Paul Walker

The Past and Present of the Theory of the Firm

A historical survey of the mainstream approaches to the firm in
economics

Rough, incomplete draft. Comments welcome.

Long 4th January 2015

ii

iii

Abstract
In this survey we give a short overview of the way in which the theory of the
firm has been formulated within the mainstream of economics, both past
and present. As to a break point between the periods, 1970 is a convenient,
if not entirely accurate, dividing line. The major difference between the
theories of the past and the present is that the focus, in terms of the questions asked in the theory, of the post-1970 literature is markedly different
from that of the earlier (neoclassical) mainstream theory. The questions the
theory seeks to answer have changed from being about how the firm acts in
the market, how it prices its outputs or how it combines its inputs, to questions about the firms existence, boundaries and internal organisation and
the role of the entrepreneur. That is, there has been a movement away from
the theory of the firm being seen as developing a component of price theory,
namely issues to do with firm behaviour, to the theory being concerned with
the firm as a subject in its own right.
Parts of this essay utilise material previously presented in
Walker, Paul (2010). The (non)theory of the knowledge firm, Scottish
Journal of Political Economy, 57(1) February: 1-32.
Walker, Paul (2013). The Reference Point Approach to the Theory of the
Firm: An Introduction, Journal of Economic Surveys, 27(4) September: 670-95.
Walker, Paul (2014). From Complete to Incomplete (Contracts): A Survey
of the Mainstream Approach to the Theory of Privatisation, Working
Paper. Available at SSRN: http://papers.ssrn.com/sol3/papers.
cfm?abstract_id=2288974
Walker, Paul (forthcoming). Contracts, entrepreneurs, market creation
and judgement: the contemporary mainstream theory of the firm in
perspective, Journal of Economic Surveys.
Keywords: theory of the firm, incomplete contracts, principal-agent,
Spulber, entrepreneurial judgement.
JEL Classification: B21, D23, L20.

iv

CONTENTS

Abstract

iii

Introduction
The past
Background 8
Neoclassical 19
Behavioural and managerial models
Behavioural models 36
Managerial models 37
Summary 40
Demsetz and the neoclassical model
Conclusion 43

1
8

36

40

The founding works

Knight - Risk, Uncertainty and Profit
Coase - The Nature of the Firm 47
Conclusion 53

44
44

The present
The post-1970 theories of the firm 55
Mainstream theories 55
Principal-agent type models 56
Incomplete contracts models 68
The reference point approach 102
Spulber 2009 110
Foss and Klein 2012 113
Summary 115
Reference points, property rights and transaction costs

55

116

vi
The theory of privatisation 118
Background 119
The post-1980 theories of privatisation
Summary 142
Conclusion 142

129

Partial versus general equilibrium

Conclusion
Appendix
Appendix
Appendix
Appendix

1:
2:
3:
4:

References

the particular expenses curve 151

Simon (1951) 153
monotone comparative statics 159
examples of poor SOE performance 162
164

144
148

Introduction

Firms1 are a ubiquitous feature of the economic landscape, much of the

activity undertaken within an economy takes place within their boundaries.
McMillan (2002: 168-9), for example, estimates that less than a third of all
the transactions in the U.S. economy occur through markets, and instead
over 70 percent are within firms. Lafontaine and Slade (2007: 629) state that
the [d]ata on value added, for example, reveal that, in the United States,
transactions that occur in firms are roughly equal in value to those that occur
in markets. With regard to the number of firms and their importance to
employment Otteson (2014: 30) reports that for the U.S.A. alone: [i]n
2008, the United States has some 31.6 million businesses across thousands
of industries employing some 120 million people. The scale of activity
within firms ranges from that of global giants to that of sole proprietorships.
Kikuchi, Nishimura and Stachurski (2012: 2) note that [ . . . ] in 2011, Royal
Dutch Shell operated in over 80 countries, had annual revenue exceeding the
GDP of 150 nations, and paid its CEO 35 times more than the president
of the United States. In the same year, the total number of employees at
Wal-Mart exceeded the population of all but 4 US cities. In addition to such
giants, tens of millions of smaller firms operate around the world. Bowen
(1955: 1) highlights the importance of firms to peoples wellbeing by noting
that [t]he business enterprise is one of the most pervasive and influential
institutions of our society, and one in which innumerable important decisions
and responses are made. These decisions and responses, in small and large
enterprises, are links in the chain of factors determining the range of products
available to consumers, the level of national income, the degree of economic
security, the rate and direction of economic progress, and the distribution
of income. These decisions and responses also significantly influence the
character of human relations in industry, the quality of the lives of those
who work in industry, and even the power structure of our society.
1

Spulber (2008: 5, footnote 8) gives the origin of the word firm as [t]he word firm
derives from the Latin word firmare referring to a signature that confirmed an agreement
by designating the name of the business.

Introduction

Given the size of the contribution made by firms to economic activity,

employment and growth, having a sophisticated theoretical understanding
of the nature and structure of firms is an important component of a proper
understanding of how an economy functions.2 And yet [t]he theory of the
firm has been a neglected area of study in mainstream economics. Despite
Ronald Coase bringing the issue up for discussion in 1937, it was not on the
research agenda until the 1970s. Even now, as both Coase and Oliver Williamson, the founder of and prominent scholar in the transaction cost-focusing
analysis of firm organization, have received the Nobel Prize in economics,
the area remains in the periphery of economic analysis (Bylund 2011: 189).
Coase and Wang (2011: 1) remark [b]ut the gain in rigor achieved in modern price theory comes with a heavy price tag. The most obvious and serious
omission in price theory is that it sees no role for production, let alone entrepreneurship. How goods and services are actually produced, how new
goods and services and new ways of production are constantly invented in
the economy, how production and innovation are organized, and what forces
are at work are rarely on the research agenda in economics. It is extraordinary that the process of production is virtually invisible in economic theory
while Coase himself commented in an 2013 interview that [m]odern economics shows little interest in production (Wang 2014: 118).
With this essay we hope to help remedy this neglect, if only a little, by
showing that ongoing developments in the theory of the firm justify moving
the analysis of the firm from the margins of economic inquiry to its centre.3
We aim to do this by providing a short overview of how the theory of the firm
has been formulated within the mainstream4 of economics, both past and
2

Certainly such a view has been put forward in the past. Bowen (1955: 6-7) argues
[m]any economists, but by no means all, believe that greater and more exact knowledge
of the decisions and responses of business enterprises would enhance our ability to predict the outcome of changes in basic economic variables and of changes in public policy.
For example, it is frequently asserted that if economists knew more about the factors
determining rates of investment in enterprises, they should be able to predict the level of
national income with greater assurance. Or if they knew more about the goals or motives
of enterprises, and the processes by which decisions and actions are related to these goals,
they should be able to explain prices and outputs with greater reliability. Similarly, if
economists knew more about the responses of enterprises to changes in taxation, interest
rates, price control, and public regulations of various kinds, they should be able to offer
better advice on economic policies.
3
That a theory of the firm is important to economic theory in general has been
argued by some since the early days of the neoclassical theory of firm level production. In
1942 Kenneth Boulding wrote [t]hese volumes [Robinson (1933) and Chamberlin (1933)]
mark the explicit recognition of the theory of the firm as an integral division of economic
analysis upon which rests the whole fabric of equilibrium theory. General equilibrium
is nothing more than the problem of the interaction of individual economic organisms,
under various conditions and assumptions; as a necessary preliminary to its solution, an
adequate theory of the individual organism itself is necessary (Boulding 1942: 791).
4
Colander, Holt and Rosser (2004: 490) argue that the [m]ainstream consists of the
ideas that are held by those individuals who are dominant in the leading academic in-

