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[This is a chapter from The Problem of Production: A New Theory of the Firm.]

This book is about what is generally referred to as the ‘firm’, a phenomenon in the market that appears obvious but that remains difficult to explain. While there is a field of study referred to as the theory of the firm, there are in fact a number of noteworthy theories. All of these theories claim to explain the firm’s rationale, value, and purpose. But the theories tend to describe the firm in different ways. The discussion is further complicated as there are several different definitions of this seemingly elusive concept. As a result, our understanding for the economic reality of the firm is inhibited.

The purpose of this book is not to reconcile these theories or definitions, however, but to try a new approach and provide an explanation for the firm by looking at the market setting where we find firms. We start by constructing an economic model of the market as an elaborate yet dynamic system of production without firms. This, in turn, allows us to study the limitations of the economic system of production, and what means are available to overcome them; or, more precisely, how the market deals with this ‘problem of production’. The goal is to elaborate on an explanation for the firm by seeking its economic function within the extensive production apparatus of the specialised market.

This chapter positions this book in the extant literature on the economics of organisations and institutions. It does so by summarising and delineating two strands of the academic literature that are separate but should complement each other: strategic management (or, as it is sometimes referred to, organisational economics), especially the theory of the firm, and the Austrian school of economics. While they have things in common and have recently been approaching each other, we will here draw from both strands to produce a theory of the firm. Our theory is based on the Austrian conception of production in the dynamic market process and it takes market-based production and the evolving dynamic of the market process as its point of departure. The perspective is Austrian, but the object for our analysis is borrowed from strategic management. The discussion thereby indirectly attempts to reconcile these literatures by providing a theoretical explanation for particular phenomena in the overlapping space between them. This first chapter is intended to provide background by making the reader familiar with economic theorising on the firm and what the two aforementioned literatures have in common.

Theorising on the Firm

Whereas firms are ubiquitous in the economy and therefore often assumed to be a natural component of the market, the concept of a ‘firm’ poses an interesting question relating to economising, organisation, and production. The question can be stated as simply ‘Why are there firms?’, but its simplicity is deceiving. The question requires both elaboration and contextualisation to make the problem clear. The ‘why’ in the question suggests that there must be a rationale for forming firms such that there is a distinct value of coordinating production specifically within firms, which directs our attention to the question of what possible alternatives to firm organising there could be. The commonly assumed alternative is a model of the market as predominantly decentralised exchange-based coordination of production. The theory of the firm literature aims to formulate an economic argument for firm organising in contrast to decentralised market exchange, and under what specific conditions this is of value and therefore can be the predicted outcome. Due to the importance placed on this distinction between firm and market, a significant and important subset of this literature stresses issues relating to the firm’s ‘boundaries’. A firm’s boundary denotes the point where the firm ends and the market begins (and vice versa), which indirectly suggests what makes the firm different from the market. The ‘why’ of the firm therefore relates to (if not requires) a definition of what constitutes a ‘firm’, since ‘why’ must point toward a certain ‘what’. Knowing the ‘why’ and ‘what’ should also provide insights necessary to investigate the ‘how’ of the firm, which is another important question at the core of the theory of the firm literature.

The questions of the firm’s why, what, and how are generally referred to as the Coasean questions of the firm since they were posed or implied in Ronald H. Coase’s ground-breaking, Nobel Prize-winning 1937 article ‘The Nature of the Firm’. Coase was not the first to pose questions about the firm’s rationale, boundaries, and internal organisation, but his comparative framing was novel and the article’s approach has become starting point for the modern study of economic organisation and the firm. Coase’s basic question, which asserted a clear theoretical distinction between the firm as a planned hierarchy and the decentralised exchange in the market, was stated rather bluntly: ‘in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation [the firm] necessary?’. Indeed, as Coase points out, if the market economy is efficient there should be no need for and certainly no value in such alternative means to organise production. Coase answers the question by introducing a cost specific to market exchange — a marketing or transaction cost — that produces a cost-based rationale for organising hierarchies in the place of markets. The firm is according to the Coasean view a means to economise on the market’s transaction costs.

