theory of the firm he and many other theorists have accepted. Obviously, the only way to reconcile the Mises/Rothbard's theory of the essential role of the entrepreneur with their theory of the diminishing efficiency of a market system in which the area of price coordination shrinks and the island of central planning expands, is to
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assume that the firm is not a central planning entity at all. That means that ''within'' it, a multitude of buying and selling operations is constantly taking place, i.e. that firm is a part of the market itself. Only if that is somehow the case, the existence of the firm can be seen as a contribution to the economic efficiency and a problem solving tool, rather than the source of wasting resources and economic miscoordination. We shall show that exactly this is the case, i.e. that the firm is a nexus of markets and not a central planning entity. Which is to say that the Misesian definition of an entrepreneur as a speculator in the capital market is too narrow, and that should be substantially broadened to include not only speculation in labor markets (buying services of the people instead of products of other people) but also every use of a superior capability or knowledge to improve the financial condition of an actor, "within" or "outside" the firm. The first significant problem we have to deal with here is to try to answer the question: when an entrepreneur organizes the production within the firm what does he really do? Does he engage in central planning? To begin with, an entrepreneur is just one individual. Every individual according to Mises's praxeological axioms pursues his own ends by cooperating with other individuals. The market is not (only) transactions via prices, the market is primarily a second name for the peaceful cooperation of individuals within the system of private property rights (the market prices are just a consequence of the existence of the private property rights). Every individual has his own interests, his own vision of how to improve his condition. When an entrepreneur organizes the firm he pursues in that way his own self interests, and his employees do the same, as well. However, an entrepreneur does not "supersede" the market when he organizes the firm: he just operates in different markets than when he buys inputs from other "firms". In a standard Coasian setting, an entrepreneur must decide whether to buy the product on the open market or to organize its production within the firm. However, and this is the crucial point, when he decides to make a product within the firm he only decides to achieve the same goal using a different market instead of using the market for final or intermediate products, he uses the market for labor and managerial services and does not abandon market coordination altogether. By buying services of various groups of people (in the firm), an entrepreneur speculates that it is going to be a more profitable course of action than buying the final or intermediate product. As Mathews nicely said: "...the firm's make-or-buy decision is not a decision about whether to manage or to use input markets; it is a managerial decision about which input markets to use" (Mathews, 1998, 44). Potential labor and managerial services, assembled in a firm are just some of the possible input markets for the entrepreneurial speculation of an individual, while products bought from another firm is another one. In that regard, as it has been emphasized, the difference between the market and the firm is only in the type of contract in the first case it is a selling contract,
13
while in the other it is a wage contract. A person-entrepreneur is buying a set of services rather than a final product.5 Does that mean that he somehow operates "outside" the market when doing this? One thing that is obvious from the previous analysis (and from explicit statements of Austrians led by Mises as well) is that the central role in economic organization in Austrian economics does not belong to the "firm," but to the entrepreneur/individual (consistent with methodological individualism). Also, whether the "firm" exists depends only upon an entrepreneur's decision regarding which input market to use in the pursuit of profit market for goods or market for services. The "firm" as a central planning island, and a key part of the theory of industrial organization developed the is clearly a praxeologically invalid concept. The firm is a construct which refers to a certain number of people seeking their self-interests via specific contractual arrangements. The analysis of the economic organization must focus on an entrepreneur and the environment in which he operates, and not only on the one specific market and one specific contractual form of market cooperation, called the "firm". An entrepreneur, on the basis of existing productive factors (being them capital, intermediate products, labor services, knowledge...) speculates on what is the most profitable way of improving his economic condition. The firm is only one usual specific case of this endeavor, but by no means the only conceivable one. A fundamental weakness of the Misesian theory of the firm is confining the entrepreneurial role to only financial speculation in the capital market. The Misesian entrepreneur is a kind of Frankenstein-like creature he is a speculator and investor who is guided by the price signal outside the firm. He is also a central planner, almost a socialist commissar, within the firm. That way the scope of entrepreneurship is very much narrowed, and ultimately reduced to the financial speculation. Mises makes a very strong distinction between the entrepreneur and manager. "They (market socialists, IJ) fail to realize that the operations of the corporate officers consist merely in the loyal execution of the tasks entrusted to them by their bosses, the shareholders, and that in performing the orders received they are forced to adjust themselves to the structure of the market prices, ultimately determined by factors other than the various managerial
This kind of argument against distinguishing firms and markets should not be confused with the arguments recently put forward by some neoclassical economists, according to which the new technologies and the economy with a prevailing importance of outside sources of science and knowledge make boundaries between the market and the firm somewhat more fuzzy, or flatten the hierarchies within the firms (Cowen and Parker, 1997). On the contrary, our analysis does not need this kind of redefinition, because it assumes that the basic distinction between markets and hierarchies is wrong and misleading to begin with, and that it does not apply even to the standard, classical corporation. Our argument is not that the modern firm ceases to be so hierarchical as the traditional corporation, but, following in the footsteps of Demsetz-Alchian and Jensen-Meckling's early contributions that classical corporation was never hierarchical in the first place.
