Theories of the Firm



The corporation is the most important of modern economic institutions. The nineteenth century saw the emergence of business organisations with many employees and differing shareholders. Mostly, in the first instance, railroads and railways: bank and resource companies followed. And subsequently the manufacturing corporations which came to dominate the industrial scene in the twentieth century. (Hannah,1976) When Fortune produced its first list of the world’s largest corporations in 1956, nine of the top ten were manufacturing companies – three in automobiles, three in steel. (Table 1)

Table 1:





1 General Motors 12,443.3 1,189.5
2 Exxon Mobil 6,272.4 709.3
3 Ford Motor 5,594.0 437.0
4 U.S. Steel 4,097.7 370.1
5 Chrysler 3,466.2 100.1
6 General Electric 3,095.4 200.9
7 Esmark 2,404.1 22.9
8 Bethlehem Steel 2,096.6 180.2
9 Armour 1,967.7 10.1
10 DuPont 1,909.2 431.6

Source: Fortune (1956)

The nexus of contracts

The rise of such corporations led economists to give belated attention to the theory of the firm. Credit for founding this branch of knowledge is generally given to Ronald Coase, whose 1937 article (based, he later explained, on ideas put forward five years earlier when he was only twenty-one) remains seminal. (Coase, 1937, 1991)   Transactions costs were central to Coase’s argument. The boundaries of the firm were defined by the relative costs of two methods of co-ordination: markets and the price mechanism versus central direction, and management hierarchies.

Companies such as General Motors and du Pont – companies featured in Alfred Chandler’s magisterial account (1962) of the rise of the diversified manufacturing corporations – appeared to have extensive need of hierarchy, with extensive horizontal diversification and vertical integration. Oliver Williamson (1975) greatly extended the Coaseian framework, emphasising the importance of idiosyncratic investments which were specific to the needs of a particular product – including both physical equipment and acquired skills. If the manufacture of a part required specialist tooling and knowledge, then the related functions would take place within an integrated firm.

This firm was ‘a nexus of contracts’. (Jensen and Meckling (1976), Easterbrook and Fischel (1989, 1993)).   This idea was present from the very beginnings of the modern corporation in the legal doctrine of corporate personality – people dealing with the firm transacted with a corporate entity, not the individuals who represented the organisation. From an economic perspective, the firm was at the centre of a web of legal agreements, with employees, suppliers, customers and lenders.

What of the position of shareholders? Legal agreements can never be sufficiently comprehensive to cope with all eventualities. Much of what is contracted is implicit, and the courts may identify and enforce implicit terms: but much remains to be resolved by hierarchy. Grossman and Hart (1986) Hart (1989) characterised the ‘owner’ within the nexus of contracts as the person who determines the indeterminate elements of inevitably incomplete contracts.   The shareholders, residual claimants to revenues and assets, and at least in theory collectively possessed of the power to enforce their will, fulfilled this role of arbitrators of whatever was not spelled out contractually.

Thus the problem of management is essentially reducible to the specification and resolution of principal-agent problems. And in the classic text of Milgrom and Roberts, this principal-agent problem explains the central issue of organisational design. Thus ‘although delegating authority to those with the information needed to make good decisions is an important part of good organisation design, it is of little use unless the decision makers share the organisation’s objectives. We have already mentioned incentives as a way to align individual and organisational objectives….. incentives and delegated authority are complements: each makes the other more valuable’. (Milgrom and Roberts, 1992, p.17). The contract is a device for creating incentives such that the individual (with local knowledge unavailable to persons more senior in the hierarchy) will act as if the objectives of the organisation (and, by extension of the previous argument, the shareholders) were his or her own.

The scale of the twentieth-century corporation made inevitable the separation of such shareholder ‘ownership’ from control. This issue had been noted even before Coase and Chandler, famously by Berle and Means (1932)   Such separation generated an additional principal agent problem: that of the shareholder ‘owners’ as principal and the executive managers as agent. The emphasis in Jensen and Meckling’s 1976 article on the need to align these interests, by designing appropriate incentive schemes proved highly influential, not least because its conclusions were so congenial to the executive managers themselves. Over the following decades explosive growth in the use of stock options was associated with explosive growth in the levels of executive remuneration.