Introduction

present.5 We will argue that over time a more sophisticated understanding

of firms has been developed, which has in turn lead to the development of
related areas such as the theory of privatisation, and look at possible ways
that the mainstream theory of the firm could evolve to continue this trend
into the future.
That there has been a close relationship between the general economic
mainstream and the development of the theory of the firm has been noted
by Foss and Klein (2006),
[ . . . ] the evolution of the theory of the firm has never taken
place far away from the economic mainstream. On the contrary,
it has in fact been much driven by advances in the mainstream,
and the relatively limited borrowing from other disciplines that
has taken place has usually been strongly adapted to conform
to central mainstream tenets. To be sure, the theory of the firm
may have been revolutionary in the (somewhat limited) sense
of introducing new explananda to economics, but it is generally true to say that it has not been revolutionary in the sense
of representing a radical break with any of the main tenets of
mainstream economics (Foss and Klein 2006: 3-4).
stitutions, organizations, and journals at any given time, especially the leading graduate
research institutions. Mainstream economics consists of the ideas that the elite in the
profession finds acceptable, where by elite we mean the leading economists in the top
graduate schools. It is not a term describing a historically determined school, but is instead a term describing the beliefs that are seen by the top schools and institutions in
the profession as intellectually sound and worth working on. Dequech (2007: 281) says
[ . . . ] that mainstream economics is that which is taught in the most prestigious universities and colleges, gets published in the most prestigious journals, receives funds from
the most important research foundations, and wins the most prestigious awards. In this
survey we do not distinguish the orthodoxy from the mainstream. The terms are used
interchangeably. See Colander, Holt and Rosser (2004, 2005) for a more sophisticated
discussion of the concepts which draws a distinction between them.
5
For much more complete surveys of the literature on the theory of the firm see, in
chronological order, Boulding (1942), Papandreou (1952), Bowen (1955) [this book contains a relatively comprehensive selected bibliography covering works on the business
enterprise in English for the period, roughly, 1940-1955], Boulding (1960), Simon (1962),
Cyert and March (1963: chapter 2), Alchian (1965), Machlup (1967), Cyert and Hedrick
(1972), Williamson (1977), Milgrom and Roberts (1988), Tirole (1988: 15-61), Hart (1989),
Holmstr
om and Tirole (1989), Wiggins (1991), Moore (1992), Borland and Garvey (1994),
Hart (1995), Holmstr
om and Roberts (1998), Foss (2000), Foss, Lando and Thomsen
(2000), Khachatrian (2003), Garrouste (2004), Roberts (2004: 74-117), Furubotn and
Richter (2005: 361-469), Gibbons (2005), Mahoney (2005), Menard (2005), Garrouste
and Saussier (2008), M
uller (2009), Aghion and Holden (2011), Hart (2011) and Zenger,
Felin and Bigelow (2011). Schultz (1939) looks at the application of the theory of the firm
to farm management. For surveys of the empirical literature see Joskow (1988), Shelanski
and Klein (1995), Vannoni (2002), Klein (2005), Lafontaine and Slade (2007) and Hubbard
(2008). In addition, The Handbook of Organizational Economics (Gibbons and Roberts
2013) contains a number of chapters relevant to both theoretical and empirical issues to
do with the theory of the firm.

Introduction

An implication of this is that the heterodox approaches to the firm have had
little direct effect on the development of the economic theory of organisations. Thus this surveys concentration on the mainstream literature may
do little damage to the story of the emergence of the theory of the firm but
it does mean that little will be said of those non-mainstream or heterodox
ideas, such as those from the overlap between economics and management
or the Marxist approaches or the Austrian inspired theory of the firm or the
relevant contributions from business history, that have developed outside of
the orthodoxy.6
6

Since the 1990s there has emerged a small Austrian literature on the firm, see for example Dulbecco and Garrouste (1999), Ioannides (1999), Witt (1999), Yu (1999), Lewin
and Phelan (2000), Sautet (2000), Jankovic (2010), Bylund (2011, 2014b) and Carson
(2014). For general discussions of this literature see Foss (1994, 1997), Foss and Klein
(2009, 2010), Klein (2010), Foss, Klein and Linder (2013) and Langlois (2013). For
discussions of the contributions from the resource-based theory of the firm see Penrose
(1959), Wernerfelt (1984), Conner (1991), Lockett, OShea and Wright (2008) and Foss
and Stieglitz (2010). On the knowledge-based view see Richardson (1972), Kogut and
Zander (1992, 1996), Conner and Prahalad (1996) and Demsetz (1997). For critiques of
knowledge-based theories see Foss (1996a, 1996b). Examples of the capabilities literature
are Barney (1991) and Jacobides and Winter (2005). The most important work in the
evolutionary economics approach to the firm is Nelson and Winter (1982). A discussion
of the insightful but largely neglected paper, Malmgren (1961), is missing from this survey, but see Foss (1996c). The relationship between the work of Malmgren and G. B.
Richardson and their impact on the modern approaches to the theory of the firm is discussed in Arena (2011: chapter 5). An early discussion of entrepreneurship and vertical
integration is given in Silver (1984). For a discussion of some of the critics of the theory
of the firm see Foss and Klein (2008). Sawyer (1979: chapter 9) considers radical critique
and radical alternatives to the theory of the firm. Sawyer briefly discusses Galbraiths
theory of countervailing power (Galbraith 1963), Baran and Sweezy on Monopoly Capital (Baran and Sweezy 1966), Rothchilds Price Theory and Oligopoly (Rothchild 1947)
and Galbraiths The New Industrial State (Galbraith 1969). Hagendorf (2009) gives a
Marxian critique of the theory of the competitive firm. The Marxian notion of the conflict theory of the firm is examined in Baker and Weisbrot (1994). Another topic ignored
here is the multinational firm, for overviews of this literature see Markusen (1995), Barba
Navaretti et al (2004), Gattai (2006) Antr`
as and Yeaple (2013) and Antr`
as (2014). For
an overview of research into the growth of firms see Coad (2007, 2009). From business
history comes Alfred D. Chandlers classic works on the origins of the modern large-scale
business enterprise, Chandler (1962, 1977, 1990). For a brief history of the development
of the limited liability company see Hickson and Turner (2006). Walsh (2009) offers a
Mengerian theory of the origins of the modern business firm. Some topics that are often
seen as being closely related to the mainstream theory of the firm but are also ignored
here are issues such as corporate finance and corporate governance. On such issues see
Shleifer and Vishny (1997), Bolton and Scharfstein (1998), Zingales (2000), Rajan and
Zingales (2001), Tirole (2001, 2006) and Hermalin (2013). For an application of the property rights approach to the firm to corporate tax avoidance see Borek, Frattarelli and Hart
(2013). The conditions under which different forms of firm ownership are optimal are discussed in Hansmann (1996, 2013) but are not considered here. For an early example of
the application of the theory of the firm to farm management research see Schultz (1939).
For a discussion of the modern approach to the economics of farms see Allen and Lueck
(2002). The Handbook on the Economics and Theory of the Firm (Dietrich and Krafft
2012) contains a number of chapters covering material not discussed below.

Introduction

As to what constitutes the past and the present, 1970 is a convenient,

if not entirely accurate, dividing line since it was around this time that the
present mainstream largely Coaseian based approaches to the firm started to develop with works such as Williamson (1971, 1973, 1975), Alchian
and Demsetz (1972), Jensen and Meckling (1976) and Klein, Crawford and
Alchian (1978). The major difference between the mainstream theories of
the past and the mainstream theories of the present, at least as far as they
are conceived of here, is that the focus in terms of the questions the theory
attempts to answer of the post-1970 mainstream literature is markedly
different from that of the earlier (neoclassical) mainstream theory. The
theory of the firm for Ronald Coase, Oliver Williamson, Bengt Holmstr
om
or Oliver Hart is a very different thing from that of Arthur Pigou, Lionel
Robbins, Jacob Viner, Joan Robinson or Edward Chamberlin.
The questions the theory seeks to answer have changed from being about
how the firm acts in its various markets: how it prices its outputs or how
it combines its inputs; to questions about the firms existence, boundaries
including the boundary between state and private enterprise and internal organisation. That is, within the mainstream theory there has been
a movement away from seeing the theory of the firm as simply developing
one component (albeit an important component) of price theory, namely the
element concerned with the factor and product market behaviour of producers, to the theory being concerned with the firm as a important economic
institution in its own right.
In addition there are recent contributions to the theory of the firm which
exploit ideas that on the surface make it seem as though they are developing an approach which undermines the mainstream theories. But it will be
argued below that these new theories can be more usefully interpreted as
following a course which extends, rather than subverts, the orthodox literature. In particular these contributions allow for the integration of the theory
of the entrepreneur7 with the theory of the firm. Questions to do with the
7
The word entrepreneur originates from a thirteenth-century French verb, entreprendre, meaning to do something or to undertake. By the sixteenth century, the
noun form, entrepreneur, was being used to refer to someone who undertakes a business
venture. The first academic use of the word by an economist was likely in 1730 by Richard
Cantillon, who identified the willingness to bear the personal financial risk of a business
venture as the defining characteristic of an entrepreneur. In the early 1800s, economists Jean-Baptiste Say and John Stuart Mill further popularized the academic usage of
the word entrepreneur. Say stressed the role of the entrepreneur in creating value by
moving resources out of less productive areas and into more productive ones. Mill used
the term entrepreneur in his popular 1848 book, Principles of Political Economy, to
refer to a person who assumes both the risk and the management of a business. In this
manner, Mill provided a clearer distinction than Cantillon between an entrepreneur and
other business owners (such as shareholders of a corporation) who assume financial risk
but do not actively participate in the day-to-day operations or management of the firm
(Sobel 2007: ??). In his 1931 English translation of Cantillon (1755) Henry Higgs rendered
entrepreneur as undertaker.

