The new theories of the firm

General economic equilibrium theory considers relations among legally independent economic agents and tries to show how, under certain assumptions, equilibrium solutions may be reached. A problem thus arises: why should the firm exist?

Let us recall that while within the market legally independent agents enter in relation with each other, within each firm organisational set-ups

5 Akerlof's example is that of the used cars market: the buyer is unable to exactly evaluate the conditions of the used car offered for sale, and it is likely that if the price demanded is the average one for a car of that age, the specific car offered for sale is of an inferior quality compared to the average one. The cases to which this theory is applicable are numerous: from selection among loan applications to selection among potential insurance clients, up to selection among workers on hire.

prevail based on 'command', that is on hierarchy and on centralisation of decisions and control over their execution. What is it then that determines the boundary between these two different forms of organisation of economic life, market and command?

Within the neo-classical tradition, the most widely accepted answer may be traced to an article published in 1937 by the American Ronald Coase (b. 1910, Nobel prize in 1991), whose ideas have been taken up and developed by others mainly over the past twenty years, after a long period of near oblivion. Coase stressed that market transactions have a cost for participants: it is necessary to collect information, search for a counter-party ready to exchange, negotiate over prices and other conditions. All this implies time and expense. In the absence of the organisational structure of the firm, each worker would have to bargain to acquire a variety of inputs - the semi-finished products and raw materials he himself uses, his working tools, engineering services, and so on - and then to bargain for the sale of his own product, which in general will only be a semi-finished product or part of the final product. The firm allows for simplification, drastically reducing the number of necessary transactions and replacing the bargaining over all aspects of the productive process with an organisation based on command (that is, on a hierarchical deci-sional structure). When the size of the firm grows, its internal organisation becomes more and more complex, less and less efficient; once a certain point - corresponding to the optimal size of the firm - is passed, the costs of expanding relations based on command become higher than the costs of recourse to exchange, that is, to the market.

A quite different answer to the question concerning why the firm exists is provided by radical economists looking to economic power relations. The American Stephen Marglin (1974) maintained, for instance, that the superiority of the firm - in particular, of the large firm - as a form of organisation of production is based on technological choices (mass production of standardised goods) which were not necessitated. An alternative line of technological development would have been possible, based on flexible production; such an alternative would have favoured organisational forms more similar to artisan shops than to large-size modern manufacturing industry. The technological line of mass scale production of standardised goods, thus the big corporation, prevailed - according to Marglin - mainly because this favours appropriation of the surplus on the part of the dominant classes, thanks to control over the productive process made possible by the organisational form of command and by division of labour within the firm.

Marglin's ideas have been severely criticised by the American historian David Landes (1986). The latter reproposed Smith's original answer:

the modern firm prevailed over artisan shops because it allowed cost reductions, by exploiting economies of scale obtainable through division of labour in the productive process and through the consequent introduction of machinery. However, it should be noted that such an answer lies outside the approach based on the traditional notion of equilibrium. Indeed, according to Smith's line of argument, firms do not have an optimal size: their growth takes place in time, in the course of a dynamic process which cannot be interpreted by the static analysis of traditional theory.

Growth in firm size, which brings big corporations to the fore, leads to another problem: who controls the firms? Public companies have top managers who are in general not the proprietors, who are often very numerous.

American economists Adolf Berle (1895-1971) and Gardiner Means (1896-1988), in a book published in 1932, indicated in the public company and in the separation between owners and managers the characteristics of a new form of society, managerial capitalism. In an initial stage of the process of industrialisation, competitive capitalism, small firms directly managed by their owners prevailed. Subsequently, with the rise of big firms organised as public companies, ownership is subdivided among many small shareholders; the managers of the firm acquire sufficient autonomy to become the real protagonists of economic life, assuming responsibility for all decisions relative not only to the current life of the firms but also to strategic long period choices.

Many economists (among them the American William Baumol, b. 1922, in a book published in 1959), sharing Berle's and Means's ideas, inferred from them a change in firm objectives: the objective of profit maximisation had prevailed in the stage of competitive capitalism, when firms were directly managed by their owners; in the stage of managerial capitalism other objectives prevail, especially sales maximisation, which better corresponds to the interests of the firm's managers.

Obviously the managers have to consider the risk of being replaced, at the shareholders' annual meeting, if a new group of owners takes over the firm. This may happen when many shareholders, dissatisfied with the management of the company and in particular with their dividends and the share price, sell their shares on the stock market; in this case the firm's takeover by a new group is favoured, since this new group can more easily acquire a sufficient number of shares to gain a majority in shareholders' meetings. It is on this constraint on managers's freedom of action that the 'theory of managerial capitalism' is based, as developed by the English economist Robin Marris, in a book published in 1964.