5
operations." (Mises, 1949, 727) To underline even more strikingly the difference between the inter-firm operations and market transactions Mises adds: "Those who confuse entrepreneurship and management close their eyes to the economic problem." (ibid 728). If the manager is only executing the tasks assigned to him by an entrepreneur / shareholder, then the firm itself is devoid of any kind of entrepreneurship. Other Austrian authors offer a more sensible definition of entrepreneurship that to a much higher degree can be reconciled with what we observe as entrepreneurship in everyday life. Schumpeter considers entrepreneurship to be an instrument of creative destruction by which capitalism permanently improves the technological and managerial ways of conducting business. Entrepreneurship for him is a second name for the genuine creativity of the market process which brings about the new and better products, managerial and technological innovations, modes of branching or integration of capital, and so on. Entrepreneurship is in the market, not in the firm, or solely between the market and the firm (as in Mises's theory). It occurs at every level of economic life, although Schumpeter in the institutional sense most often identifies the entrepreneur with an independent contractor (Klein and Foss, 2005). Unlike Mises, who by and large, identifies the capitalist and the entrepreneur, Schumpeter sharply, sometimes maybe too sharply, distinguishes between them, asserting that every entrepreneur when he creates a firm, ceases to be an entrepreneur. Although this is probably an exaggerated formulation, it bears significant elements of truth entrepreneurship cannot be identified with the speculation with one's own capital. Similarly, Kirzner in his Hayekian theory of competitive process as a discovery procedure, dramatically widens the scope of entrepreneurship, over and above what the canonical Misesian definition assumes. According to Kirzner, the defining feature of an entrepreneur is his alertness to profit opportunities missed by others (Kirzner, 1973). An entrepreneur is a person accidentally possessing specific useful knowledge and knowing how to use that specific information in order to reap a profit. Like Schumpeter, although in different theoretical language, Kirzner develops the theory that leaves no room for any privileged systematic link between the entrepreneur and the firm. Entrepreneurship is a widespread mode of economic behavior we can find in many different market settings, both within and outside the firm.6 So, the economic, monetary entrepreneurship as a risk-taking
This is not to deny the merits of standard critique of the Kirznerian concept of entrepreneurship by the Austrians such as Rothbard and Salerno, according to which Kirzner completely abolished any systematic link between the physical capital and the entrepreneurship. But, when the Austrians of the main current got it wrong in criticizing Kirzner is in emphasizing that entrepreneurship necessarily must mean the ownership over the capital per definitionem; i.e. that the entrepreneurial function must necessarily and always be performed by an owner of the physical asset, and never
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activity in conditions of uncertainty is a universal praxeological fact. Entrepreneurship emerges because some individuals have information that is not possessed by others. If person X buys a car not in A's shop but in B's shop, where it is cheaper, it is because X knows that B sells cars at a certain price that happens to be lower than A's prices. However, a certain other individual, named Y, may be completely ignorant about this, therefore buying in A's shop. We may describe the feature of his behavior that has to do with the use of certain information present in his "domain", as entrepreneurship. If he opens a factory, or invests in a company, or manages a firm, the same principle is at work his behavior is also entrepreneurial in the economic, i.e. financial sense. Person X in both cases has made a monetary gain (profit) on the basis of the superior use of a specific knowledge of time and place (Hayek).7 It is not immediately apparent on what basis we can exclude the first type of using or economizing scarce information from the domain of entrepreneurship. Just like in the case of isolated individuals, we can speak about the entrepreneurial behavior at many levels within the firm. Every person X having better information on, or knowledge of the specifics of his managerial or working or buying/selling situation, can perform better than person Y lacking that knowledge, and thus provide higher monetary value added to the firm and to himself. It may be true that "market socialists" completely ignored the financial speculation in the capital market as one of the crucial roles of entrepreneurship. However, it also may be true that Mises himself made the completely opposite mistake he removed entrepreneurship completely, not only from the firm, but also from non-financial markets as well. A manager is, according to him, a mere robotic machine carrying out the orders and plans of an entrepreneur, regardless of the question of his capacity to do his job. Workers are also, by and large, the robots carrying out someone else's plans; in the same way the neoclassical theory adopted by market socialists described the behaviour of the economic actors in general. Different units of a firm are subjected to the central planning authority of their center, carrying out the orders that are given to them, without any autonomy or initiative. The only difference between Mises's description of the firm and the description of the firm given by market socialists, is that he adds, over and above that central planning mechanistic entity a capital market with prices and the vigorous financial speculator as some kind of liaison officer between the market