Introduction

importance of judgement8 to the role of the entrepreneur with regard to

the existence and organisation of firms, as well as the importance of the
entrepreneur to the formation of firms and through them the creation of
markets are beginning to be examined.
The rest of this essay consists of five more major sections. The section
directly following this introduction examines the past of the theory of the
firm. This section concentrates mainly on a discussion of the classical theory
of production and the neoclassical model of the firm. Consideration is also
given to two of the first, be they largely unsuccessful in terms of affecting
the mainstream economics literature, theoretical attempts to look inside the
black box that is the neoclassical firm. Descriptions of both the behavioural
and managerial models of the firm are briefly presented. Following on from
this comes an outline of Harold Demsetzs, non-Coaseian, interpretation of
the neoclassical model.
The third section of the paper consists of a short survey of the founding
works Knight (1921b) and Coase (1937) on which the present versions
of the mainstream theory of the firm are based while the fourth section deals
with the present mainstream theories themselves.
The fourth sections first subsection covers the post-1970 Coaseian/Knightian inspired theories of the firm. Within this category two general groups
of theories are identified: principal-agent models and incomplete contract
models. In both groups simple formal models of the major contributions
are presented. Following on from this we consider three of the more recent
contributions to the theory of the firm. Given their recent origins these
theories are not as well known as the other contributions considered in this
subsection and have yet to be integrated into standard discussions of the
theory of the firm. The reference point approach to the firm developed by
Hart and Moore (2008) is looked at first with a discussion of the theory
put forward in Daniel Spulbers book The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations
following that. The last of the three approaches considered is the entrepreneurial judgement perspective associated with Foss and Kleins 2012 book
Organizing Entrepreneurial Judgment: A New Approach to the Firm. Such
contributions offer a number of possible springboards to future advances
in the theory of the firm. Specifically it is the last two of these theories
that open pathways to the integration of the theory of the entrepreneur
with the theory of the firm. The second subsection involves a discussion of
the relationship between the three main contemporary theories of the firm:
the reference point, property rights and transaction costs approaches. In
the third subsection of section four the theory of privatisation is concisely
summarised.
The fifth section examines the use of partial versus general equilibrium
8

Decision making in situations involving Knightian uncertainty.

Introduction

modelling within the contemporary theory of the firm. It is noted that partial equilibrium analysis has come to dominate general equilibrium analysis
as the preferred approach to modelling the firm.
The last section is the conclusion.

The past

The brief overview of the past of the theory of the firm given here consists
of a discussion of the classical view of production, which doesnt contain
a theory of the firm or even a theory of firm level production, followed by
a look at the development of the neoclassical - or textbook - approach to
firm level production. Next there is a discussion of the behavioural and
managerial models of the firm, these being significant since they are some
of the first models to look inside the black box of the neoclassical firm. Last
there is an short outline of Harold Demsetzs view of the neoclassical model.

Background
While it can be argued that the theory of the firm has existed for only
80-90 years, in practice firms have existed for several thousand years.9,10
9

Cho and Ahn (2009: 160-1) state The oldest company in the world is known to be a
Japanese construction company, Kongo Gumi, which was founded in 578 and thus existed
for 1431 years. [However a footnote at this point states Kongo Gumi went bankrupt in
2006 and was acquired by Takamatsu group, thus depending on the definition of corporate
death it may be excluded from a long-lived company]. There are also several other
companies which are reported to have existed over 1000 years such as Houshi Ryokan
(Japan, Innkeeping, founded in 717), Stiftskeller St. Peter (Austria, restaurant, founded
in 803), Chateau de Goulaine (France, vineyard, founded in 1000) and Fonderia Pontificia
Marinelli (Italy, bell foundry, founded in 1000).
10
The first existence of a firm becomes especially problematic if we consider a farm to
be a firm. Farming is an ancient human activity: The first clear evidence for activities
that can be recognized as farming is commonly identified by scholars as at about 12,000
years ago [ . . . ] (Barker 2006: 1). Tudge (1998: 3) writes I want to argue that from at
least 40,000 years ago the late Palaeolithic people were managing their environments
to such an extent that they can properly be called proto-farmers . At what historical
point did the farm first become a firm? If we accept production for others as an important
characteristic of the firm then farms can be seen (at least partially) as firms from a very
early stage. Ofek (2001: chapter 13) argues that agriculture developed with a symbiotic
relationship with exchange/trade. There is a conflict between the fact that we specialise in
production but diversify in consumption. This conflict is reconciled by redistribution, i.e.
via exchange/trade. Ridley (2010: 127-30) agues there would be no farming without trade,

The past

Taking ancient India as an example, Khanna (2005) argues that the sreni11
- which was a complex organizational entity that shared similarities with
corporations, guilds, and producers cooperatives - was being used as early
as 800 B.C. and was in more or less continuous use from that time until
1000 A.D., at which time an Islamic invasion of India started.12 Sreni were
utilised in occupations involving workers such as carpenters, ivory workers,
bamboo workers, money-lenders, barbers, jewellers and weavers (Khanna
2005: 10).
In an analysis of the business history of the ancient Middle East Moore
that trade was a precursor to farming: One of the intriguing things about the first farming
settlement is that they also seem to be trading towns. [ . . . ] it is a reasonable guess that
one of the pressures to invent agriculture was to feed and profit from wealthy traders
to generate surplus that could be exchanged for obsidian, shells or other more perishable
goods. Trade came first (Ridley 2010: 127). Spulber (2009: 103) takes a contrary
position when he argues that the early farms where not firms. He writes that farms
from the earliest times to the eighteen century are precursors to the contemporary firms.
What distinguishes these economic actors from firms in that their enterprises tended to be
integrated with the personal economic affairs of the entrepreneur. There was no separation
between the owners commercial activities and their personal consumption activities. For
more on Spulbers approach to the firm see pages 110113 below.
11
Sreni were separate legal entities which could hold property separately from their
owners, create their own regulations controlling the behaviour of their members, contract,
sue and be sued in their own name (Khanna 2005: 8-9). Khanna (2005: Table 1, p. 27;
table footnotes removed) gives a summary of characteristics of the sreni:
Characteristics
Separate Entity
Centralized Management
Transferability of Interest
Limited Liability
Agent has power to bind entity?
Management elected?
Can management be removed?
Duty of Loyalty Probably
Duty of Care
Liability insulation
Screens on shareholder suits and internal
enforcement activity
Internal rules have binding effect
Some reimbursement for legal defense
Formation is easy
Register with state
State approval needed
Use of incentive payments
Entry is easy
Sharing of assets and liabilities
Exit is easy
Board/Committee Independence
Other board qualifications
Voting Regulation
Open debate in meetings & shareholder resolutions
Transparency is valuable and disclosure is
encouraged
12

Present in Ancient Indian Sreni?