Milton Friedman’s (1970) article ‘The Social Responsibility of Business is to Maximise its Profits’ may be one of the most cited articles ever published in the New York Times. Friedman’s assertion followed naturally from the identification of shareholders as ‘owners’ and managers as ‘stewards’, and that article may be seen as a precursor of the era of ‘shareholder value’. Jack Welch of General Electric is widely credited with inaugurating that era in a speech at the Pierre Hotel in New York soon after he took over as that company’s CEO. (Welch, 1982) Welch did not in fact use the phrase ‘shareholder value’, but it become more and more widely heard in the two decades that followed. Only in 2009, some years into retirement, would Welch describe shareholder value as ‘the dumbest idea in the world’. (Welch, 2009).

The core model of the modern firm, then, visualises it as a cascade of principal-agent problems.   That model was the logical culmination of what had earlier been described (though with a degree of scepticism which had increased over time) as ‘scientific management’. Shareholders–owners, too busy and too numerous to manage the business themselves, contract with executives to run the business. These executive functions include determination of the appropriate scope of the firm, integrating idiosyncratic activities within the overall common organisational structure, and contracting in competitive markets where there are multiple potential suppliers of homogenous inputs. Internal organisation requires decentralisation to those who hold the diffuse information required for efficient production, while incentivising them to use that information for the advantage of the firm rather than the holder of the information. The incompleteness of contracts requires that those with superior access to information are given appropriate incentives to internalise the objective of the firm – the maximisation of value for its shareholders. A suite of models of these kinds provides a rationalist and reductive account of the role and functions of the firm which is still pervasive.

Different forms of business organisation

The approach to the theory of the firm still dominant today was derived from observation of the American manufacturing corporations of the twentieth century. But, as that century came to a close, that type of business organisation came to be less and less representative of American industry – and the economic theory of the firm became more distinct from the study of actual business activity. And as business became global, the extent to which there are distinctive business organisations in countries with different history and culture became apparent.

General Motors would be displaced as the world’s largest car producer by Toyota, which only a few years earlier had been a small manufacturer of textile machinery. If the American firm was a nexus of contracts, Japanese business was characterised by an absence of formal contracts.   Elaborately hierarchical in one sense, the hierarchy was defined by deference rather than as a principal agent problem. And Toyota, in common with many other Japanese companies, functioned within a ‘keiretsu’ – a network of suppliers willing to engage in highly specific and idiosyncratic investment related to Toyota products without either the opportunity to sell in competitive markets or the need for an overarching hierarchy of common ownership. (See, for example, Miyashita and Russell (1994)).

Privately owned northern Italian business was characterised by clusters of firms. Independent entities within a small geographical area would specialise in the manufacture of particular products – the tie manufacturers of Como, the specialist metal workers of the Brescia valley, the suit makers of Prato, sharing knowledge and providing other kinds of mutual assistance. The notion of clusters was popularised by Porter (1990) who provides extensive accounts of both Japanese and Italian structures. But the most famous description remains that of Marshall (1890) – ‘the mysteries of the trade become no mysteries, but are as it were in the air’. The economies of these businesses were bound up in the social reality of the communities. But were they one firm, or many? Like the keiretsu, they seemed to be neither markets nor hierarchies.

And these differences in the nature of business organisation across countries were seen in the changing nature of US business itself. The trend to vertical integration seen in the earlier growth of manufacturing corporations was replaced by outsourcing and the construction of global supply chains. Companies such as distributors of branded apparel subcontracted the manufacture of shoes or clothes to low cost locations, mostly in Asia, and sold on the basis of design and branding. Production was in one location, value added accrued in another. The ‘make or buy’ was regarded as a key issue in the business community. But the approach to that decision, emphasising competences and capabilities rather than specificity and idiosyncrasy, was very different from that which was suggested by the nexus of contracts/markets and hierarchies tradition.

And by the early twentieth century, most of the world’s most valuable companies could be characterised in this way. (Table 2)

Table 2:

Largest companies by Market Capitalisation

April 2017

1. Apple 6. Facebook
2. Alphabet 7. Exxon Mobil
3. Microsoft 8. Johnson & Johnson
4. Amazon 9. J P Morgan Chase
5. Berkshire Hathaway 10. Alibaba

Source – Bloomberg

These firms were often described as platforms – Amazon was itself an online retailer, but also a marketplace. Microsoft and Apple offered technology through which others could do business; Google and Facebook were conduits for content produced entirely by other people. Uber and Airbnb, which claimed to have few employees at all, epitomised the virtual business. And was Berkshire Hathaway a capital market, or a hierarchy? The easy characterisations appropriate when business was characterised by General Motors, Exxon, and du Pont, no longer applied.