by the person entrusted by the owner to use it (ie. CEO). 7 I used over this convenient example of buying a car from the internet site of the Austrian Economics Forum (http://www.austrianforum.com/index.php?showtopic=577&hl=Foss,and,Klein). The usual example of an entrepreneur who is not risking real physical capital is a speculative short-seller or arbitrageur on the stock market, but I thought it was much more interesting to assign the entrepreneurial character to an "ordinary" behavior that has financial concequences as well.
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and the firm/socialist island. The entrepreneur is somehow inserted from outside the firm provides an informational basis for decision-making within that socialist island. One additional way of seeing why this rigid Misesian concept of entrepreneurship as a speculation in the capital markets is not a useful concept, is to consider the modern corporation. Who is the entrepreneur, and who is "just a manager" in the modern corporation? Many of those essential activities of entrepreneurs to "establish corporations and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; (to) buy and sell the shares and bonds of already existing and of new corporations; grant, withdraw, and recover credits;" (Mises) are essentially in the modern corporation carried out by the people whom Mises and his followers basically would describe as managers people hired by the shareholders and capitalists to manage the firm. They make the decisions about the new emissions of stocks, about borrowing and lending, about business strategies, about takeover bids, and about the whole range of the crucial entrepreneurial issues, with shareholders playing clearly a side role in the whole process. From the orthodox Austrian perspective, this is complete nonsense how can mere managers act as entrepreneurs? However, according to nexus-of-contracts and nexus-of-markets theories, this development is quite possible. Since the firm is just a fictional set of contracts among individuals, there is nothing especially intriguing or scandalous in the fact that this nexus of contracts can evolve in such a way to allow for different organization of entrepreneurial speculation in capital markets. It is exactly the fact that a corporation is a nexus-of-markets that allows and requires such a redistribution of roles between the owners and managers. Managers can successfully operate with the firm's capital, dissolve and merge the firms, buy and sell shares, recover credits and all the rest, because they are in a wide network of different markets that evaluate their services. Managers are exposed every day to the disciplining force of the capital markets that value the quality of their investment decisions by share price indicators; then they are exposed to the market for corporate control (to the threats of hostile takeovers if they do not perform well) (Bittlingamyer, 1999), then to the market for managers both within and outside the firm (Fama and Jensen, 1983) and so on. Without understanding the nexus-ofmarkets nature of the corporation, we cannot satisfactorily account for the very fact of its existence and survival, in spite of the complete separation between the ownership and managing functions within it. Most of the modern corporations are limited liability entities, which means that shareholders are responsible for the firm's debt and obligations only to the extent of the dividends and other sources of income they received. If Klein (2010) is right when stating that the entrepreneur is nearly always also a capitalist and the capitalist is also an entrepreneur, then corporation must be an awfully inefficient form of business organization, since it
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produces a very strong moral hazard, by allowing to shareholders to reap the full fruits of corporation's profitable activity while avoiding to bear the full cost of its failure (socialization of costs). A capitalist-owner-entrepreneur with the limited liability for his own business decisions is there anything more contradictory to the Misesian notion of an entrepreneur? Still, the corporate form of the firm is dominating today's business world. Does that mean that the financial and product markets are so inefficient that they bolster an inferior form of business organization (corporation), while suppressing the superior forms private firms and proprietorships, with their unlimited liability of an owner? Obviously not. The corporations out-competed to a large extent the private firms in the open market. The prevalence of the corporations in today's economic life is not a sign of a market failure (as one would be tempted to think on the basis of the Misesian theory of the entrepreneurship), but the clear sign that the Misesian theory of entrepreneurship is flawed, or at least incomplete. Once we drop a too restrictive assumption that capitalist=owner=entrepreneur, the paradox of corporation entirely disappears. CEO can become an entrepreneur, in spite of not owning the single share of the corporation. Moreover, its even possible to hypothesize that the corporation is so efficient a form of business organization compared with all the alternatives because it encompasses so many different markets that