Firms are a dominant institution in industrial capitalism. Firms’ organisation and decision making shape our experiences of work, the goods and services we consume, and the technology that will influence future generations.

Economists do not agree on how to conceptualise firms. Different theoretical approaches are used to answer different questions. Neoclassical economists reduce decision-making to a problem of maximisation of profits within certain constraints. Institutional economics explores the internal organisation of firms focusing on distribution of information, knowledge and incentives as the key to industrial efficiency.

There are number of themes that will be explored:

• technology and technological progress
• property rights
• organisation of economic activity
• morals and ethics

The neoclassical model identifies the firm’s profit-maximising output given demand and costs conditions. The model is influential and widely used. It generates predictions about the relation between market structure and firms’ behaviour (sometimes referred to the ‘Structure-Conduct-Performance’ paradigm).

Three key assumptions of the model:

• the idea of equilibrium is fundamental;
• timelessness: historical time is unimportant, decisions can be reversed;
• full knowledge about costs and revenues.

Standard analysis assumes that all the firms are identical. But what limits the size of the firm in neoclassical models? Why over time do some firms not grow to dominate the marker? One attempt to these questions was to develop the monopolistic competition model.

The assumption of perfect knowledge is an unsatisfactory. Neoclassical theorists recognise that entrepreneurs cannot know the future with certainty. The risk of loss can be incorporated into neoclassical theory by assuming that firm considers the probability of all possible future outcomes of its decision-making.

Firms that are indifferent to risk, given the same level of expected value of the projects, are called risk-neutral. Firms that dislike risk are risk-averse, and opt for less risky projects. Firms that seek innovation, carrying higher risks, are risk-seekers.

However, for some projects firms may be unable to assign probabilities to possible outcomes – may not even not know all the possible outcomes. Economists refer to this as uncertainty. Uncertainty creates problems for economic analysis since it appears widespread, and we therefore want to know how decision-makers behave under uncertainty.

New Institutional economics (NIE) retains the individualist assumption of neoclassical theory. The key question that NIE asks is, if the market is an efficient co-ordinator, why are some activities combined together in firms rather than being coordinated through markets – why make products inside the firm, when the firm can buy them in the market. NIE tackles the problem of defining the boundary between the market and the firm.

Much of neoclassical theory treats market and internal business transactions as costless. However, market exchange has many different types of costs: search costs, costs of bargaining, and costs of monitoring and enforcing contractual agreements. Internal business transactions have management costs of co-ordinating production, and costs of monitoring and supervising the workforce.

New institutionalists (Williamson, Coase and North) argue that where economic co-ordination could be organised more cheaply within the firm than through the market, this form of organisation would be chosen. The marginal decision to ‘make or buy’ then determines the size of the firm. A firm will expand until the costs of organising an extra transaction within the firm becomes equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm.

Moreover, NIE argue that there are initially two governance structures: market and hierarchical management. Markets are considered primary. Firms only emerge where hierarchy economises on market transactions cost.

Underlying the concept of transaction costs are assumptions that move away from the neoclassical theory. Transactions are costly because information is incomplete and the economic environment is uncertain. Also economic agents are opportunistic: ‘self-interest seeking with guile’. NIE assumes that economic actors are less than honest in promoting their interests. Since information is limited, opportunism increases the costs and risks of market transactions.

Transactions cost economics (TCE) considers the economic factors that influence a firm’s decision to buy-in (or make) a manufactured input or service, rather than producing (or purchasing) it. Oliver Williamson argues that at least four factors may force a firm to internalise transaction - to make rather than buy:

• specificity of assets: where physical and human assets are highly specific, firms will internalise; e.g., a firm (say, a car assembler) is vulnerable to another firm (say, car component supplier) acting opportunistically, so the car assembler may make rather than buy the car components;
• quality of the product: where the quality of a good or service is hard to assess, a supplier will have an incentive to behave opportunistically because negotiating and enforcing a market contract is difficult, so the firm may produce within its organisation;
• frequency of transactions: where a repeated market transaction among a small number of participants allows for an immense scope for opportunistic behaviour, a firm may internalise the transaction to reduce opportunism.
• environmental uncertainty: where a transaction is associated with a good deal of uncertainty, searching for relevant information is costly, so the firm’s internal supply may improve the information available;

According to NIE, internal disputes may be more easily and cheaply resolved than disputes over external contracts, which usually involve lengthy court proceedings. Thus, TCE provides one type of explanation for the size of firms and their boundaries.

However, Williamson’s work has been criticised for not sufficiently discussing costs of hierarchy: hierarchy also allows for considerable scope for opportunism – concealing information and incentives not to be efficient. Another criticism is that TCE fails to break free from the rational and self-interest assumptions of the neoclassical tradition. It is worth noting that TCE see incentives as an important influence on transaction costs. So to reduce costs, the firm has to change the incentive structure.