Another stream of research concerns the market power of large firms. The Italian Paolo Sylos Labini (b. 1920) and the American Joe Bain (1912-93), in two books both published in 1956, developed a theory of oligopoly (focusing attention respectively on the cases of concentrated and differentiated oligopoly), considered as the common market form, compared to which pure competition and monopoly constitute two polar limit-cases. In the case of oligopoly, the firms present in the market are partially protected from competition of potential entrants by a 'barrier to entry', the study of which is the subject of the theory. Such a barrier is not insurmountable (in which case there would be monopoly, while the case of a non-existing barrier corresponds to perfect competition); its size, hence the difficulty in overcoming it, depends on a series of factors discussed in the writings of Bain and Sylos Labini and in subsequent literature on the subject. For instance, in the case ofconcentrated oligopoly, the size of the barrier to entry depends on the minimal technologically optimal size of the plant, and in general on economies of scale, which require the new firm to enter the market with a rather sizeable minimum production, such as not to find a market outlet at current prices; in the case of differentiated oligopoly, it depends on advertising expenses necessary to impose the new trademark on the market. Defended by these barriers, firms already active in the market may enjoy profits well above the competitive level and a certain freedom of action, though within the limits determined by the risk of entry of new competitors into the sector.6

Theories of the behaviour of the large firm which display noticeable similarities to those of Marris, Bain and Sylos Labini have been developed by some Keynesian economists. Let us recall in particular the Austrian Josef Steindl (1952), the American Alfred Eichner (1976) and the Englishman Adrian Wood (1975). These economists took over the Keynesian view according to which investment decisions by the firms constitute the primum mobile in the evolution of the economy. Once the level of investments to be realised has been decided, firms must decide how to finance them; for a number of reasons, they prefer to use internal sources (profits not distributed as dividends to shareholders) rather than debt.7 Therefore, according to the post-Keynesian theory of the firm,

6 This theory was reformulated by Modigliani 1958 in terms compatible with traditional neoclassical analysis, with a 'neoclassical synthesis' parallel to that realised by himself concerning Keynes's theory.

7 The 'Modigliani-Miller theorem', according to which under conditions of perfect competition and perfect knowledge the different sources of financing are equivalent (cf. Modigliani and Miller 1958), is considered inapplicable, explicitly or implicitly, by these economists, who in general consider non-competitive market conditions and imperfect knowledge as prevalent.

entrepreneurs set product prices so as to obtain a profit margin sufficient to finance the desired level of investments.

Quite naturally this theory may refer only to firms endowed with some market power, which are able to set autonomously their product prices and which in doing so are not rigidly constrained by competition with other firms. However, even in the case of oligopolistic firms it is to be doubted whether prices may be set freely, so as to generate an amount of profits sufficient to finance any amount of investments the firms desired to enact. We may thus interpret Keynesian theories of the firm as concerning utilisation of margins of choice which top managers enjoy in the presence of strong elements of uncertainty and of oligopolistic conditions.

A development of the theories of market forms based on barriers to entry is the contestable markets theory developed by Baumol and others (1982). Perfectly contestable markets are those for which there is no cost of entry or exit. In such markets, no firm can enjoy extra-profits. Indeed, any opportunity of extra-profits, even temporary ones, immediately attracts new firms into the market. Absence of exit costs allows new firms to avoid any risk, for instance due to reactions of firms already present in the market: if market conditions change and the extra-profits turn negative, the new firm can immediately exit without having to bear any cost (with what is commonly called 'hit and run' behaviour). Exit costs mainly derive from existence of fixed capital goods which cannot be reutilised once the activity for which they had been acquired has been abandoned: the so-called 'sunk costs'. This element constitutes the main novelty of contestable markets theory relative to the theory of market forms based on barriers to entry.

Completion of this quick survey of the modern debate on the theories of the firm requires at least recalling evolutionary theories, which we have already mentioned in the conclusion of the chapter on Marshall. These theories have been proposed to explain in particular the behaviour of the firm and the industry in the process of technological change. In the approach proposed by the Americans Richard Nelson (b. 1930) and Sidney Winter (b. 1935) in a book dated 1982, the industry structure in any moment in time is considered as the result not of a process of maximisation (of profits or sales), but of an evolutionary process. Some firms may grow more rapidly than others, some go bankrupt while others are started up; the industry evolves over time as the result of the vicissitudes of firms within it. As in biology, recourse is proposed to mathematical stochastic models, which are able to allow for the random element always present in economic events, but also the different probabilities of different events. The 'genes' of firms - which determine the identity of each of them, transfer from one to the other the main behavioural features and undergo 'mutations' over time - consist of'routines': standard procedures adopted by the firm in production, product commercialisation, financial management, and so on. In a market economy the routines which prevail, and thus determine the dominant features of firms, are those which ensure success, namely those which in the long period ensure profit maximisation.

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