intersect each other, or in our language, because the corporation is an extraordinarily complex and rich nexus of various markets. In no other form of business organization do we have so many price signals coordinating the activity of so many people who work in some kind of team. So, far from being a hierarchical island of central planning in the sea of market coordination, the firm is actually an extraordinarily rich focal point of so many markets, and of hundreds of different prices. This brings us back to the initial problem of entrepreneurship and the nature of the firm in the Austrian economics. A standard Austrian explanation of why the firm as a centrally planned entity can function is that entrepreneurs, via profit and loss, obtain the necessary information about the relative efficiency of their business decisions. It is not necessary for a market to exist within the firm as long as it exists outside it (Rothbard, 2004; Klein, 1996). However, although an outside market can provide a firm with the information as to whether it makes or loses money, such a market, perceived as being outside the firm, cannot help the entrepreneur to discover the source of relative inefficiency within the firm, and to help him to improve its performance. He must have some kind of price signal for most of the factor inputs he uses within the firm, in order to be able to know which of those factors contributed to the overall under-performance of the enterprise. And in order to have the prices for factors, the market (actually, myriad of markets) must permeate the firm. There is no other way to objectively assess the reasons for business failure except to have an internal factor market; as
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we have seen, if the firm was to be conceived as a centrally planned entity, it would have no reason to exist whatsoever, from the Austrian perspective at least. From that perspective, the firm's existence would only create problems in economic calculation, or in Rothbard's jargon, it would represent an island of incalculability inside the market. In some way, this has been clearly recognized even by the neoclassical theorists: Errors are bound to be less frequent when price information guides every activity performed, says Stephen Cheung (Cheung, 1983), referring to the firm. So, only insofar as the firm is able to use or create the price mechanism in its internal operation we can speak about the firm's efficiency or its ability to evolve or improve its performance. In other words, the firm can be a problem-solving tool, only insofar as it is NOT a centrally planned or commanding entity. For example, in the Alchian/Demsetzs model, the firm arises as a tool of minimizing the shirking within the team production. However, the real problem here is the existence of the positive cost of discovery of the relevant market prices of individual contributions within the team, and not the different, allegedly non-market nature of inter-firm relationships. The costs of discovering individual contributions within the team are not different praxeologically at all from transaction costs as the costs of discovering the market prices, pertaining to enforcement and monitoring of the observance of ordinary contracts among the market participants in the conventional Coasian analysis. In both cases, the owner of a productive input makes a contract with other market participant (Cheung, 1983) and is equally bound to solve the same kind of problems of discovering the best prices and enforcing the contracts. The only difference between those two cases (firm and market) is an irrelevant one inputs used in the first case are different from those used in the second case. However, the costs of discovering the price of individual contributions within the team work or of enforcing and monitoring the wage contracts are praxeologically indistinguishable from the conventional Coasean transaction costs on the market.8 Both settings include the same concerns of the cost of information, of making and maintaining contracts, insufficient and limited knowledge and so on. Problems of information costs, monitoring contracts, and structural uncertainty are with us, within the firm or outside it. Prices guide the operations of management within the firm, just as they guide the operations of an
One of the Austrian authors who clearly understands this is Pascal Salin. He observes that the illusion of a firm as a hierarchy which is fundamentally different from the market, stems from asymmetry in monitoring costs between managers and workers: Thus, the manager spends far more time ensuring compliance of the workers than the workers spend ensuring compliance of the manager. This differentiation of roles and monitoring tasks gives the impression that there is a hierarchy. Again, let us be clear, the manager is not a commander-in-chief of an army of workers. A well-functioning capitalist firm incorporates monitoring procedures, but no hierarchical relations. It could even be said that the capitalist firm has been invented because it is not a hierarchical system. (Salin, 2002, p.9)