From our contemporary perspective, Coase’s article appears as the culmination of a vast literature on economic organisation and management of the firm in the 1920s and 1930s. This literature continued the earlier work by primarily Alfred Marshall, who discussed the abstract conception of a ‘representative firm’ and offered an extensive study of industrial organisation. This line of research, to which Coase’s article was likely intended as a challenge but ended up making little if any impact, subsided within mainstream economics in the late 1930s. The economic study of the firm was not revived until Coase’s pioneering work was rediscovered in the late 1960s and early 1970s, primarily through the work of Oliver E. Williamson who adopted Coase’s comparative institutional analysis (‘firm vs. market’) as well as the concept of ‘transaction costs’. The rediscovery of the Coasean ‘make-or-buy’ perspective on coordination became the starting point for an extensive literature in economics aiming to explain firm organising, which developed over the course of some twenty years. This literature is still core to the study of the firm.

Austrian Economics and the Firm

The emergence and development of the literature on economic organisation in the 1920s and 1930s coincides with the Socialist Calculation Debate, one of the great debates in economics. The latter was prompted by the work of Austrian economist Ludwig von Mises, who argued that an economic system based on socialism was both theoretically and practically impossible. Mises was a proponent of the Austrian or ‘causal-realist’ school of economics founded at the University of Vienna, which focuses on studying the real market through the lens of a deductive theoretical framework. The tradition’s focus on the market as it is, rather than — as in modern mainstream economics — highly formalised mathematical models with only occasional relevance to the real workings of the market, suggests it perhaps should have researched the firm. After all, markets both then and now are predominantly populated with firms; most economic activity takes place within or between such organisations. Yet, in contrast to neoclassical economics, which gave the topic a lot of attention in the 1960s, 1970s and 1980s, the Austrian school did not develop a theory of formal economic organisation, and even less a theory of the firm.

This appears as a conundrum but is also an opportunity. That it is an opportunity is evident from two recent trends in the literature related to the Austrian body of research, on the one hand, and the study of the firm, its governance and organisation on the other. One trend is the growing interest for issues relating to economic organisation from within the Austrian school and by Austrian scholars. Since the 1990s, articles and books have been published as part of the Austrian research program that propose approaches to and directions for developing an Austrian theory of the firm. The other trend is evident by the (re)discovery of and then growing use and influence of Austrian economic concepts and theory in strategic management and entrepreneurship research. These two trends, while addressing similar issues, have different starting points and approaches, and build off different theoretical frameworks. But, as we will see, they nevertheless have similar theory implications, however with different emphases, and therefore suggest a possible future convergence.

For scholars in management and entrepreneurship, Austrian economics has offered an opportunity to open new venues for research. While the formal models in mainstream economics, especially industrial organisation (IO), originally laid ground for the study of strategic management, they are deficient for producing predictions and advice in a dynamic world. The formalised economic approach offers little support for more practically oriented or realistic research aiming for understanding and aiding in the creation or management of real firms. In contrast, the Austrian view of the market as a dynamic, entrepreneurship-driven competitive discovery process, and its focus on realism in aiming to explain real empirical phenomena, has considerable potential to enhance research and practice in both management and entrepreneurship. As we shall see, modern research in these fields has already adopted several core Austrian concepts and insights.

The study of strategic management was originally an offshoot of the so-called Bain/Mason paradigm of industrial organization (IO). While IO focused on the overall efficiency of the economic system as compared to the perfectly competitive model, strategic management developed strategies for the individual firm to exploit the efficiency logic and so establish monopoly power through which it can earn above-normal returns. But the empirical market in which business leaders draft strategies and make decisions is scarcely similar to the perfectly competitive model. Also, in stark contrast to the model, real production is neither perfectly optimised nor instantaneous (which is often the case in formal economic models), and business decisions are always made under uncertain conditions. The market, in other words, is dynamic and uncertain, it is in a constant flux and is fundamentally less than perfectly foreseeable. Businesses consequently operate in a changing world — that is, disequilibrium — that is rather far from a stable equilibrium state, and this makes the formalised models describing maximising behaviour of rational actors with perfect information quite inapplicable in real business management.