Yes
Yes
Probably Yes
Probably Not
Yes
Yes (though at times appears hereditary)
Yes
Yes
Yes
Yes (though apparently not very detailed)
Yes (though apparently not very detailed)
Yes
Yes
Yes
Yes
Yes
Yes (though apparently not very detailed)
Some conditions, but no caste bars.
Terms of agreement and additional rules
Yes, but with obligations potentially
Probably Yes
Yes (though apparently not very detailed)
Yes (though apparently not very detailed)
Yes, with some limits (though apparently
not very detailed)
Probably Yes (though apparently not very
detailed)

Importantly classical Islamic law does not grant standing to corporations, it recognises
only national persons. For a discussion as to why Islamic law did not develop a concept
akin to the corporation see Kuran (2005).

10

The past

and Lewis (1999) show that firms go back well before 800 B.C. They point
out that the first known multinational enterprises13 occurred around 2000
B.C. in the times of the Assyrian Empire.
As they formed their numerous commercial colonies in foreign
lands, these Old Assyrian merchants of the second millennium
BC perfected a thousand-year-old system of private enterprise
inherited from Sumer and Babylon. [ . . . ] Even more importantly, the businesses operated by the ancient Assyrian colonists
constituted the first genuine multinational enterprises in recorded history (Moore and Lewis 1999: 27).
Silver (1995: 50) notes that
[p]rivate firms (btatu) were prominent in late-third-millennium
Akkad (the region south of Baghdad), in the Old Assyrian trade
with Cappadocia [ . . . ] and, somewhat later, at Nippur. In the
mid-second millennium the firm of Tehip-tilla played a major
role in the real estate transactions and other business activities
at Nuzi. A list of about the some time from Alalakh in northwest
Syria refers to sixty-four firms participating in leatherworking,
jewelry, and carpentry.
Sobel (1999: 21) points out that during the Roman Republic contracting
out of economic activities to private firms was the norm:
[t]he republican Senate left virtually all economic activities to
private individuals and companies, known collectively as the
publicani. Tax collection, supplying the army, providing for religious sacrifices and ceremonies, building construction and repair,
mining, and so on were all contracted out. There was even a contract for summoning the assembly in session and one for feeding
the sacred geese.
Micklethwait and Wooldridge (2003: 4) also note the private nature of tax
collection in Rome, pointing out that companies were formed for this, and
other purposes:14
13

Perhaps the oldest still existing multinational firm is the Roman Catholic Church.
Ekelund and Tollison (2011: 1) argue that [t]he longest-running institution in Western
culture and arguably one that has had an enormous influence on Western civilization has
been the Roman Catholic Church. Ekelund et al (1996: 17) note that [t]he formal
character of the Catholic Church, the single institution that come to embody Christianity
in its official capacity, emerged as a result of the Edict of Milan in A.D. 313. In note 1,
page 38, they explain that the edict meant that [ . . . ] the Church became the recognized
legal holder of property.
14
For a brief discussion of the forms that firms could take in ancient Rome see Hansmann,
Kraakman and Squire (2006: 1356-64).

The past

11

[t]he societates of Rome, particularly those organized by tax

farming publicani, were slightly more ambitious affairs. To begin
with, tax collecting was entrusted to individual Roman knights;
but as the empire grew, the levies became more than any one
noble could guarantee, and by the Second Punic War (218-202
b.c.), they began to form companies societates in which each
partner had a share. These firms also found a role as the commercial arm of conquest, grinding out shields and swords for the
legions. Lower down the social scale, craftsmen and merchants
gathered together to form guilds (collegia or corpora) that elected their own managers and were supposed to be licensed.
And some of these ancient firms were of reasonable size. Silver (1995:
66-7) notes,
[w]e may note here that during the Ur III period a new mill at
Girsu required the services of 679 women and 86 men (Maekawa
1980: 98)
and
[a] number of cities possessed large workshops employing hundreds of women in spinning and weaving. For example, a latethird-millennium text from Eshnunna lists 585 female and 105
male employees in a weaving house (Silver 1995: 143).
Ancient firms also diversified their activities.
Large commercial houses flourished in Babylonia from the seventh to the fourth century. The House of Egibi, for example,
bought and sold houses, fields, and slaves, took part in domestic
and international trade, and participated in a wide variety of
banking activities.
[. . . ]
Earlier, in the late third-millennium Sumer, the rulers and governors controlled vertically integrated firms that used wool of the
sheep they raised in their weaving workshops. At the same time,
an Umma businessman (- bureaucrat?) named Ur-e-e busied
himself with manifold operations, including raising livestock;
transactions involving cheese, oil, leather, carcasses, wool; the
weaving and finishing of cloth; shipments by boat of fish and
grain; and even the construction of boats (Silver 1995: 67).
Thus the firm is an ancient and important empirical feature of the
economic landscape but a feature which has been largely overlooked by
economic theorists. The dichotomy between theory and practice could not

12

The past

be more stark. Even the most cursory of examination of the development of

the contemporary theories of the firm would reveal that theorists have not
long considered firms to be important economic entities. As Foss, Lando
and Thomsen (2000: 632) note:
[i]t is only relatively recently, [ . . . ], that economists have felt
the need for an economic theory addressing the reasons for the
existence of the institution known as the (multi-person) business
firm, its boundaries relative to the market, and its internal organization - to mention the issues that are generally seen as the
main ones in the modern economics of organization [ . . . ].
Foss and Klein (2006: 9) also note that the theory of the firm has been
a neglected area of study in economics until quite recent times,
[ . . . ] few economists were working on the development of
theories of the firm, in the modern sense, until recently. And
if we by economic theory understands what has been called
mainstream economics, neoclassical economics, microeconomics, etc., it is hard to dispute that economic organization
was in general a much neglected subject area until relatively recently in the history of economic doctrines.
Such neglect has resulted in situation in which the theories of the firm
that do exist can be, and are, criticised for being rudimentary and bearing
little relationship to the organisations we see in the world. With regard to
the state of the modern theory of the firm Oliver Hart has written,
[a]n outsider to the field of economics would probably take it
for granted that economists have a highly developed theory of
the firm. After all, firms are the engines of growth of modern
capitalistic economies, and so economists must surely have fairly
sophisticated views of how they behave. In fact, little could
be further from the truth. Most formal models of the firm are
extremely rudimentary, capable only of portraying hypothetical
firms that bear little relation to the complex organizations we see
in the world. Furthermore, theories that attempt to incorporate
real world features of corporations, partnerships and the like
often lack precision and rigor, and have therefore failed, by and
large, to be accepted by the theoretical mainstream (Hart 1989:
1757).15
15
In personal correspondence (November 2008 - used here with permission), Professor
Hart said of the 1989 quote [t]he language of 1989 is strong, and Id probably tone it down
a bit now. Theres been a lot of work in the last twenty years, and some progress. However,
we are still not at the point where we have good models of the internal organization of
large firms.

The past

13

This lack of an adequate theory of the firm, or even an adequate theory of firm level production, is an issue that had been commented on long
before the late 1980s. More than 80 years before Hart, when surveying the
history of the theory of production, Edwin Cannan argued that, [b]efore
the middle of the eighteenth century a theory of production can scarcely
be said to have existed. Durable objects being looked upon as the sole or
chief kind of wealth, the functions of industry and trade seemed to be the
circulation of wealth. When the physiocratic school turned the attention of
economists to the consumable goods obtained by means of agriculture, the
idea of circulation gave way to the idea of an annual reproduction, which
gradually grew into the modern conception of production and consumption
(Cannan 1917: 35-6). Cannan also explains that Production and Distribution do not seem, however, to have been used in England before 1821 as
titles of divisions of political economy; and, before Adam Smith wrote, they
were not in any sense technical economic terms (Cannan 1917: 32).16
But the theories of production Cannan analysed were not theories of the
firm, if we use the current mainstream approaches to modelling firms as the
definition of such theories.17 It was noted by Cannan that [o]ne of the most
familiar and striking features of the theory of production, as taught in the
text-books of the second half of the nineteenth century, is the practice of
ascribing production to the co-operation or concurrence or joint use of three
great agents, instruments, or requisites of production. Labour, Land, and
Capital (Cannan 1917: 40). Such an approach has more in common with
the later neoclassical production function18 approach to production than the
16

