The Firm

Economic history, what do firms do, and just why exactly do they exist at all

Many economists have asked why it is that firms exist. And many have tried to answer that question. In fact, the study of industrial organization largely seeks to address this very issue. Though, I think that the answers currently at our disposal are too broad. The answer to specifically why firms exist needs to be specific to the existence of the firm. If that seems self-evident, that’s because it is. But much economic thought has been spent on analyzing how firms provide the given function they do, rather than explaining their rise to prominence. I’d like to suggest an explanation for why firms arose, but in order to do so, I’ll need to divulge some backstory first.

Ronald Coase began a minor revolution in economics in his seminal essay, “The Nature of the Firm”. The essential insight of this essay was simply that transaction costs are prevalent in the market environment. By transaction costs, he is referring to the costs of participating in the market, negotiating prices, searching for inputs, contract negotiations, and various opportunity costs. Coase effectively pointed out that these transaction costs are ever present in the market, creating an environment that would be prohibitive for consumer participation if not for the firms that minimize them. In Coase’s estimation, firms exist to minimize those transaction costs such that the consumer can participate in the market and the firms can make a profit. There are quite a few other insights that Coase makes, but if I were to pick a primary takeaway, it would be this.

I cut the analysis of that essay short to delve deeper into economic theory. Coase was influential in part because of his propensity to discover gaps in economic theory and fill them in such a way that developed an entirely new field of study. His work on externalities eventually led to the study of law and economics, and his work on the firm started the ball rolling on the study of industrial organization. In either case, what he was so good at over the course of his career was identifying holes in our theory and providing intuitive explanations that required further exploration. In this case, the relevant hole his treatment of the firm addressed was one created by the Austrians.

It doesn’t take a steward of economic history to know the names of Ludwig Von Mises or F. A. Hayek. These men were the primary contrarian voices of the socialist calculation debate and both were incredibly influential to the field of economics. They were both of the Austrian school of economic thought. The Austrian school of today is more muted than it was during the calculation debate. There are more influential works coming from the Chicago school these days for example, and the Chicago school is a chip off the Austrian block so to speak. But this school of thought was quite influential in its heyday. Through the calculation debate, the Austrians developed what we know as market process theory. Market process theory served a dual purpose, it was both a response to the socialist of calculation and it was an explanation of how markets function. Austrian economics itself was a response to the Classical treatment and the German Historical school, the classical treatment is most relevant here.

Classical economics is what most remember from their high school and undergraduate economics courses. The idea is that markets operate in a state of perfect competition with a large number of both buyers and sellers, requiring that buyers are therefore price takers and that all parties involved have perfect information during the process. If you walked out of those courses thinking that scenario is unrealistic, the Austrians are for you. The Austrians, instead, viewed the market as dynamic and equilibrium as quixotic. Rather than equilibrium representing a stable point of market operation, it is the end goal. Rather than a process with a set number of participants and full information, the market is ever changing due to the entrepreneur, and faces dispersed knowledge that cannot be concentrated into one mind. The Austrians described the market as physicists describe entropy. Entropy is nature’s tendency to seek low energy states, for example, a burning log will continue to burn until all its potential thermal energy is dispersed, resulting in its lowest energy state. The market is like the burning log. It will burn brightly and expel energy through entrepreneurial actions in search of a final equilibrium point where it will then be stable – it is always changing. However, unlike that log, the market will never reach its stable point, the market process is ongoing. Markets tend toward equilibrium like wood tends to be burned, brightly and with high energy.

Market process theory represents one of the major successes of the Austrian movement, but it didn’t address the firm. While entrepreneurship played a fundamental role, organizing seemed to run counter to its core ideas. In many ways, firms are miniaturized central bodies. Though firms are not traditional central planners, they do represent a command and control operation that features some internal markets. Firms are obviously subject to the price system and even leverage local knowledge through their employee base, but overall, the idea of a firm is not expressly consistent with the Austrian vision of the market. Further, market process theory is as elegant as it is effective. But if markets truly are so effective, why would there be a need for firms to exist at all?