It should therefore have been an obvious and expected development within strategic management to move toward adopting and analysing a more dynamic conception of the market and the firm. The change to focusing on the analysis of a more dynamic and ‘messier’ view of the market constituted a shift from the formal models of mainstream economics toward an Austrian conception of the market as a competitive and equilibrating process. As Robert Jacobson observed in the early 1990s, there are ‘relatively few strategy researchers [who] explicitly attribute or link their analysis to Austrian economics’, but ‘the influence of Austrian thinking is more widespread than this lack of attribution might suggest’. He continued by noting that much of the then-recent strategy research ‘fit[s] squarely into the Austrian school of thought’ and that this work even ‘can be seen as forming an “Austrian School of Strategy”’.

A similar shift has occurred in the study of entrepreneurship, though this field (at least the research done outside of economics departments) never adopted as fully the streamlined economic models on which strategic management was originally based. Entrepreneurship is here commonly perceived as some form of open-ended change, whether it is the fundamental ‘driving force of the whole market system’, as Mises puts it, or simply the act of creating firms. As it constitutes a process of change, the concept and its impact on the market are profoundly difficult to express in formal notation. As a result, entrepreneurship could never rely on the models of modern economic theory as was the case in strategic management. This may be a reason why, as William J. Baumol noted, ‘[t]he theoretical firm is entrepreneurless — the Prince of Denmark has been expunged from the discussion of Hamlet’.

Expunged is probably a proper description. Since at least the early 18th century studies in economic theory have placed the entrepreneur at the centre. Richard Cantillon, for instance, defines entrepreneurship as working for non-fixed income (and therefore the bearing of uncertainty) and saw in the entrepreneur the force that brings equilibrium to the market. Adam Smith, commonly regarded the ‘father’ of economics, saw in the ‘undertaker’ an agent that transforms demand into supply. Jean-Baptiste Say saw the entrepreneur as a speculator who runs the firm for profit. The common denominator of these classical approaches to entrepreneurship is that the concept is considered primarily in terms of the role or function it plays in the economy. Modern entrepreneurship, in contrast, has to a great extent approached entrepreneurship as an empirical phenomenon, in which entrepreneurship is measured as ‘self-employment’ or as the degree of non-concentration in an industry.

It was not until the work of Scott A. Shane and Sankaran Venkataraman, who suggested the study and implications of the entrepreneurial opportunity as common denominator for studies in entrepreneurship, that theorising without direct basis in empirical observation regained its foothold in the field of entrepreneurship. Shane and Venkataraman relied heavily on the work of Israel M. Kirzner in reformulating the study of entrepreneurship, and contrasted Kirzner’s ‘alert’ entrepreneur with a conception of Joseph A. Schumpeter’s ‘disruptive’ innovator-entrepreneur. This has ultimately led to Austrian economics having a strong influence in entrepreneurship.

The use of Austrian concepts in strategic management is as prevalent as in entrepreneurship, but far from as explicitly attributed. Whereas entrepreneurship theory was built on an openly Austrian foundation, strategic management research only infrequently recognizes that many of the field’s core concepts have already been used, elaborated on and scrutinized by the Austrians. While there are indeed a number of studies in strategic management that explicitly use an Austrian approach or even adopt Austrian theory, the measurable relative influence of Austrian economics has not increased. Instead, concepts such as resource heterogeneity, uncertainty and dispersed knowledge — and their implications — are reinvented and drafted anew, and used as means to deal with problems arising due to the reliance on formal economic models. This may at times give a thoroughly strategic management flavour to these concepts that can seem to create a distinct paradigm, but it also subjects the field to costs as already developed theoretical concepts, which can be common knowledge in the Austrian tradition, are reinvented and suffer problems achieving consistency. The latter, in fact, is in line with a warning drafted by Jacobson, who cautioned that while Austrian economics is a mature theoretical framework and therefore both useful and valuable, it is also highly integrated due to its strictly deductive method; this means that ‘inconsistencies can arise when attempting to integrate other frameworks with Austrian paradigms’. This may turn out to be a severe problem in strategic management as the field borrows, whether or not intentionally or even knowingly, several core concepts from Austrian economics, and it can equally become a problem in entrepreneurship theory as it originated as an application but not elaboration of Austrian theory. But, as we shall see in the next section, the same type of problem is latent also in Austrian theories of the firm.