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entrepreneur when he makes a contract on the open market. So the Coasian and Austro-Coasian limiting of the scope of those problems to the firm is without a basis. It is equally wrong to assert that from the fact that it is hard to determine the price of individual contributions within the teamwork it follows that inter-firm cooperation is not guided by the prices at all, as well as to say that the presence of positive transaction costs on the open market entails that cooperation on the open market is not guided by prices whatsoever. There are costs of discovering the relevant market prices within the firm and outside it. The only difference is in the type of goods and services the prices of which we need to discover. 4. Firms, cartels and vertical integration In this section we shall try to further elucidate why not only in the neoclassical, but also in the Austrian setting, there is no way to provide any meaningful and non-tautological definition of the firm. This will be shown by analyzing cartels and vertical integrations. Nicolai Foss (2001), relying upon the Mises's contribution, objects to those who try to understand the firm in categories of market analysis: "In his critique of market socialism Mises (1949) pointed to the folly of "playing markets" and I draw on his overall argument that bringing coordination mechanisms characteristic of market organization into a planned organization is inherently problematic." So, according to Foss, any attempt to question a standard Coasean notion of the firm as a commanding hierarchy with the clear outside boundaries toward the market means just repeating mistakes of the market socialists who wanted to play the market. However, Mises himself also "played the market" in the same way, to begin with. In the following passage he explains, contrary to his general theory about the strong difference between the entrepreneur and the manger/firm, that market very well exists also within the firm: "Operation of the market does not stop at the doors of big concern...It permeates all its departments and branches...It joins together utmost centralization of the whole concern with almost complete autonomy of the parts, it brings into full agreement responsibility of the central management with a high degree of interest and incentive of the subordinated managers" (Mises, 1945, p. 47). So, an almost complete autonomy of the parts of the "firm" exists, the market "permeates" all branches and divisions of the firm, and combines centralization with the highest degree of competition. The profit centers within the firm not only have a substantial autonomy in conducting business, but their profitability is independently evaluated on the market via the transfer prices (Rothbard, ibid). This description of the firm is similar to some descriptions of the cartel we are accustomed to; firms in cartels unite competition and cooperation, price
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transactions and joint coordination of business. They cooperate in one area, e. g., through price-fixing or quality standardization, while competing in the other, e. g., services (Salin, 1991, Richardson, 1986) providing that way a productive service to the society, that needs a combination of homogenization and differentiation of products. Moreover, strictly speaking, we have no praxeological way of distinguishing between the highly sophisticated and decentralized Misesian big firms or "concerns" and classical "cartels". What do a firm's independent profit centers do that independent firms within cartels do not? Both "join together utmost centralization of the whole concern with almost complete autonomy of the parts". Praxeologically, the firm and the cartel are very hard to distinguish. Pascal Salin points out that the most productive way of describing the cartel is that it is a firm, which is in the process of splitting into separate profit centers, with different owners. Instead of viewing the cartel as a set of firms which are about to merge, it may be both more realistic and more efficient to consider it as the ultimate stage at which a big firm has been decentralized into various decision centers and, ultimately, split into independent profit centers with different owners." (Salin, 1991, 46). Therefore, the question of where to set the boundary between the firm and the cartel is quite an artificial issue without the theoretical ramifications whatsoever, and probably has much more to do with the tax laws and government regulations rather than with some a priori theoretical considerations. Therefore, the horizontal integration and disintegration function in the way that effectively abolishes praxeological differences between the firm and the cartel. However, the problem is even more far-reaching than that, and it can be observed in vertical integration as well. Steven Cheung shows that many contractual arrangements can be seen both as a "firm" and as a "market", depending only upon how tax authorities and laws define some particular economic activity. He cites two very interesting examples. The first one is where the owner of an apple orchard contracts with a beekeeper, to pollinate his fruits. The question that Cheung posed to Coase was do we have here one or two firms? According to Cheung, this contractual arrangement at the same time could be a hive-rental contract, a wage contract, contract sharing of the apple yield, or a combination of these. Economics cannot help us decide. Or even better, consider the second of Cheung's examples, which even more casts doubt on the thesis that the firm can be separated from the market, and conceived as a commanding entity. The price signal in this example is transmitted from the "market" via several intermediate steps toward the final consumer in a way that strongly resembles the firm's operation, but at the end of the day we cannot be sure whether the whole enterprise is a firm or not. A landlord wants to build a house; he makes a contract with a building contractor. The contractor subcontracts with a hardwood floor contractor for that part of the job, on the basis of the price per square foot. This subcontractor imports wood material and makes a sub-subcontract with a vendor
