Chapter Content
Okay, so, um, this section is all about, like, the modern theory of the firm, right? And it starts with this kind of funny quote attributed to Ely Devons by Ronald Coase, saying that if economists wanted to study horses, they wouldn't, like, actually go look at horses. They'd just sit around and, like, imagine what they would do if they *were* a horse. Which is, you know, kind of a dig at economists for being too theoretical, maybe?
And that idea, that economists are too disconnected from the real world of business, it's been around for a while. Apparently, this Clapham guy criticized Adam Smith back in the 1920s for not, like, actually visiting factories. And a businessman, David Sainsbury, even said that economics, as a field, still kinda sees firms in this, like, abstract way.
So, enter Igor Ansoff. This guy, he was a big deal at Carnegie Mellon. They were trying to make business education more scientific. And Ansoff argued that microeconomics, the usual economic theory of the firm, wasn’t really helping with making decisions in real companies.
And he had a point, right? There was this other guy, Joe Bain, considered, like, the father of modern Industrial Organization Economics. But even he said that his work was about the environment companies operate in, not how they should run their *internal* operations. He was looking at industries, not individual companies.
Then you had F.M. Scherer, who built on Bain's work. His framework, Structure-Conduct-Performance, basically said that the industry structure determines how companies behave, and that determines their performance. But Scherer was focused on things like "allocative efficiency" and "full employment" – public benefits, not the private benefits to the companies themselves.
So then Michael Porter, like, literally crossed the river at Harvard to bridge the gap between economics and strategy. His "five forces" framework, suppliers, customers, etc., it's basically S-C-P translated into business language. But it still doesn’t explain why different companies perform differently even when they face the same five forces. It kind of ignores the whole issue of how to outperform competitors.
And because of all this, these economic models have had more influence on antitrust and regulation than on actual business strategy. I mean, a friend of mine, he did some consulting work for IBM back in the '80s, and, you know, his analysis was helpful in their antitrust case, but it wasn't really relevant to how they ran their business.
And honestly, to this day, economics is still mainly used for public policy toward business, not business policy itself. Most businesspeople just think economics is about forecasting growth and inflation, which they want, but don't really trust.
So, there was this guy, Sir Denys Henderson, chairman of a big British company. He got frustrated with economists because they couldn’t predict the economic events of the '70s and '80s. He wanted reliable predictions, but he couldn't get them. An economist, Sir Alan Budd, told him that economic systems are too complex for reliable prediction. And you know, I suggested maybe looking at microeconomic analysis of firms and markets, but Henderson was still super frustrated. He just wanted those forecasts.
It's this universal "need to know," right? People want certainty that just isn't there. I was lucky to combine my academic career with meeting real businesspeople, and it helped me see the uses and limitations of economic models.
These models, they often assume that people are "rational" and maximizing their own interests. They describe "small worlds" where you can list all the opportunities and constraints, and then use math to make predictions. But that's not really how the real world works.
Friedrich Hayek, he said that we have to be careful about "the pretense of knowledge." He argued that we can use math to describe the general character of a pattern, but we can't necessarily predict the exact numerical values. It's dangerous to act like we have more knowledge and power than we actually do.
Real businesspeople, they operate in "large worlds," where problems are ill-defined and there are no objectively correct answers. They can't maximize because they don't have all the information. They face radical uncertainty. They don't even know what might happen.
So, instead of demanding unanswerable questions, we need to reformulate the problem and provide information that's actually useful for decision-makers.
There’s this idea of “saltwater” versus “freshwater” economics, with freshwater economists, like those in Chicago, being more conservative.
Ronald Coase’s article "The Nature of the Firm" is super important. It basically said that firms exist because sometimes it's cheaper to coordinate things internally, through hierarchies, than through markets. Sometimes markets are better, sometimes hierarchies are better. It's about the relative costs and efficiency of each.
He said that trading in markets is always costly. But subordinates might not always do what they're told as well as superiors would like.
The choice also depends on "hold-up" problems. This is, when people make investments that are specific to a particular relationship, their bargaining power changes. Remember the fishermen? Once they were in Alaska, the canners couldn’t easily replace them.
To avoid hold-up problems, you can write a really detailed contract. But the world is too uncertain for that. No contract can anticipate everything. And by the time you need to adapt, everyone's already committed to the relationship.
One solution is vertical integration – when a company buys its supplier. Then there's no incentive to exploit the other side because you *are* the other side. So General Motors bought Fisher Body, the company that made their car bodies, to avoid hold-up problems with the tooling.
So, Coase interacted with people at the Chicago law school, and this "law and economics" movement started. The idea was that law could be viewed from the perspective of economic efficiency. And the Olin Foundation gave money to support this approach.
Then there's this article by Jensen and Meckling on the theory of the firm. They said that a corporation is just a way to facilitate agreements between individuals, like shareholders, employees, and customers. It's just a "nexus of contracts." Everyone is self-interested, and all relationships are transactional.
This contrasts with the idea of "corporate personality," which says that the firm has a life of its own, separate from its stakeholders. It owns assets, and its directors and employees owe duties to *it*. It has rights and obligations.
So, there's tension between these two views. The "nexus of contracts" approach says the corporation isn't real, while corporate personality says it is. And this "nexus of contracts" approach became super popular in law and economics, even though the economy was becoming dominated by large corporations with professional managers. So, like, reality and theory were moving in opposite directions.
Interestingly, Jensen and Meckling's ideas are similar to Marx's view of the capitalist firm, and even Ayn Rand's. Sometimes left and right agree when they're both wrong, I guess.
So, another way of thinking about it is that the firm as a problem of contract design, because information isn't perfect and it's unevenly distributed. How do you design contracts to make sure everyone contributes to the objectives of the firm? That's the principal–agent problem. You want to make sure everyone's incentives are aligned.
This led to a convergence between economics and law. The hold-up problem and the principal–agent problem became central to economics. People even won Nobel Prizes for their work on these topics.
Modern textbooks, like those by Margaret Meyer, Paul Milgrom, and John Roberts, frame the organization around the principal–agent problem. They say that delegating authority is important, but you also need to make sure that decision-makers share the organization's objectives. You need incentives to align individual and organizational goals. So, the goal is to create incentives so that individuals will act as if the organization's objectives were their own. But then, what are the objectives of the organization, and who gets to decide what they are?