Stigler (1941: 2-3) writes In 1870 there was no theory of distribution. Most English
economists after Smith devoted separate chapters to rent, wages, and profits, but without
important exception such chapters were only descriptive of the returns to the three most
important social classes of contemporary England. Rent went to the landowners, wages
to the laboring masses, and capitalists secured profits of stock. This type of analysis
may have had its uses in the England of Ricardo and Mill, but its analytical shortcomings
are obvious. Extended criticism is unnecessary at this point; the fundamental defect was
clearly the failure to develop a theory of the prices of productive servies.
17
In terms of the neoclassical theory, the theories considered by Cannan (and Stigler
(1941)) are half a theory. The neoclassical theory considers firms decisions in both
factor and product markets but as Williams (1978: 3) notes [a] study of the historical
development of the complete theory of the firm would be redundant. It would be redundant
because there already exist standard historical treatments of the firms decisions in factor
markets. [Cannan (1917) and Stigler (1941) are given as an examples of such studies] So
the present study relates only to the literature of those decisions of the firm which relate
directly to product markets the pricing and production decisions. So Cannan and
Williams each deal with half the components that constitute the neoclassical theory.
18
The first algebraic production function was most likely due to Johann Heinrich von
Th
unen in his book The Isolated State (Humphrey 1997: 63-4). In a letter to Leon Walras
dated January 6, 1877 Hermann Amstein derived the conditions of optimal factor hire
from the competitive firms constrained cost function. He solved a cost-minimization
problem in which the production function entered as a constraint (Humphrey 1997: 66-8).
Edgeworth (1889) uses a production function when giving the conditions for solving the

14

The past

Coaseian inspired approaches utilised in the current mainstream theories of

the firm.
The theories that Cannan was discussing where aimed at explaining the
creation, and distribution, of the wealth of a nation19 rather than explaining
the existence, boundaries and organisation of firms.20 Therefore the theories
being analysed are macroeconomic theories of the production of an entire
economy rather than microeconomic theories of firm production. OBrien
(2003: 112) remarks that [c]lassical economics ruled economic thought
for about 100 years. It focused on macroeconomic issues and economic
growth. Because the growth was taking place in an open economy, with
a currency that (except during 1797-1819) was convertible into gold, the
classical writers were necessarily concerned with the balance of payments,
the money supply, and the price level. Monetary theory occupied a central place, and their achievements in this area were substantial and - with
their trade theory - are still with us today. Foss and Klein (2006: 7-8)
note that classical economics was largely carried out at the aggregate level
with microeconomic analysis acting as little more than a handmaiden to the
macro-level investigation,
[e]conomics began to a large extent in an aggregative mode,
as witness, for example, the Political Arithmetick of Sir William Petty, and the dominant interest of most of the classical
economists in distribution issues. Analysis of pricing, that is to
say, analysis of a phenomenon on a lower level of analysis than
distributional analysis, was to a large extent only a means to an
end, namely to analyze the functional income distribution.
OBrien (2004: 63) makes the same basic point by noting the differences in
emphasis between classical and neoclassical economics:
[t]he core of neo-Classical economics is the theory of microeconomic allocation, to which students are introduced in their
first year in an elementary and largely intuitive form, and which
receives increasingly sophisticated statements during succeeding
years of study. On top of this, as a sort of icing on the cake, comes
the macroeconomics theory of income determination, with, in
profit maximisation problem. Production functions were common by the early 1890s, see
for example, Berry (1891), Johnson (1891) and Wicksteed (1894).
19
Production and distribution in political economy have always meant the production and distribution of wealth (Cannan 1917: 1). Chapter 1 of Cannan (1917) surveys
the various meanings of wealth utilised in the economic writings of the 1776-1848 period.
20
Two possible (partial) exceptions to this are J.S. Mills discussion of the advantages
and disadvantages of the joint stock company, Mill (1848: Book I, Chapter IX), and
Babbages consideration of the effects of technology and the division of labour, Babbage
(1832). OBrien (1984: 25) argues that these two authors influenced parts of Alfred
Marshalls work on the firm.

The past

15

little attached boxes so to speak, theories of growth and trade

appended. But the approach of the Classical economists was the
very reverse of this. For them the central propositions of economics concerned macroeconomic problems. Their focus above
all was on the problem of growth, and the macroeconomic distribution conclusions which followed from their view of growth.
On the one hand, international trade, at least for Smith, was
inextricably bound up with all this: on the other, the microeconomic problems of value and microdistribution took their place
as subsets of the greater whole.
Lionel Robbins remarked that the classical theories of production and
distribution were about determining the total wealth, or total product, of
the nation: [t]he traditional approach to Economics, at any rate among
English-speaking economists, has been by way of an enquiry into the causes
determining the production and distribution of wealth.[a footnote at this
point refers the reader to Cannan (1917)] Economics has been divided into
two main divisions, the theory of production and the theory of distribution,
and the task of these theories has been to explain the causes determining the
size of the total product and the causes determining the proportions in
which it is distributed between different factors of production and different
persons (Robbins 1935: 64).
As an example of a missed opportunity to construct a classical economics
based theory of the firm consider Adam Smith who opens his magnum opus,
An Inquiry into the Nature and Causes of The Wealth of Nations, with a
discussion of the division of labour at the microeconomic level, the famous
pin factory example,21 but quickly moves the analysis to the market level.
When discussing Smiths approach to the division of labour McNulty (1984:
237-8) comments,
[h]aving conceptualized division of labor in terms of the organization of work within the enterprise, however, Smith subsequently
failed to develop or even to pursue systematically that line of
analysis. His ideas on the division of labor could, for example,
have led him toward an analysis of task assignment, management, or organization. Such an intra-firm approach would have
foreshadowed the much laterindeed, quite recentefforts in this
direction by Herbert Simon, Oliver Williamson, Harvey Leibenstein, and others, a body of work which Leibenstein calls micromicroeconomics. [ . . . ] But, instead, Smith quickly turned his
attention away from the internal organization of the enterprise,
and outward toward the market and the realm of exchange, perhaps because he found therein both the source of division of
21

For a discussion of the origins of Smiths pin making example see Peaucelle (2006)
and Peaucelle and Guthrie (2011).

16

The past
labor, in the propensity in human nature . . . to truck, barter
and exchange and its effective limits.

Blaug (1958: 226) summed up the classical economics approach to the

firm by arguing that the classical economists simply [ . . . ] had no theory of
the firm,22 and as will be argued below the neoclassical economists did little
better in terms of a genuine theory of the firm. Kenneth Arrow explains,
[i]n classical theory, from Smith to Mill, fixed coefficients in production are
assumed. In such a context, the individual firm plays little role in the general
equilibrium of the economy. The scale of any one firm is indeterminate,
but the demand conditions determine the scale of the industry and the
demand by the industry for inputs. The firms role is purely passive, and
no meaningful boundaries between firms are established (Arrow 1971: 68)
and he went on to add, with regard to the (general equilibrium) neoclassical
model,
[w]hen Walras first gave explicit formulation to the grand vision
of general equilibrium, he took over intact the fixed-coefficient
assumptions and therewith the passive nature of the firm. In
the last quarter of the nineteenth century, J. B. Clark, Wicksteed, Barone, and Walras himself recognized the possibility of
alternative production activities in the form of the production
function. However, so long as constant returns to scale were assumed, the size of the firm remained indeterminate. The firm did
have now, even in equilibrium, a somewhat more active role than
in earlier theory ; it at least had the responsibility of minimizing
costs at given output levels (Arrow 1971: 68).
This does raise the obvious question as to why economists ignored the
firm, as an important economic institution in its own right, for so long.23
One reason for the neglect of the firm is simply that for a long time economists did not see economic theory as being relevant to business or saw
22

Bowen (1955: 5-6) argues in a similar fashion: [ . . . ] economists of the classical

tradition had usually assumed that the level and distribution of income and the allocation
of resources were determined by forces that could be understood without a detailed theory
of the firm. [ . . . ] Everything else would be settled by the impersonal forces of the market,
and there would be no need to consider in detail the decisions and actions of the individual
firm.
23
As to why the firm was ignored in Austrian economics Witt (1999: 108) writes, [t]he
neglect of the firm as the organizational form of an entrepreneurial venture has a tradition
in Austrian economics. It may be traced back to a characteristic of the scientific community in the German language countries. There, economic theory (Volkswirtschaftslehre)
and business economics (Betriebswirtschaftslehre) were institutionally segregated as early
as at the turn of the century to a degree still unknown today in the Anglo Saxon world. As
Lachmann once conjectured, Austrian writers therefore considered the organizational form
of entrepreneurial activities to be a topic best left to their business economics fellows.

