Key insights and ideas for thirteen core topics in economics, organised by selecting the most relevant theoretical approaches per topic and contrasting them with each other.
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.
In our economies most production is organized through firms, from enormous multinational corporations to small family shops and independent contractors. Given their importance, many scholars have thought about and analysed firms. Core questions in the field: why do firms exist in the first place, and how do they work? Are firms social structures that help stabilize and control power relations, or are firms better understood as technical solutions to organize the economy efficiently? Another key question is what makes one firm successful while another one fails?
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
Main opposing perspectives: Field theory and institutional economics
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.
Main complementary perspective: Evolutionary economics
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.
Additional perspectives and insights
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.
Chapters & Papers:
- Economics: The User’s Guide by Ha-Joon Chang, from 2014, chapter 7. This brief and accessible pluralist book contains a useful introductory chapter on the world of production.
- Economics After The Crisis by Irene van Staveren, from 2015, chapter 4. This well-written textbook sets out the neoclassical, post-Keynesian, social economic and institutional perspectives on the firm and management.
- The Economy by The CORE Team, from 2017, chapter 6. This successful textbook introduces students to the economics of the firm with attention to the division of labour as well as the labour discipline model and agency theory.
- The Microeconomics of Complex Economies: Evolutionary, Institutional, Neoclassical and Complexity Perspectives by Wolfram Elsner, Torsten Heinrich, and Henning Schwardt, from 2014, chapter 16. This innovative textbook makes readers familiar with new insights coming from frontier mainstream economic research, with one chapter devoted to firms, networks and innovation.
- The Handbook of Economic Sociology by Neil J. Smelser and Richard Swedberg, from 2005, chapters 19-21. This extensive and yet accessible book for non-sociologists, provides an impressive and useful overview of the field of economic sociology, including three chapters on the role of firms, business groups, and entrepreneurship in the economy.
- Introducing a New Economics by Jack Reardon, Maria A. Madi, and Molly S. Cato, from 2017, chapter 10. This ground-breaking textbook introduces firms and industries and weaves together pluralist theory and real-world knowledge.
- Capitalism: Competition, Conflict, Crises by Anwar Shaikh, from 2016, 4 & 6. This impressive and extensive book compares multiple perspectives on many traditional economic topics including production, costs, prices, capital and profit.
- The Routledge Handbook of Heterodox Economics: Theorizing, Analyzing, and Transforming Capitalism by Tae-Hee Jo, Lynne Chester, and Carlo D’Ippoliti, from 2017, chapter 14. This broad and diverse book sets out a variety of theories on the business enterprise.
- What is a firm? A historical perspective by Alfred Chandler, from 1992. A useful short article which introduces students to the influential research and ideas of Chandler on how firms and management work and shape the modern economy.
- How do UK companies set prices? by Hall, Simon, Mark Walsh, and Anthony Yates, from 1997. An informative study that empirically investigates, rather than assumes, how firms set prices by analyzing the behaviour of 654 UK firms.
- Towards a political theory of the firm by Luigi Zingales, from 2017. A useful paper enabling students to better understand how political and economic processes overlap and interact, in particular how the political power and profits of firms can reinforce each other.
- Handbook on the Economics and Theory of the Firm by Michael Dietrich and Jackie Krafft, from 2012. This impressive collection of essays introduces students to the wide variety of ideas on the firm, from Marshall and new institutional economics to Schumpeter and the resource-based view.
- The Theory of the Firm: An Overview of the Economic Mainstream by Paul Walker, from 2016. This book introduces students to the classical, neoclassical, and new institutional perspectives on the firm.
- Theory of the Firm: Governance, Residual Claims, and Organizational Forms by Michael C. Jensen, from 2000. This book introduces students to the agency and shareholder theory of the firm, arguing that firms should exclusively focus on maximizing shareholder value in order to prevent inefficiencies.
- The Transformation of Corporate Control by Neil Fligstein, from 1993. An influential book examining changes in how US firms were run throughout the 20th century as a result of its interaction with the wider society and how control shifted from manufacturing to sales and marketing to finance.
- Predatory Value Extraction by William Lazonick and Jang-Sup Shin, from 2019. This informative book builds on the resource view and helps students understand how firms can engage in value creation and innovation, but also value extraction and rent-seeking.
- The Problem of Production: A New Theory of the Firm by Per L. Bylund, from 2015. This book introduces students to the Austrian theory of the firm, which is viewed as a part of the market, not standing outside of it, and putting the emphasis on entrepreneurship and information.