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for a price per square foot. Finally, the sub-subcontractor employs workers to provide wood for a wage (Cheung, 1983). The question is how many firms do we have in this case one, two, three or four? Cheung notices that e.g. Hong Kong laws consider every party to be responsible for paying taxes, and hence as separate "firms", but economic analysis also shows that all four stages are vertically integrated via transfer prices, and thus fulfill all the necessary conditions to be treated as the parts of a single firm. The only way to decide how many firms we have here is to draw the line somewhere arbitrarily, using the regulation or tax laws as the benchmark. "The truth is that according to one's view a "firm" may be as small as a contractual relationship between two input owners, or, if the chain of contracts is allowed to spread, as big as whole economy". (Cheung, 1983) A different way of emphasizing the same point is to say that both the firm and the market are always combinations of competition through prices and cooperation, or, as Cheung puts it delegations of right to use and transmission of prices information are matters of degree (emphasis added). So, price coordination of economic activity, or Misesian entrepreneurship, very well exists "within" the "firm", as well as coordination by delegating the right to use exist "outside" it (in cartels for example, but also in joint ventures, franchising contracts and so on). It does not make much sense to try and explain what the firm is and what its boundaries are, by referring to the "non-market" forms of coordination as its distinctive feature. The difference between the firm and the market is the difference in some details of contracts, not in the type of relationship between the individuals.9 As Demsetz pointed out, we have no way of sharply distinguishing between an open market purchase and internal managerial decision, because a firm that buys the factors on the open market from other firms also pays the managerial costs of these other firms; on the other hand, a firm that produces something in-house out of inputs bought on the market also buys the transaction costs of those other firms (Demsetz, 1988;145) . Using the Austrian arguments Mathews echoes the Demsetzs analysis of the problem. It is, according to him, pointless to draw a precise distinction between managing and buying: Buying an input involves a whole series of decisions that amounts to managing; making an input requires the firm to use the market for managers. In other words, the firms make-or-buy decision is not a decision about whether to manage or use input markets; it is a managerial decision about which input market to use (Mathews, 1998, 43). As an illustration, let's imagine an entrepreneur who buys the components for a machine on the open market, assembles them and then sells the final product (the machine) on the market again. What is going to change if he
For this, see Cowen and Parker, e.g. "Rather than difference between the firm and the market as a resource allocator involves what might be more usefully viewed as subtle difference relating to the form of contracting" (Cowen and Parker 1997, p.15)
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decides, instead of buying the components, to hire five people (create a firm) to produce the same components out of raw materials bought on the market? Would his enterprise of producing and selling this machine suddenly become a non-market in nature? In what sense buying the physical product from other people is a market transaction, while buying the services of other people is engaging in central planning or exerting the commanding authority? Mises and Rothbard, as well as their followers in Austrian orthodox theory of the firm were contradictory in explaining the basic relationship between the firm and the market; on the one hand, all of them use or implicitly assume the Coasean notion of a firm as a planned island (island of incalculability) in the competitive sea, and occasionally even ridicule the attempts to play the market within the firm. However, at the same time, starting with Mises and Rothbard themselves, they often emphasize the importance of transfer prices in coordinating the inter-firm operations. All of them, again led by Mises and Rothbard, believe that it is essential for the firm that transfer prices are based on the real market prices. In other words, they themselves are playing the market within the firm. Even more strikingly, Mises emphasizes that ...whatever people do in the market economy, is the execution of their own plans. In this sense every human action means planning. What those calling themselves planners advocate is not the substitution of planned action for letting things go. It is the substitution of the planner's own plan for the plans of his fellow-men. (Mises, 1981). In what sense then the entrepreneur as a leader of the firm is planning, while the worker or manager are not planning? If the individual planning on the basis of market prices is a universal praxeological fact (as Mises seems to suggest in the quoted passage), how then the same individual planning on the basis of market prices can be a differentia specifica of an entrepreneur's activity exclusively? To conclude, even within the Austrian camp it is not clear what the firm is; when trying to emphasize the role