The past

17

the internal workings of the firm to be outside the competence of economists. Edwin Cannan saw the usefulness of economics as being in politics
rather than business, [t]he practical usefulness of economic theory is not in
private business but in politics, and I for one regret the disappearance of the
old name political economy, in which that truth was recognised (Cannan
1902: 60). With regard to the relationship between economic theory and
business Cannan wrote,
I do not mean to argue that a knowledge of economic theory
will enable a man to conduct his private business with success.
Doubtless many of the particular subjects of study which come
under the head of economics are useful in the conduct of business,
but I doubt if economic theory itself is. [ . . . ] economic theory
does not tell a man the exact moment to leave off the production
of one thing and begin that of another; it does not tell him
the precise moment when prices have reached the bottom or
the top. It is, perhaps, rather likely to make him expect the
inevitable to arrive far sooner than it actually does, and to make
him underrate, not the foresight, but the want of foresight of the
rest of the world (Cannan 1902: 459-60).
Cannan was not alone in making this type of argument. Arthur Pigou
wrote:
[ . . . ] it is not the business of economists to teach woollen manufacturers to make and sell wool, or brewers how to make and sell
beer, or any other business men how to do their job. If that was
what we were out for, we should, I imagine, immediately quit
our desks and get somebody - doubtless at a heavy premium, for
we should be thoroughly inefficient - to take us into his woollen
mill or his brewery (Pigou 1922: 463-4).
Lionel Robbins argued similarly, in that
[t]he technical arts of production are simply to be grouped
among the given factors influencing the relative scarcity of different economic goods. The technique of cotton manufacture [ . . . ]
is no part of the subject-matter of Economics [ . . . ] (Robbins
1935: 33).
Foss and Klein (2006: 6-7) argue that there is the possibility of an empirical reason for the firm being overlooked; the relative unimportance of
the firm. Until relatively recently firms were simply not a large part of the
economy. But they also point out that such an explanation is not wholly

18

The past

convincing. Large firms24 have existed since before the time of Adam Smith
and the classical economists knew this. A more precise, and more defensible,
version of the argument would be that the large, vertically integrated and
diversified firm was not empirically important until recently. Thus analysing
anonymous firms may not have been a bad approximation to the empirical
realities of the time.25 But the evidence presented above on the size and
24

Mokyr (2002: 122-3) summarises manufacturing in the U.K. before the Industrial
Revolution by noting that [ . . . ] large plants were not entirely unknown before the
Industrial Revolution. For instance, Pollard (1968) in his classic work on the rise of
the factory, mentions three large British plants, each employing more than 500 employees
before 1750. Perhaps the most modern of all industries was silk throwing. The silk mills
in Derby built by Thomas Lombe in 1718 employed 300 workers and were located in a
five-story building. After Lombes patent expired, large mills patterned after his were built
in other places as well. Equally famous was the Crowley ironworks, established in 1682 in
Stourbridge in the Midlands (not far from Birmingham), which at its peak employed 800
employees. [ . . . ] In textiles, supervised workshops production could be found before 1770
in the Devon woollen industry and in calico printing (Chapman 1974). The development
of factories and firms during the industrial revolution is discussed in Mokyr (2009: chapter
15). Also chartered companies were well known as witnessed by Adam Smiths negative
assessment of chartered companies in general and the East India Company in particular,
contained in the Wealth of Nations. Jones and Ville (1996a: 898) note that Adam
Smith, no friend of chartered companies, argued that this separation of ownership from
control contributed to gross administrative inefficiency, inattention to detail, and the
pursuit of managerial goals, which raised prices to consumers and reduced returns to
shareholders. He believed that only the extraction of monopoly rents ensured the success
and continuance of such companies. See Smith (1776: Book V, Chapter 1, Part e, pp.
731-58). Smiths view of chartered companies is discussed in Kennedy (2010: 143-7).
On the issue of whether the joint-stock chartered trading companies were an efficient
institutional response to long-distance trade or were inefficient, rent-seeking monopolists
see Carlos and Nicholas (1996), Jones and Ville (1996a,b) and Ogilvie (2011). A general
history of the chartered companies is given in Cawston and Keane (1896), Griffiths (1974)
and Ekelund and Tollison (1997: chapters 6 and 7). An important development for the
modern large firm, following on from the chartered companies, was the introduction of
limited liability. See Copp (2008) for a discussion of the reasons for the introduction
of limited liability in the U.K. Limited liability protects investors from claims of the
corporation, organisational law also does the converse. The assets of the corporation are
protected from claims by investors. Hansmann, and Kraakman (2000a,b) and Hansmann,
Kraakman and Squire (2005) emphasise the importance of this asset separation to the
development of the firm. Hansmann, Kraakman and Squire (2006) traces the history of
the emergence of entity shielding.
25
As an approximation to anonymous firm production - that is, fully price-decentralised
production - consider the case of rife manufacture in Birmingham, England in the 1860s,
[o]f the 5800 people engaged in this manufacture within the boroughs boundaries in
1861 the majority worked within a small district round St Marys Church. . . . The reason
for the high degree of localization is not difficult to discover. The manufacture of guns,
as of jewellery, was carried on by a large number of makers who specialized on particular
processes, and this method of organization involved the frequent transport of parts from
one workshop to another.
The master gun-maker-the entrepreneur-seldom possessed a factory or workshop.
. . . Usually he owned merely a warehouse in the gun quarter, and his function was to
acquire semi-finished parts and to give these out to specialized craftsmen, who undertook
the assembly and finishing of the gun. He purchased materials from the barrel-makers,

The past

19

diversified nature of ancient firms as well as the size of some pre-industrial

revolution firms (see footnote 24, p.18) should give us cause for refection
before accepting this conclusion without some reservations.

Neoclassical
For whatever reason it is certainly true that it is only in more recent
times that the firm has attracted serious attention in terms of its role as an
important part of the economic system. Many would date the beginning of
a genuine theory of the firm, at its earliest, from either Knight (1921b) or
Coase (1937), rather than to either the classical school or the neoclassical
revolution.26
Before the contributions of Knight and Coase we had discussions of pin
factories, but the discussion was about the importance of the division of
labour rather than being an enquiry into the nature and causes of the
firm.27
lock-makers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture makers, and, if
he were engaged in the military branch, from bayonet-forgers. All of these were independent manufacturers executing the orders of several master gun-makers. . . . Once the parts
had been purchased from the material-makers, as they were called, the next task was
to hand them out to a long succession of setters-up, each of whom performed a specific
operation in connection with the assembly and finishing of the gun. To name only a few,
there were those who pre-pared the front sight and lump end of the barrels; the jiggers,
who attended to the breech end; the stockers, who let in the barrel and lock and shaped
the stock; the barrel-strippers, who prepared the gun for rifling and proof; the hardeners,
polishers, borers and riflers, engravers, browners, and finally the lock-freers, who adjusted
the working parts (Allen (1929: 56-7 and 116-7), quoted in Stigler (1951: 192-3).)
Such a method of production would be a guide to the way production would take
place under a functioning version the neoclassical model of the firm. However it could
be argued that this form of production isnt neoclassical since it is not clear that the
neoclassical separation theorem is satisfied. See Spulber (2009) for a discussion of the
separation theorem.
26
OBrien (1984: 25) takes a contrary position: [s]erious discussion of the history of
the theory of the firm has to start with Alfred Marshall. OBriens argument is based,
in the main, on Marshall (1920a). OBrien also argues that developments subsequent to
Marshall have resulted in many of Marshalls insights being lost to succeeding generations
of economists. We would therefore argue that Marshall has left little in the way of a legacy
in terms of the mainstream theory of the firm. In addition to his views on Marshalls
work and later developments OBrien also argues that any attempt to construct a preMarshallian theory from the materials available is likely to be unsuccessful. See, however,
Williams (1978) for such an attempt. On the neglect of Marshalls Industry and Trade
(Marshall 1920a) see also Liebhafsky (1955). The development of the theory of the firm
from Marshall to Robinson and Chamberlin is also dealt with in Moss (1984).
27
When writing about Adam Smiths approach to the firm Williams (1978: 11) says,
[t]he firm was disembodied and became a unit in which resources congeal in the productive
process. When we come to examine the equilibrium/value theory of The Wealth of Nations
it will be shown that, in that context, the firm is little more than a passive conduit which
assists in the movement of resources between alternative activities. Best (2012: 29) states
simply that Adam Smith did not elaborate a theory of the firm.