Coase and the Austrians

Austrian approaches to studying the firm face similar problems as those we just discussed with respect to theories in strategic management including Austrian concepts and constructs. The approach, however, is the obverse: they take Austrian theory as starting point and then add concepts, theoretical devices and reasoning from mainstream (non-Austrian) theories of the firm to it. In contrast to typical Austrian theorising then, which maintains consistency through strict deductive reasoning, Austrian approaches to the firm place mainstream conceptualisations within an Austrian ‘market process’ framework. In order to make the pieces fit, the framework is often made out to hinge on a single or couple of Austrian core concepts (such as knowledge, capital theory, entrepreneurship or uncertainty). Consequently, we see Austrian theories that discuss how concepts in mainstream economic theories of the firm, like transaction costs, incomplete contracting, monitoring costs and so on, relate to, can be combined through, are supported or otherwise further explained by utilising an approach that at least in part is or derives from Austrian thinking. By placing ‘bridging’ Austrian concepts at the core of the theory, which supposedly adds an explanatory dimension to existent mainstream theories, an argument is indirectly generated for the value of incorporating core components of Austrian economics in mainstream theory development. But doing so could also introduce inconsistencies. The product is in any case a theoretical amalgamation that appears to be mainstream in many ways and therefore builds on strengths perceived in the already established theories, but is presented with a distinctly Austrian flavour.

Whereas these approaches purport to indicate steps toward an integrated framework that can explain economic organisation on Austrian terms, they predominantly attempt to achieve this goal by relying on the unorthodox method of ‘combining’ Austrian with decidedly non-Austrian theoretical constructs. As these constructs have different histories, are from different bodies of theory and commonly are formulated using very distinct (and, at least to some extent, incommensurable) assumptions and reasoning, they risk appearing more as a jumble of concepts inspired or held together by an Austrian-style market process argument than an integrated theory. As I concluded elsewhere, ‘the existing [Austrian] attempts fail to convincingly explain why there are firms because they are too narrowly focused on specific characteristics rather than on the firm in the market’. It should, in fact, be difficult to imagine an Austrian approach to explaining economic organisation that does not see the firm as having or supplying a distinct and important function to the integrated market system in which it is thoroughly embedded. The firm should be both affected by and effectuate change in the market process. In this sense, the firm cannot be seen as ‘only’ a governance choice for certain types of transactions or applicable under a certain set of conditions or in specific situations (as several theories suggest), but should — considering the firm’s relative omnipresence in the market — play a more substantial role in how the market process works. The firm, seen from an Austrian point of view, should provide a function that fits in the broader scheme of things.

At this point it may be appropriate to address the question of how we define a ‘firm’. But this is exactly the problem with existing theories of economic organisation, whether they are Austrian or mainstream — there is no established definition of the phenomenon, so common in the market, that we refer to as a ‘firm’. Instead, the theoretical literature suggests (at least) four distinct definitions or rationales for the firm: as a technological necessity, as having a nature that is distinct from the market, as a means for avoiding costs of using the price mechanism, or as an accumulated collection of resources. As can easily be seen, there is no reason to assume that all four rationales are necessarily and always present where there is a firm, which makes the situation theoretically unsatisfying. If we for a moment assume that firms are more than simple ‘legal fictions’, by which we mean that economic organisation provides an actual and real economic function regardless of legal status, it should be clear that the empirical observation that firms are ubiquitous in advanced markets cannot properly guide the development of Austrian theory. This is not to say that empirical observations are unimportant, but quite the opposite. The fact that business firms are practically ‘everywhere’ should to theorists of the firm indicate that there may be more to this phenomenon than suggested by either of the simple rationales relied on in the extant literature, and that it therefore could play a more important role in the market process than, for example, offering a means for avoiding some costs of market transacting. Cost minimisation through choosing the ‘cheaper’ means of coordination can of course be a benefit of the firm, as is Coase’s argument, but the full out adoption of the mainstream market/hierarchy duality as one’s theoretical point of departure does not necessarily follow from this statement.