of entrepreneurs, the Austrians derogate the firm to a centrally planned puppet of the money-market speculator. However, when explaining the calculation problems of socialism they point to transfer prices and other market mechanisms as part and parcel of every successful firm and sharply contrast the individual and collective or central planning, which (contrast) undercuts the basis for the theory of the firm as a central planned entity. In the prevailing Austrian theoretical experience, just like in the neoclassical Coasean one, a firm is in praxeological sense indistinguishable from a cartel, joint venture, franchising business or any other set of contracts which in some way combine price competition and delegation of rights to use an asset. Our conclusion from the previous analysis is that the firm should be seen in the Austrian context as a specific contractual arrangement between the entrepreneur and the outside economic environment, or entrepreneurial speculation in various input markets, not as some kind of central-planning
23
instrument of the entrepreneur. All people are owners of some productive factor, capital, land or at least their labor. They seek to contract with other people in order to improve their economic condition. If we would like to speak in terms of planning instrumentalization, we could equally say that an entrepreneur is a planning instrument of a worker, as well that a worker is an entrepreneur's instrument. As we already emphasized, when market arrangements take the shape of labor contracts, i.e. when an entrepreneur decides that his most profitable course of action is to speculate in the labor market, i.e. to employ labor inputs or services instead of making a contract for a final product, we often speak about the firm. However, often we do not know exactly how to distinguish between firm and non-firm contracting in labor and services markets. As Steven Cheung says: "...it is futile to press the issue what is or what is not a firm. If each individual is private input owner of his own labor, if nothing else then almost all individuals in the society are bound by contracts when they compete and interact" (Cheung, 1983, 18). The most fundamental thing in this connection is that an entrepreneur has the price signals, irrespective of whether he speculates by hiring labor or by buying an intermediate product on the market. He is always in some market. A firm is efficient to the extent it allows to the entrepreneur to speculate based on the market prices of inputs. Rothbard's warning that the widening of the area of economy coordinated by central planning brings about the increased costs of coordination is quite appropriate, and it is clear that the firm cannot be viewed as a centrally planned entity exactly for that reason. If it were a central planning unit, then it wouldn't have any reason to exist. It is impossible to reconcile the idea that central planning diminishes the economic efficiency (and that the firm is a centrally planned entity in the same time), with the basic assumption that the firm is a problem-solving tool of the market, which exists to satisfy the real demands of the market economy. The "firm" cannot be the problem and the solution at the same time. Conclusion Both the classical Coasean theory of the firm and a Misesian update with entrepreneurship as an appendix to the centrally planned firm are wrong. There is no island of central planning, surrounded by a sea of market transactions; there is only a multitude of contractual arrangements. The three part Austrian theory of the firm (firm, market and the entrepreneur as a connection between the two) developed as a synthesis of Coase's, Mises's and Rothbard's contributions should be in my view abandoned and replaced by a program of integrating the contractual tradition (Demsetz, Alchian, Jensen/Meckling, Cheung) with the Misesian praxeology. In this endeavor, the theory of economic organization
24
should have two basic pillars, entrepreneurship and contract arrangements through a wide range of different markets (capital, managerial, labor, inputs...). A firm is a nexus of those markets, legal fiction for various types of contracts of free individuals seeking to improve their economic condition. Literature: - Alchian Armen, Demsetz Harold (1972), "Production, Information Cost and Economic Organization", Journal of Political Economy. - Bittlingmayer George (1999), The Market for Corporate Control, in Bouckaert, Boudewijn and De Geest, Gerrit (eds.), Encyclopedia of Law and Economics, Volume III. The Regulation of Contracts, Cheltenham, Edward Elgar, 2000. - Cheung Stephen (1983), "Contractual Nature of the Firm", Journal of Law and Economics, Vol 26, no.1 pp.1-23 - Coase Ronald (1937), "The Nature of the Firm, Economica, New Series, Vol. 4, No. 16, pp. 386 - 405. - Cowen Tyler and David Parker (1997), Markets in the Firm; A Market Process Approach to Management, London, Institute of Economic Affairs. - Demsetz Harold (1983), The Structure of Ownership and the Theory of the Firm, Journal of Law and Economics, Vol. 26, No. 2. - Demsetz Harold (1988), "The Theory of the Firm Revisited, Journal of Law, Economics, & Organization, Vol. 4, No. 1, pp. 141-161.. - Fama F. Eugene (1980), "Agency Problems and the Theory of the Firm", Journal of Political Economy, vol 88, no. 2. - Fama F. Eugene, Jensen Mihael (1983), "Separation of Ownership and Control", Journal of Law and Economics, Vol. XXVI. - Foss Nicolai J. (1994), "The Austrians as Precursors and Critics of Contemporary Theory of the Firm", Review of Austrian Economics, 7(1), pp. 3166.