20

The past

As noted above the classical economists28 followed Adam Smith in neglecting micro-microeconomics in favour of a more macro based approach.
In the period following the classical economists, with the possible exception
of Alfred Marshall, few economists wrote anything much on the firm. When
reviewing the contribution of the old institutionalists to the theory of the
firm Hodgson (2012: 55) writes, [ . . . ] we search in vain for a well-defined
theory of the firm within the old institutional economics. Carl M. Guelzo
argues that one of the leading old institutionalists, John R. Commons, [ . . . ]
did not construct a rigorous theory of the firm since this was never his purpose (Guelzo 1976: 45). With reference to the German historical school Le
Texier (2013: 80) writes [m]embers of the German historical school such as
Gustav von Schmoller analysed at length the birth and growth of the business enterprise, but they were more historians than economists. None of
these thinkers proposed a theory of the business firm. When writing about
the work of Joseph Schumpeter, Hanappi (2012: 62) says [a] well-defined
theory of the firm thus cannot be found in Schumpeters oeuvres. As to
Austrian economics Per Bylund writes, [b]ut despite the focus in Austrian
economics on [ . . . ] mundane economics, and the fact that the Austrians
[have] so many necessary ingredients for a theory of the firm [ . . . ], there is
no Austrian theory of the firm (Bylund 2011: 191) and [w]hereas the theory of the firm has been a neglected area of study in mainstream economics,
it has been missing from the Austrian economics literature (Bylund 2011:
191). Hutchison (1953: 308) comments [t]he Austrian School, with the
exception of Auspitz and Lieben, did not concern themselves much with the
analysis of markets and firms, except in respect to their general principle
of imputation. Hutchison also summarised the early neo-classical contributions to the theory of the firm, and markets, as Jevons has little on the
firm. [ . . . ] Walrass assumptions of perfect competition (maintained virtually throughout) and of fixed technical coefficients, limited his contribution
to the analysis of firms and markets, [ . . . ]. Paretos contribution to the theory of firms and markets were not rounded off, and of very varying value,
[. . . ] (Hutchison 1953: 307).
As has been pointed out by Demsetz (1982, 1988a, 1995) before Knight
and Coase and it could be added for much of the period after them
the fundamental preoccupation of (micro) economists was with the market
and the price system and hence little, or no, attention was paid to either
the firm or the consumer as separate, significant, economic entities. Firms
(and consumers) existed as handmaidens to the price system.
The interest in the price system, culminating in the (neoclassical) perfect
competition model, has its intellectual origins in the eighteenth-century
28

For discussions of economic thought - including production, the little there is - before
the classical economists see, for example, Bonar (1893), Whittaker (1940: chapter VIII)
and Samuels, Biddle and Davis (2003: chapters 1-6).

The past

21

debate between free traders and mercantilists. Butler (2007: 25-6) briefly
sums up mercantilism in the following way:29
[ . . . ] it measured national wealth in terms of a countrys stock
of gold and silver. Importing goods from abroad was seen as
damaging because it meant that this supposed wealth must be
given up to pay for them; exporting goods was seen as good
because these precious metals came back. Trade benefited only
the seller, not the buyer; and one nation could get richer only
if others got poorer. On the basis of this view, a vast edifice
of controls was erected in order to prevent the nations wealth
draining away - taxes on imports, subsidies to exporters and
protection for domestic industries. [ . . . ] Indeed, all commerce
was looked upon with suspicion and the culture of protectionism
pervaded the domestic economy too. Cities prevented artisans
from other towns moving in to ply their trade; manufacturers and
merchants petitioned the king for protective monopolies; labour
saving devices such as the new stocking-frame were banned as a
threat to existing producers.
The extent of government control of the mercantile economy is illustrated
by Appleby (2010: 40) with the example of the granting of monopolies in
seventeen century England,
King James I found in the granting of monopolies a particulary
facile way of increasing his income. As one scholar has reported
in the early seventeenth century a typical Englishman lived in
a house built with monopoly bricks . . . heated by monopoly coal.
His clothes are held up with monopoly belts, monopoly buttons,
monopoly pins . . . He ate monopoly butter, monopoly currants,
monopoly red herrings, monopoly salmon, monopoly lobsters.30
The holders of monopolies has the exclusive rights to sell these
items and charged as much as people would pay for them.
The free trade versus mercantilism debate was, to a large degree, about
the proper scope of government in the economy31 and the model it (eventually) gave rise to reflects this. The question implicitly at the centre of the
29

For a detailed discussion of mercantilism see Heckscher (1934), Viner (1937), Magnusson (1994) and Ekelund and Tollison (1997).
30
The quote given by Appleby is from Hill (1961: 32).
31
Mercantilism requires a dominate state, not just to provide and enforce monopolies
but also to regulate and control both domestic and international trade and to direct the
economy in general. Higgs (1897: 16) explains [t]he Mercantilists seem always to have
propounded to themselves the problem, How can Government make this nation prosperous? Nationalism, state-regulation, and particularism are the essence of their policy while
Blackhouse (2002: 58) notes [m]ercantilist policies include the use of state power to build
up industry, to obtain and increase the surplus of exports over imports, and to accumu-

22

The past

debate was, Is central planning necessary to avoid the problems of a chaotic

economic system? Adam Smith famously answered no.32 Smith
[ . . . ] realised that social harmony would emerge naturally as
human beings struggled to find ways to live and work with each
other. Freedom and self-interest need not lead to chaos, but
as if guided by an invisible hand would produce order and
concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others
solely in order to better their own condition the nations
land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends
and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued
supervision of kings and ministers. It would grow organically as
late stocks of precious metals. In France during this period [mid-1700s] the concept
[mercantilism] was utilized in order to describe an economic policy regime characterized
by direct state intervention, intended to protect domestic merchants and manufacturers
(Magnusson 2003: 46). When discussing the general economic background to the development of the mercantile chartered companies in England, Griffiths (1974) explains that
[t]he rightand the dutyof the Crown to control the economy was taken for granted
and according to Coke the royal prerogative had an ancient and special force in the
government of trade (p. ix) and [t]he underlying concepts were those of monopolies,
collective trading or regulation of trade and the right of the Crown to control the economy (p. 3). In a comment on Eli Heckschers view of mercantilism Deepak Lal writes
that Heckscher had argued that the mercantilist system arose as the Renaissance princes
sought to consolidate the weak states they had inherited or acquired from the ruins of the
Roman Empire. These were states encompassing numerous feuding and disorderly groups
which the new Renaissance princes sought to curb to create a nation. The purpose was
to achieve unification and power, making the States purposes decisive in a uniform
economic sphere and to make all economic activity subservient to considerations corresponding to the requirements of the State. The mercantilist policies-with their industrial
regulations, state-created monopolies, import and export restrictions, price controls-were
partly motivated by the objective of granting royal favors in exchange for revenue to meet
the chronic fiscal crisis of the state [ . . . ]. Another objective was to extend the span of
government control over the economy to facilitate its integration (Lal 2006: 307).
32
According to Smith the government has three duties: [t]he first duty of the sovereign,
that of protecting the society from the violence and invasion of other independent societies
[ . . . ] (Smith 1776: Book V, Chapter 1, Part First, p. 689). The second duty of
the sovereign, that of protecting, as far as possible, every member of the society from
injustice or oppression of every other member of it, or the duty of establishing an exact
administration of justice, [ . . . ] (Smith 1776: Book V, Chapter 1, Part II, p. 709). The
third and last duty of the sovereign or commonwealth is that of erecting and maintaining
those publick institutions and those publick works, which, though they may be in the
highest degree advantageous to a great society, are, however, of such a nature that the
profit could never repay the expense to any individual or small number of individuals, and
which it therefore cannot be expected that any individual or small number of individuals
should erect or maintain (Smith 1776: Book V, Chapter 1, Part III, p. 723). For book
length discussions of Smiths thought see, for example, Evensky (2005), Kennedy (2005,
2010) and Otteson (2002, 2011).