Despite this, many Austrian theories adopt Coase’s transaction cost theory of the firm, or in any case its argument or assumptions, as starting point. While it is true that Coase introduced the comparative institutional analysis of economic organisation in a nice way, there is reason to think that Coase’s framework is incompatible with Austrian theory. His theory of the firm was intended as a defence of economic planning, and it was in support of planning in the market (Coase’s conception of the firm) that he introduced the concept of transaction costs — a kind of cost affecting market exchange yet that somehow exists outside of economic actors’ opportunity cost assessments and therefore have no effect on efficient resource allocation. Coase’s point was that the market is ‘costly’ because resources are heterogeneous and market coordination is not rationally planned, and it follows from this that rational planning (by definition unaffected by this cost) would tend to be less costly. Coase explains that this is the reason such a ‘large sphere’ of the Western market economies are not coordinated through market exchange but are instead planned within firms, and contrasts this ‘decentralised planning’ through firms in the market with the centralised economic planning in Soviet Russia (as Coase notes, Lenin had said the country would ‘be run as one big factory’).

Setting the political connotations aside, Coase’s economic argument stands in stark contrast to how Austrian economists understand the market and how they conceive of capital heterogeneity and the implications thereof. To Austrians, as to Coase, it is ultimately the fact that resources in production are heterogeneous, produced and non-permanent that makes economic planning costly (if not impossible). But Austrians would argue, along the lines of Mises’s argument against socialist economic planning, that this is what makes the market an unbeatable (though still, it must be emphasised, imperfect) coordination mechanism for advanced specialised production — not the other way around. It is Coase’s decidedly un-Austrian framework that allows him to conclude that ‘planning’ is superior to and therefore a multitude firms are formed to supersede the market’s price mechanism.

Whereas Coase’s analytical approach of comparative institutionalism is rightly accepted and appreciated by Austrians, it is difficult to see why the rest of his argument should be. Rather than using a theoretically streamlined but otherwise realistic ‘imaginary construction’ (the common method in Austrian theorising) to isolate causal links and interdependencies in the real economy, Coase’s assumptions intentionally do away with any structural differences so that only the means of coordination remains to distinguish the firm from the market. The conclusion that the choice (which to Coase appears to be made by the economy rather than by an actual actor) of coordinating force between price mechanism and manager is a matter of selecting the least costly alternative is neither interesting nor important — it follows directly from the stated assumptions. This is an important difference between Coase’s analysis and the deductive theoretical framework of Austrian economics. Coase relies on a set of strong assumptions without obvious grounding in theory, whereas the Austrian approach incorporates assumptions within a causal-realist framework that provides a bulwark against arbitrariness.

An Austrian Theory of Economic Organisation

Coase’s theory ultimately challenged the theory of economic organisation at the time and thereby the body of literature in economic organisation that developed in the 1920s and 1930s. While inspired by E. Austin G. Robinson, an influential Cambridge economist who had written on the logic of industrial organisation, Coase’s approach deviated from Robinson’s in one important respect: he assumed that the firm’s internal organisation is practically a carbon copy of the market’s allocation of resources, which facilitated his marginal transaction analysis and allowed him to conclude that there is a strict cost rationale for the firm. The common starting point in the literature at the time, in contrast, was that the firm is defined contra the market by its more intensive division of labour. This difference means that the boundary of the firm, according to Coase’s theory, is the result of a simple cost comparison between different means for allocating resources, whereas ‘pre-Coaseans’ like Robinson derived organisational boundaries from real differences in productivity through resource heterogeneity and specialisation intensiveness.

The latter view was further developed in the works of Edith Penrose, who with mentoring assistance by Austrian economist Fritz Machlup, authored an influential book on the evolution and growth of firms. The modern resource-based view of the firm, which applies a strict strategic management perspective on the value creation and value capture problems that arise due to resource heterogeneity, is based on Penrose’s non-Coasean approach as derived from the work of Robinson and Machlup. As will emerge through the discussion in subsequent chapters, this legacy of Robinson — and the classical economics approach to the study of the firm that it was based on — should be a much more appropriate starting point for developing a dynamic theory of the firm. Not only is this particular approach evolutionary and dynamic in the same sense that Austrian economics provides a framework for studying and understanding the market as a process, but it already includes several concepts that are compatible with the Austrian approach.