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- Foss Nicolai J. (2001), "Misesian Ownership and Coasian Authority in Hayekian Setting: The case of Knowledge Economy", The Quarterly Jurnal of Austrian Economics, vol 4, no. 4, pp. 3-24. - Foss J. Nicolai, Klein Peter (2005), "Entrepreneurhip and Economic Theory of the Firm: Any Gains from Trade?", in Rajshree Agarwal, Sharon A. Alvarez, and Olav Sorenson, eds, Handbook of Entrepreneurship: Disciplinary Perspectives (Kluwer) - Huelsman Guido Joerg (2004), "The A Priori Foundations of Property Economics", The Quarterly Journal of Austrian Economics, 7(4), pp. 41-68. - International Chamber of Commerce Australia (2002), Submission to the Trade Practice Act (1974). - Jensen Michael, Meckling William (1976), "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure", Journal of Financial Economics, Vol. 3, no. 4, pp. 305-360. - Jensen M., Meckling W. (1983), "Corporate Governance and Economic Democracy: An Attack on Freedom", Proceedings of Corporate Governance, A Definitive Exploration of Issues, ed. H. Elzinga. - Klein Peter (1996), "Economic Calculation and the Limits of Organization", The Review of Austrian Economics, vol9, no.2, pp. 3-28. - Klein Peter (1999), "Enterpreneurship and Corporate Governance", The Quarterly Journal of Austrian Economics 2(2), pp. 19-42. - Foss, Nicolai J., and Peter G. Klein. (2005), Entrepreneurship and the Economic theory of the Firm, In Rajshree Agarwal, Sharon A. Alvarez, and Olav Sorenson, eds., Handbook of Entrepreneurship: Disciplinary Perspectives. Norwell, Mass: Kluwer. - Klein, Peter, and Sandra Klein. 2001. Do Entrepreneurs Make Predictable Mistakes? Evidence from Corporate Divestitures. Quarterly Journal of Austrian Economics 4(2): 323. - Klein Benjamin, Crawford Robert G,. Alchian Armen (1978),Vertical Integration, Appropriable Rents, and the Competitive Contracting Process : Journal of Law and Economics, Vol. 21, No. 2, pp. 297-326
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- Langlois Richard, Foss Nicolai (1997), "Capabilities and Governance; the Rebirth of Production in the Theory of Economic Organization", DRUID Working Papers No. 97-2) - Mathews Don (1998), "Management vs the Market: An Exaggerated Distinction", The Quarterly Journal of Austrian Economics, vol 1. no. 3, pp. 4146. - Mises Ludwig von (1981), Socialism, Liberty Fund, Indianapolis. - Mises Ludwig von (2004), Human Action, Mises Institute, Alabama. - Mises L.v. (1951, 1 ed) (1980), Planing For Freedom, Libertarian Press. - Mises L.v. (1990), Economic Calculation in The Socialist Commonwealth, Ludwig von Mises Institute, Alalbama. - Rothbard Murray (2004), Man, Economy and State, Mises Institute Alabama. - Salin Pascal, (1991), "Cartels as Efficient Productive Structures", Review of Austrian Economics, Ludwig von Mises Institute, Alabama. - Salin Pascal (2002), "The Firm in a Free Society: Following Bastiat's Insights", Journal of Libertarian Studies, Vol. VI, no.3, Ludwig von Mises Institute, Alabama. - Zingales Luigi (1998), "Corporate Governance", The New Palgrave Dictionary of Economics and Law, London, McMillan, pp 497-511. - Williamson Oliver (1985), Economic Institutions of Capitalism, New York: The Free Press .
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Journal des Economistes et des Etudes Humaines

Volume 16, Number 1 2010 Article 3

Firm as a Nexus of Markets

Firm as a Nexus of Markets

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

Jankovic: Firm as a Nexus of Markets

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

Jankovic: Firm as a Nexus of Markets

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

Jankovic: Firm as a Nexus of Markets

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

http://www.bepress.com/jeeh/vol16/iss1/art3 DOI: 10.2202/1145-6396.1241

Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010

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