The Theory of the Firm

“So far as [the spirit of individual liberty} is really lacking, the first task must be to waken it; and this a regime of freedom will do but a system of regimentation will not,” (F.A. Hayek)


It is surprising how limited, sporadic and incomplete the economic analysis of “The firm” has been. In fact, despite the central role played in economic development by firms, no really satisfactory theory has ever been developed to explain their existence, extent, functioning and internal structure. Correspondingly, no adequate model exists to explain the best relationship between the individual and the firm. The result is that this vital relationship often degenerates into a simple exchange of a fixed income for a fixed period of, often reluctant, obedience to hierarchy. The unsatisfactory result is camouflaged by lip service paid to largely mythical team spirit and company objectives. The few employees who are not affected by this malaise are, by contrast highly effective and end up shouldering the majority of the real burden while others look on, either disbelieving or disinterested. Those few hardy souls only sometimes get recognition, and cannot get appropriately rewarded due to the dead weight of the larger number who are, sometimes literally, only here for the beer. The cumulative effect is a split between the effective and under-appreciated minority, the idle majority with their sense of entitlement and overstretched managers trying to cope with resulting problems of inefficiency, economic distress and chronically poor quality.

My conclusion is that the basic relationships underpinning the conventional firm are un-workable and need to be rethought. In the words of Karl Popper from The Logic of Scientific Discovery “If by chance they find themselves unable to accept any of the existing creeds, all they can do is to begin afresh from the beginning”

Thus the questions we are faced with are:

What theories of the firm are in current use?

Do these need to be changed or developed to more fully define what a firm actually IS

How the relationship between the individual and the firm should be changed to free the former from the stultifying effects of the later and the later from the economic drain of the former.

The first real effort at defining the reason why firms exist, or more accurately the reason they develop to their current size and structure, was developed by Professor Coase in the 1930’s. This saw the firm as a long-term construct between formerly independent input owners in which they are governed by an entrepreneur. Prof Coase used the concept of transaction cost, the cost of using the market mechanism to postulate an explanation for why firm grow to a certain size, conducting some work in a vertically integrated manner and going to the external market for other operations. This work lay until the 1970’s before Williamson and others developed the idea further. Although perhaps shedding some light on matters this failed to explain why and under what circumstance the entrepreneur and formerly independent workers would choose to do this and offered no workable means of calculating transaction costs. It does highlight the key role of the entrepreneur but offers little more of use in this current search.

In recent years, economists of the Austrian school have started to examine this issue, which, although touched upon indirectly be the great figures or Austrian economics had hitherto not received any detailed attention. Ioanides suggested that “The firm is a planned social order within which an ongoing process of entrepreneurial discovery is organised.” This highlights two important and potentially conflicting points, firstly that the presence of a firm implies some degree of central planning and organisation and secondly that the firm as a whole is engaged in entrepreneurial activity. This implies that central planning must be limited if the creation of new ideas and opportunities is not to be stifled.

Other Austrian school adherents have offered further insights. Nelson et al view that “The firm is a repository of collective, tacit knowledge and capacities embodied in firm-specific routines, evolved over time in a competitive environment”. This knowledge based view also has some merit, particularly for the design professions where, ultimately, it is our knowledge and ability that we sell. The more lonely existence of the sole practitioner, removed from the casual but creative interaction with other like-minded people on a daily basis is unlikely to develop as broad a knowledge base, and as profound an understanding of his chosen craft or skill. Hence the creative and learning advantages definitely constitute one of the roles of the firm. Also, as Alfred North Whitehead observed, “Civilisation advances by extending the number of important operations which we can perform without thinking about them. Operations of thought are like cavalry charges in a battle; they are strictly limited in number, they require fresh horses, and they must only be made at decisive moments”. Thus the development of knowledge that can be easily and quickly applied is a significant asset. Potentially a firm can assemble this intellectual capital much more rapidly than an individual and allow more to share from the benefits. The development of this intellectual capital is essentially a gradual process, learning from experience, as Karl Popper put it in Conjectures and Refutations “It is part of my thesis that all our knowledge grows only through correcting our mistakes”. The firm, by being a repository of such knowledge and experience, assembles and transmits a pool of value more widely and efficiently than does an informal network.

Adelstein observed “Firms emerge because the entrepreneur needs the close cooperation of others over time to realise his vision” This is clearly more readily achieved within a firm of people of varied skills and knowledge but with compatible objectives that in a series of impermanent, ad-hoc relationships. Thus, the mutual advantages of cooperation also appear to be a reason firms are preferable to networks of individuals.