Old institutionalists emphasise norms and culture in understanding and explaining institutions such as firms and markets. An institution is defined as a complex set of socially learned and shared values, norms, beliefs, meanings, symbols and standards that describe the range of expected and accepted behaviour.

An institution is a well-established way of getting things done. It is not necessarily a legal or physical entity, though it is important. Legal agreements, customs, conventions and moral codes of conducts are institutions. Cultures and routines within firms are institutions as well.

Old institutionalism has influenced two groups:

• Behavioural theorists: a firm’s objectives arise from compromises among a coalition of key players within the firm.
• Managerial theorists: emphasises the role of professional managers in setting a firm’s objectives, and argues that there is a conflict between managers’ objectives (growth of sales and their own income) and those of shareholders (maximise profits).

More recently, old institutionalism has incorporated an alternative to neoclassical concept of rationality. Instead of instrumental rationality (choice of the best means to specified ends), bounded rationality was developed by Herbert Simon. Bounded rationality is the recognition of incomplete information, but more importantly of cognitive limitations on rationality. In other words, decisions are made on the basis of partial information because the capacity of the human mind for formulating and solving complex problems is very small compared to the nature of the problems.

Simon argues that bounded rationality implies that a firm cannot maximise its objective such as profits or revenues. Instead, the firm ceases to search for new options once it finds a satisfactory option. The decision-making process is one of satisficing, rather than maximising. Rules and conventions are important mechanisms for achieving satisfactory outcomes.

The concepts of bounded rationality and satisficing have led many institutional economists to be concerned with firms’ internal decision-making processes, in sharp contrast to neoclassical economists’ emphasis on outcomes.

There are two key elements of evolutionary models.

• History matters: time brings with it different cultures, experiences and ways of doing things, so that history constrains the present. A firm’s options are path-dependent: the path the firms took in the past determines what it is capable of, shapes the way it makes decisions and closes off options.
• Firms operate with bounded rationality in the face of uncertainty. Decisions are therefore based on rules and routines. Firms are modelled as having particular capabilities and their own established decision rules and routines.

Richard Nelson and Sidney Winters classify routines into three categories:

• operating characteristics: these determine what the firm will do in the short run
• investment rules: these determines the firm’s investment behaviour
• search routines: these guide the way in which the firm scrutinises its own behaviour (e.g. the way in which advertising policy is reviewed, procedures for improving production systems, and the organisation of research and development)

Routines therefore carry the accumulated skill and knowledge of the firm that would be complex and costly to codify and set down. The firm’s managers do not have to constantly consult manuals because the learned understandings on which the firms work are largely embedded in the firm’s routines. Such routines, limited by past history, have limitations as well as the strengths of repeated practices.

One of the distinguishing features of Austrian economics is its scepticism regarding the neoclassical concept of equilibrium. Austrian economists offer a dynamic approach in which the market process refers to the constantly changing interaction among economic agents.

The market as a discovery procedure: the Austrian approach models market processes on the assumption that the background knowledge possessed by economic agents is incomplete. The surprising thing about competitive markets is how little information is needed for them to allocate resources in a way that is responsive to consumers’ wishes and the production possibilities of the economy. All that economic agents need to know, if they are to economise on newly scarce resources and make more use of newly abundant ones, is the change in their relative prices.

The market as a creative process: Austrians suggest that the creative spontaneity of the market is an additional reason for preferring it as a principle of social organisation to large central planning. The theme is that the market is a creative process, itself bringing into existence ‘new’ knowledge. The creativity of the market includes creating innovative consumer goods and intermediate resources (e.g. minerals, gases, fibres, etc.)

Equilibrium requires that all the relevant facts are known and that there is no unsuspected knowledge still to be discovered which will disturb that equilibrium. From the Austrian perspective, this is an impossible condition.

Different theoretical approaches ask different questions about the firm:

• Neoclassical theory treats the firm as a ‘black box’ of technological and managerial relationships, the costs of which are assumed to be minimised in pursuit of the firm’s profit-maximising objective.
• NIE accounts for the existence and size of the firm. The focus is on the ‘make or buy’ decision, showing how the firm chooses between hierarchy and market.
• Evolutionary theorists argue that processes and routines, which allow a firm to cope with uncertainty, are appropriate basis for explaining the firm’s actions.
• Old institutionalism pays close attention to history and institutional context, suggesting the importance of path-dependency and norms and conventions.

Of course, there are other theoretical approaches (such as Austrian economics and radical political economy) that we have not examined; though we shall come across them during the course.