This is where Coase stepped in with his “The Nature of the Firm” essay. The Austrian response to classical market theory created an explanatory gap that is self-evident in the actual markets that take place. Because firms do, in fact, exist, they must serve some purpose in the market setting. Coase identified the minimization of transaction costs as the primary function of the firm. It exists to minimize transaction costs such that all parties are thusly incentivized toward market participation. Since his insight, nearly every theory of the firm that has followed accepts transaction costs as a driving force, with effort being then spent on exactly how firms internalize those transaction costs and increase market efficiency in participation.

It may be a nitpick, in fact, I would argue that it likely is, but none of these theories of the firm explain why firms exist, they simply explain the function of the firm – the role it plays in the market. The exact reason why firms developed at all is too important to not be addressed directly. Which harkens to the final bit of exposition in my narrative. The Austrians were proponents of a concept that is both beautiful and self-evident called emergent order. Markets tend to concoct solutions to persistent problems that are as unpredictable as they are effective. Human societies showcase the very same tendency. Talking heads of the time may not like the solutions, it may not be done in the way some people would have wanted, but markets and societies cultivate creative solutions to problems. And these solutions are more effective than any planned solution could ever be because they are endogenous to the system they address.

By definition, these emergent solutions take advantage of knowledge in ways that a single planner simply cannot, largely because an emergent solution is decentralized, and therefore able to access dispersed or even unavailable knowledge through its many individual actors. Emergent orders explain the market’s dynamism. It’s an ever-changing process towards an infinitely distant equilibrium point because it cultivates continuous emergent factors that destabilize the system in this pursuit.

The origin story of the firm ought to be a simple one. Given Coase’s insight that transaction costs are prevalent, and given the Austrian perspective on emergent orders, the firm’s existence can be explained as an emergent solution to a market system with pervasive transaction costs. That the discussions surrounding exactly how firms minimize and internalize transaction costs remain contentious to this day only furthers this point. If firms came about as an emergent, market solution to the presence of transaction costs, then a percentage of the methods by which firms solve the problem of transaction costs would be undiscoverable.

Hayek’s analysis of the market paints a picture of dispersed, context specific, and emergent knowledge that is leveraged in synchronicity by many individual actors with incomplete knowledge themselves. The market itself is defined by its ability to leverage for its advantage what cannot be known in real-time to the observer. This is why economists can retroactively dissect the market process, but we have little hope of projecting it in real time. We know firms do play in this same sandbox, so, if the firm is subject to the market, and constrained by the price system, is it not also a product of the market in it of itself?

As with any emergent solution, its effectiveness is defined by its endogeneity and innovative nature. The firm is, without question, endogenous to the market and therefore able to access levels of knowledge that would otherwise be unavailable in real time. Its primary purpose was to internalize transaction costs while augmenting the entrepreneur in a dynamic pursuit of equilibrium. The firm does not offset the balance of the market process, nor does it further the stability of current market positions. The firm is of the market, was of the market, and will forever be a product of the market itself. Subject to the same constraints as individual actors, the firm developed in response to a market depressed by pervasive transaction costs in a budding socio-economic legal system. As Coase suggested, the firm lubricates the market by minimizing and internalizing those transaction costs – though the very method by which it does this is up for debate.

Insofar as a theory of the firm goes, my answer is wholly incomplete. But I suspect my answer to this specific question to be sufficient. Why did the firm come to exist in a market process defined by decentralization and dynamic, emergent orders? Because it is an emergent response itself. In the face of pervasive transaction costs, the firm emerged as the cost of organizing was exceeded by the transaction costs it hoped to address. In doing so, the creation of the firm represented yet another emergent stepping stone toward that abstract goal of equilibrium in the ongoing market process.