Pragmatic Pluralism 6: Firms

This chapter provides a map through the complex jungle of economic theories. There are many different theoretical approaches, and each aspect of the economy has been analysed by a number of different ones. However, it is neither feasible nor productive for students to engage with every possible angle for every topic. Hence, the chapters on different topics, together with Building Block 8: Economic Theories, sets out an alternative approach: pragmatic pluralism. Rather than pursuing the extreme of either only focusing on one approach, or including every possible strand of thought for every topic, we propose a pragmatic middle ground: teaching a select number of approaches for each topic. In this way, it is possible to introduce students to the variety and diversity of economic thinking, whilst still having enough time and space to properly discuss each of the insights in detail with them.

Topics:

Main opposing perspectives

■ Field theory: Firms stabilize and shape power relations

■ Institutional economics: Firms are a way to minimize transaction costs

Main complementary perspective

□ Evolutionary economics: Entrepreneurship and innovation drive success

Additional perspectives and insights

+ Classical political economy: Firms are drivers of the division of labour

+ Neoclassical economics: Firms maximize profit

+ Social network analysis: Firms largely consist of informal networks

+ Other: Business and organizational studies

A key difference of perspectives on firms, as well as other organizational forms, is whether they should be mainly seen as instrumental solutions to coordination problems or as social constructions that embody power relations.

New institutional economists view the firm as an efficient way of organizing given the fact that market transactions cost money, time and resources. In other words, they argue it is often simply more efficient to have hierarchical organization, than to do everything through market transactions between individual people, and that firms exist for this reason. In this approach, different forms and levels of organization should be explained as efficient solutions that minimize the transaction costs related to the specific economic activities and their characteristics such as asset specificity. If a social institution or organizational form is not efficient, it will cease to exist and will be replaced by more efficient ones. 

Proponents of this view, such as Ronald Coase and Oliver Williamson, are often called ‘new’ institutional economists, as opposed to ‘original’ institutional economists, such as Thorstein Veblen and John Kenneth Galbraith, who view power relations as being crucial, like field theorists do. Furthermore, new institutional economics is strongly linked to neoclassical economics in its approach and theoretical assumptions, causing many to consider new institutional economics to be a part, or an extension, of neoclassical economics. 

In new institutional economics, individuals are (boundedly) ‘rational’ and maximize their utility. But new institutional economics, sometimes also called transaction cost theory, emphasizes that engaging in transactions through spot exchange and necessarily incomplete contracts has search and information, bargaining and decision, and monitoring and enforcement costs. Besides minimizing production costs in order to maximize profits, which is a core aspect of traditional neoclassical economics, firms thus also minimize transaction costs. And as such, the hierarchical organizational forms of firms can be understood as efficient instrumental solutions to coordination problems.  

Field theorists, such as Neil Fligstein and Pierre Bourdieu, on the other hand, see firms as social institutions that are constructed through power struggles, both in society at large and in the specific local social space that the firm operates in. The existence and functioning of firms depend on the broader political-legal and socio-economic context, with its property rights, rules of exchange, governance structures, and regulation as well as labour relations and public investment, innovation, education, and infrastructure. These institutions, in which firms are embedded, are the outcome of power struggles between actors within the government, owners and managers of firms, and workers. The specific historical trajectory and balance of power in a country thus shapes how its economy and firms look. 

In capitalist societies according to field theorists, firms are in constant struggle for survival with pressure and uncertainty coming from competitors, suppliers, customers and workers. The main driving concern of firms is therefore organizational survival and creating stability, rather optimal resource allocation and maximizing efficiency. This goal is achieved by creating and maintaining social relationships and local cultural understandings. Within this context, incumbents and challengers creatively struggle to gain and maintain power, making use of the existing social structures and cultural rules in the field. 

A slightly different way of framing the debate is to oppose the new institutional view with the resource-based view of the firm, as advanced by Edith Penrose, Alfred Chandler, and William Lazonick. Rather than seeing a firm as a nexus of contracts, they see firms in terms of their organizational capabilities and productive resources. The ‘blackbox’ of production processes is opened and research has focused on how and why certain firms were able to develop them through strategic decisions, organizational learning, innovation, and interaction with their environments. This resource-based view of the firm also has considerable overlap with the evolutionary approach to analyzing firms.

Evolutionary economists emphasize the importance of entrepreneurship and innovation in explaining firm successes, or the lack thereof. Industries consist of diverse ranges of firms that engage in market competition, which is understood as an evolutionary struggle for survival. The behavior of firms depends on their routines, relating to production processes, pricing and management decisions, recruiting and selecting personnel, and advertising and selling products. But besides effectively and efficiently carrying out these routines flexibly to adapt to the environment, it is also crucial for the success and survival of the firm to innovate through experimental trail and evaluation and in doing so develop new products, and production and coordination processes. The ability of firms to innovate depends on their dynamic capabilities, which are a core object of study within the business studies literature. Innovation, however, always takes place inside a larger ecosystem, which is referred to as an innovation system and consists of government organizations, research and educational institutions, and financial institutions, as well as firms.

Classical political economy: Classical, as well as Marxian, political economists argue that the profit motive of the capitalist is dominant in how firms operate and are organized, because the small group of capitalists own the means of production. Workers, who do not have the means of production, sell their labor in order to get by. As such, they saw firms as places where capital accumulation and division of labor, but subsequently also alienation, took place. Through specialization, productivity increases and economies grow, giving rise to economic prosperity. Specialization and the division of labour, in turn, is understood to be dependent upon the extent of the market, thereby giving rise to the promotion of free trade as a way to increase economic prosperity. 

Neoclassical economics to a certain extent follows the same logic as it also sees profit as central to firms. But in contrast to classical and Marxian political economists, neoclassical economists emphasize profit maximization in a rational choice framework. In this framework, the internal functioning of firms is generally treated as a black box with a production function which gives the optimal combination of capital and labor given the available technology. 

During the 1970s, various neoclassical economists began, however, to develop theories about the internal workings of the firm. Inspired by Milton Friedman his essay The Social Responsibility of Business is to Increase its Profits, Jensen and Meckling, among others, began to develop agency theory. The key idea was that American firms struggled because their principal-agent relationships were not optimally designed. Rather than trying to tackle the problem of excessive power of top management by regulation and greater transparency and accountability as original institutional economists as Berle and Means had argued, agency theorists thought the solution was to make managers themselves shareholders of the company as well. By making the rewards for top managers dependent on the shareholder value, their conflict of interest with the owners of the firm would be solved. 

The underlying assumption that the maximization of shareholder value should be the central aim of firms, also became influential in real business practices. From the 1970s onward, the shareholder value model with the “downsize and distribute” approach replaced the stakeholder value model with its “retain and reinvest” approach (Lazonick and O’Sullivan). This has caused a shift away from long term investments in physical and human capital, to a focus on short-term profit, stock buybacks, and higher pay of top management.

Other: Economists and economic sociologists, are far from the only ones studying firms, as in particular organizational and business studies have been focused on how firms function. In these fields, multiple theoretical approaches have been applied and developed, putting the focus on organizational culture, psychology, or learning processes for example. An important difference with the economics of the firm, is that organizational and business studies are more practically oriented and aim to prepare students to become good managers of public and private organizations. Economics, on the other hand, focuses more on explaining how firms behave and shape economies at large, in order to inform policy decisions.

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