Nevertheless, an Austrian theory of the firm should probably not assume it as a starting point. Considering the deductive and integrative nature of Austrian theory, it would be a mistake to do more than take inspiration from other schools of thought — especially if they are based on different (or even incommensurable) assumptions. Despite how it is commonly approached, the economic theory of the firm is not a specialisation, but an elaboration and extension of the existent body of economic theory aimed at providing an answer specifically to the question of economic organisation. This answer cannot, obviously, contradict the theoretical framework, but can suggest a potential theoretical challenge to existing emphases or applications. In order to be true, a deductive theoretical framework and all its parts need to constitute a consistent whole; what remains, therefore, for Austrian theory to properly provide an answer to the so-called Coasean questions of the firm’s rationale, boundaries, and internal organisation is to extend the theory by applying it on and emphasising the particular issues that pertain to organisation. Indeed, as Mises notes, ‘[t]here is no specialization [in economics], as all problems are linked with one another. In dealing with any part of the body of knowledge one deals actually with the whole’. The point of departure for producing an Austrian theory of economic organisation, therefore, must be the existent body of Austrian theory and consequently the Austrian understanding for what constitutes and drives the market process. It follows that an Austrian theory of the firm should be based on or, at a minimum, be related to core Austrian concepts such as knowledge, capital theory, entrepreneurship and uncertainty. It should also fit with the theoretical framework — and in fact constitute a missing piece of the puzzle.

As finding and theorising on this piece is the task for this book, our focus must first and foremost be on what specific problem the firm can solve in the market process, by which we mean that organising certain economic activity within the firm must have a value for those involved in the firm as well as the market process as a whole. The former is a question of how the firm attracts labour and capital factors, and the latter addresses the overall value of the structure to the market as such. It is not sufficient to address either of these aspects without also addressing the other ones, as it is not sufficient to address either of the Coasean questions separately, since what then emerges as a potential solution may not fit with the overall theoretical framework. The take-home here is that the theory of economic organisation must be built on yet be ultimately delimited (if not restricted) by the theory of the market.

It should be noted that existing approaches to explaining the firm from an Austrian perspective usefully adopt a similar problem-focused methodology. From our perspective, however, they do so in a very limited sense by phrasing the question to be answered in terms of a gap in the theoretical framework rather than a real economic problem. The integrated economic function of organisation for market actors in the market process becomes an implication rather than a core contribution of the theory. Granted, this allows for the approaches to focus primarily or even exclusively on a specific concept or sub-theoretical orientation (such as capital theory or entrepreneurial discovery or judgement) while purporting to — at least indirectly — inquire into the nature of relationships that exist in the market (or, if we wish, between firms and markets). But the approach in effect emphasises trees at the cost of failing to appreciate the extent of — or even see — the forest. But the nature of economics is such that we are unlikely to fully understand the tree, as a phenomenon that arises within an economic or market context, without first considering the tree as embedded within and part of the forest. In other words, we have to deal with the market embeddedness of the firm in order to understand it, and we therefore need to target its function within the broader market context. This is the point of departure for this book.

The discussion above indicates not only that there is a seemingly unoccupied space for a theory to explain the firm from the point of view of the market process, but also that there are several theories, approaches, and frameworks that we can draw from. While a new theory of the firm can provide important insights, and it is indeed the purpose of this book to draft one, it is unnecessary to adopt a completely different approach and ‘reinvent the wheel’ completely. Yet to take the firm’s embeddedness seriously, it is necessary to derive the firm’s function from limitations that the market suffers without it. In this sense, we start from the beginning by discussing the market process and how it functions without firms. We look specifically at production as the core activity within the market process, and then elaborate on whether market production is subject to a fundamental problem or shortcoming, which can potentially be solved by entrepreneurs only through economic organising. The next chapter discusses the market as a dynamic process.