One further advantage of a firm is the sharing of risk, or more broadly using the combined resources to cope with uncertainty. The firm helps this by providing further viewpoints and the benefits of shared experience. By building in checking procedures, and peer review processes, an individual can be encouraged to explore new ideas with uncertainty being reduced and the potential losses that may result shared by a larger financial grouping.

In the area of learning, it ultimately is the individual who must take responsibility for his own development. However the firm can create an atmosphere of erudition, a sharing of insight and promote a love of learning. This has, potentially benefits to all those involved in the venture , “For it is in the process of learning and in the effects of having learned something new, that man enjoys the gift of his intelligence” (F. A. Hayek). However, firms rarely encourage such learning, concentrating on more limited training for the advancement of short term goals. This is ultimately self limiting. Again Hayek said it well in The Constitution of Liberty:”It is important to recognise that we are not educating people for a free society if we train technicians who expect to be “used”, who are incapable of finding their own niche themselves, and who regard it as someone else’s problem to ensure the appropriate use of their ability or skill.” Hence the education must be freed from central control, and instead must be the shared activity of independently minded persons. This independence of mind is a rare thing in our present culture and gets to the heart of what is wrong with many current firms. Again quoting Hayek’s Constitution of liberty: “For the independent there can be no sharp distinction between his private and his business life, as it is for the employed who has sold part of his time for a fixed income. While for the employed, work is largely a matter of fitting himself into a given framework during a certain number of hours, for the independent, it is a question of shaping and reshaping a plan of life, finding solutions for ever new problems. It is therefore only by eliminating the salary-for-time basis of employment can people be freed from the technician mentality and have access to the wider human potential

If the firm is therefore to promote intellectual development for economic ends, this means it must encourage sharing and development of effectual personal knowledge, promote critical thinking (problem solving) ability, encourage challenges to the status quo by developing ideas of how things can be better done, and provide a broad perspective by avoiding narrow specialism.

Deming in his development of total quality management highlighted the lack of constancy of purpose as a common failure in contemporary management practice. In this he correctly identified the need for an entrepreneur or a firm to strive often for a long time before reaching the breakthrough point. How many successful individuals has said something along the lines of “It took me twenty years to become an overnight success” Taleb in The Black Swan put it thus: “Many people labour in life under the impression that they are doing something right, yet they might not show solid results for a long time. They need the capacity for continuously adjourned gratification, to survive a steady diet of peer cruelty, without becoming demoralised. They look like idiots...” For a firm to show this degree of constancy of purpose it must be well led by a determined management team, with few personnel changes. There must also be a broad dissemmination of just what the objectives are; these must be understood by all those involved. This is vital if the natural concentration on short term goals (without which longer term ones cannot be met) is not to choke the progress of the firm and result in mere survival being the only objective.

So to draw these ideas together, the firm must be

Centrally planned only in so far as the right culture and beliefs are fostered

Dedicated to entrepreneurial discovery

A centre of learning and sharing of knowledge

A repository of experience and tacit understanding

An organisation with a vision of longer term objectives which are pursued with constant diligence


On a more personal note:

For our firm, Alexander Scott, the longer term goal is a cementing of the fractured construction industry, riven as it is with petty squabbles, demarcation disputes and professional jealousies. Speaking of a time before it was thus, LTC Rolt, when describing the works of Thomas Telford observed “They were not the products of dead formulae and cold calculation, but of a newly won technical mastery, fired by artistic imagination and burning enthusiasm; they were chapters in a unique and enthralling adventure story which kindled the imaginations of engineer and artist alike. To call such engineering achievements great works of art, as Telford’s contemporaries did, seems to us merely an exaggeration. Yet the tribute was sincere and meant exactly what it said. No arbitrary distinctions could be drawn while science and art enjoyed their, all too brief, love match in the mind.” The sterility of much current engineering design is due to the fact we have developed a much narrower definition of what it means to design and have forgotten the fact Murray N Rothbard pointed out in Ethics of Liberty, that “Behind every produced good, behind every man-made transformation of natural resources is an idea directing the effort, a manifestation of man’s spirit.

In our particular case, seeking creativity as a primary goal, needing both cooperation and individual brilliance and having central planning as an essential but not suffocating element, I find the model that should be followed is perhaps best summed up by the Orchestra. In this organisation, individuals of talent and ability, coordinated in an efficient manner with a minimum of management, rely mostly on shared understanding of the “rules” of music. Thus is achieved mostly self-managed execution of often complex tasks. The results are greater works than the individuals could aim for as soloists. And as for the creative element.... well we aim not to be just any orchestra....we aim to be the design equivalent of The Duke Ellington Orchestra.

And therefore, to finish I’d just like to say dear reader...

You are very beautiful and we love you madly.