Other approaches

Somewhat different approaches to theories of the firm have been developed in at least three related disciplines – organisation theory, business history, and corporate strategy. Peter Drucker published Concept of the Corporation in 1946 and claimed, somewhat extravagantly, to have created organisational theory, at least as applied to business organisation. Reflecting many years later on a book which had achieved sales and fame far beyond the dreams of author or publisher, Drucker would say ‘(it) is not a book about business ….. it was the first book that looked upon a business as an organisation, that is, as a social structure that brings together human beings in order to satisfy economic needs and wants of a community’. (Drucker, 1983).

Businesses had for long commissioned hagiographic accounts of their founders and their origins, but Alfred Chandler’s Strategy and Structure, which appeared in 1962, established the writing of business history as a scholarly activity deserving of respect in its own right. Chandler focussed on the history of General Motors, the same company that had provided the impetus – and unprecedented access to its internal workings – for Drucker’s book. And little exegesis is necessary to see that it was businesses such as General Motors which Coase – a British born and educated economist who formulated his thesis on a visit to the United States in 1931 – had in mind in preparing his famous article.

Corporate strategy emerged as a subject, in business schools and through consultancies, in the 1960s. One of its principal founders, Igor Ansoff, was explicit about his motivation.

‘Study of the firm has been the long time concern of the economics profession. Unfortunately for our present purposes, the so called microeconomic theory of the firm which occupies much of the economists’ thought and attention, sheds relatively little light on decision-making process in a real world firm’. (Ansoff, 1965, p.16)

And indeed a discipline of corporate strategy emerged in business schools and consultancies in the 1960s and 1970s largely without regard to or reference to the economic analysis of the firm. Towards the end of that period, Michael Porter literally and metaphorically crossed the Charles River in an attempt to bridge the gap between economics and strategy. But Porter more or less ignored the theory of the firm: instead he used the structure-conduct-performance framework which had been the guiding doctrine of the institutionally minded industrial economics group in the Harvard economics department of the previous two decades. Porter’s ‘five forces’ framework is effectively a translation of the S-C-P approach into business language. (Porter, 1979)

Yet the weakness of that S-C-P/five forces framework as theory of the firm is immediately apparent. The strategy of the firm is assumed to be determined by the ‘five forces’ of suppliers, customers, entrants and substitute products, mediated by competitive rivalry. There is no explanation of why different firms, facing the same five forces, perform differently.

Resource based theory

A different view of the theory of the firm had been proposed in 1959 in Edith Penrose’s Theory of the Grown of the Firm. Penrose defined at the outset a perspective very different from what would become the transactions cost/market and hierarchies school. ‘All the evidence we have indicates that the growth of firms is connected with the attempts of a particular group of people to do something’.   And yet while Coase and Williamson would be awarded Nobel Prizes for their theorizing, Penrose would be largely neglected by subsequent generations of economists. It would be in business strategy that her ideas would make a real impact.

Penrose’s central insight was that a firm was not so much a nexus of contracts as a collection of capabilities – capabilities which might be the creation of ‘a particular group of people’ or might indeed be the ‘particular group of people, or the relations between them, itself.   This resource based theory of strategy, as it became known, was subsequently developed by Barney (1991) and Wernerfelt (1984). Only if these internal capabilities were valuable, rare and inevitable could they be a sustainable source of profit. The task of corporate strategy is to match the capabilities of the firm to its external environment. The boundaries of the firm are defined less by transactions costs than by the appropriate scope of the firm’s distinctive capabilities. That is why Apple sells music but not groceries.

Fifty years later, Ansoff’s comment that ‘the so-called microeconomic theory of the firm….. sheds relatively little light on decision making processes in a real world firm’ remains pertinent. It is impossible to construct a theory of the firm without insight from organisation theory, business history, and corporate strategy, and that the focus on principal agent models within a nexus of contracts diverts attention from the complex issues of organisational design. The focus on the firm as collection of capabilities gives a different, and more illuminating, perspective for understanding the extraordinary diversity of business organisation over geographies and over time.



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