The past

23

a product of human nature (Butler 2007: 27-8).

For Smith competitive markets were the most prominent mechanism for
coordinating and motivating people to maximise the grains that result from
increased specialisation and an expanded division of labour. Well functioning market institutions leave individuals free to pursue self-interested
behaviour, but guide their choices by the prices they pay and receive. For
economists, the 200 years following Smith involved a search for conditions
under which the price system would function well, conditions under which
it would not descend into chaos.
The formal (neoclassical) model that arose from this search is one which
abstracts completely away from any form of centralised or institutional control in the economy.33 It is a model delineated by perfect decentralisation.34
Authority, be it in the form of a government or a firm or a household, plays
no role in coordinating resources.35 The only parameters guiding decision
33
For Adam Smith this would be an abstraction too far. Smith knew of the importance
of institutions to the proper functioning of the market economy. Mark Blaug points out
that [ . . . ] Smiths faith in the benefits of the invisible hand has absolutely nothing
whatever to do with allocative efficiency in circumstances where competition is perfect `
a
la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support
of what is now known as the fundamental theorems of welfare economics is a historical
travesty of major proportions. For one thing, Smiths conception of competition was, as
we have seen, a process conception, not an end-state conception. For another society, a
decentralised competitive price system was held to be desirable because of its dynamic
effects in widening the scope of the market and extending the advantages of the division
of labour - in short, because it was a powerful engine for promoting the accumulation of
capital and the growth of income (Blaug 1996: 60-1).
34
The neoclassical model is often described as one of perfect competition and one
reason that the emphasis on the firm diminished as the model developed was that the
neoclassical placed a growing emphases on the concept of market competition and thus
less emphases was given to the firm. As McNulty (1984: 240) explains [t]he perfection
of the concept of competition, beginning with the work of A. A. Cournot and ending
with that of Frank Knight, which was at the heart of the development of economics
as a science during the nineteenth and early twentieth centuries, led on the one hand
to an increasingly rigorous analytical treatment of market processes and on the other
hand to an increasingly passive role for the firm. For Knight [p]erfect competition
is conditioned by the existence of a set of assumptions, the most important of which
are the following: (1) a perfect market for productive services [ . . . ], that is, uniform
prices over the whole field (1921[a], 316); (2) complete rationality and perfect knowledge
by free and independent individuals; (3) perfect mobility in all economic adjustments,
no cost involved in movements or changes (1921[b], 77); (4) virtually instantaneous
and costless exchange of commodities (1921[b],78); (5) perfect, continuous, costless
intercommunication between all individual members of the society (1921[b], 78); (6)
perfect divisibility of commodities; and (7) an indefinitely large number of competing
organizations, each of the most efficient size (1921[a], 316) (Marchionatti 2003: 58).
35
The household in the neoclassical model is as lacking in substance as the firm. Kenneth
Boulding made the point that [t]his type of analysis [the theory of the firm] is exactly
analogous to the analysis of the reactions of a consumer by means of indifference curves.
Indeed, a consumer is merely a firm whose product is utility. The indifference curves
are analogous to the isoquants, or product contours, the only difference being that they

24

The past

making are those given within the model tastes and technologies and
those determined impersonally on markets prices. All parameters are outside the control of any of the economic agents and this effectively deprives all
forms of authority a role in allocation. This includes, of course, the firm. It
doesnt matter whether it is the general equilibrium version of the neoclassical model, characterised by Walrass tatonnement process, or the partial
equilibrium version, characterised by Pigous equilibrium firm, there is no
serious consideration given to the firm as a problem solving institution.36
cannot be assigned definite quantities of utility. The utility surface, whose contours form
the system of indifference curves, is a mountain whose shape we theoretically know, but
whose height at any point probably cannot be known; by contrast, we can assume that both
shape and height of the production surface are known. The substitution effect and the
scale effect are likewise known in consumption theory, where the scale effect is usually
called the income effect. Thus, a rise in the price of a single object of consumption will
have a substitution effect tending to reduce the consumption of that object as cheaper
alternatives are substituted for it. There will also be an income effect tending to reduce
all consumption, as the higher price makes the consumer poorer. The effect of a given
rise in price, therefore-i.e., the elasticity of demand-depends first on the substitutability
of the commodity concerned, and, secondly, on its importance in the total expenditure.
This is true either of a consumption good or of a factor of production (Boulding 1942:
799). Fritz Machlup argues that the household is not the subject of study in the theory of
the consumer: [t]he household in price theory is not an object of study; it serves only
as a theoretical link between changes in prices and changes in labor services supplied and
in consumer goods demanded. The hypothetical reactions of an imaginary decision-maker
on the basis of assumed, internally consistent preference functions serve as the simplest
and heuristically satisfactory explanation of empirical relationships between changes in
prices and changes in quantities. In other words, the household in price theory is not an
object of study (Machlup 1967, footnote 4, p. 9).
36
About the partial equilibrium approach to the firm Klein (1996: 5) writes,
[i]n neoclassical economic theory, the firm as such does not exist at all. The firm is
a production function or production possibilities set, a means of transforming inputs into
outputs. Given the available technology, a vector of input prices, and a demand schedule,
the firm maximizes money profits subject to the constraint that its production plans must
be technologically feasible. That is all there is to it. The firm is modeled as a single actor,
facing a series of relatively uncomplicated decisions: what level of output to produce, how
much of each factor to hire, and so on. These decisions, of course, are not really decisions
at all; they are trivial mathematical calculations, implicit in the underlying data. In the
long run, the firm may also choose an optimal size and output mix, but even these are
determined by the characteristics of the production function (economies of scale, scope,
and sequence). In short: the firm is a set of cost curves, and the theory of the firm is a
calculus problem.
The high water mark for neoclassical general equilibrium approach is arguably Debreu
(1959). For Debreu there are no firms, in the normal sense of the word, there are just
producers,
[ . . . ] when one abstracts from legal forms of organization (corporations, sole proprietorships, partnerships, . . . ) and types of activity (Agriculture, Mining, Construction,
Manufacturing, Transportation, Services, . . . ) one obtains the concept of a producer, i.e.,
an economic agent whose role is to choose (and carry out) a production plan (Debreu
1959: 37).
It is also clear from the context that the agent referred to is a person. The only role
for the agent is to pick the profit maximising production plan from the set of available

The past

25

Like so much of neoclassical economics it was Alfred Marshall who began

the developments that resulted in the (partial equilibrium) neoclassical theory of the firm. It was Marshalls notion of the representative firm that
began a controversy that led to the development of the now common textbook theory of the firm. For Marshall firms were dynamic, heterogeneous,
in disequilibrium; they progressed through a life cycle in much the same
way as people. They began young and vigorous, but after a period of maturity they became old and were displaced by newer more efficient firms
(Backhouse 2002: 179). Marshall gave us the famous metaphor of an industry being like a forestwhile it might appear unchanged if considered as
a whole, the individual trees that make it up are constantly changing. To
reconcile his dynamic view of individual firms with the static view of industries Marshall introduced his (nebulous) idea of a representative firm. The
representative firm is composed of the salient characteristics of all firms in
the industry (Moss 1984: 308). It would need to be in some sense representative both of the cost and of the sales position of other firms within
the industry. For this to be true it would need to be representative with
respect to its business ability, age, luck, size and its access to net external
economies (Williams 1978: 102).37,38 Or as D. H. Macgregor put it [t]he
plans. Langlois (1981: 5) explains that [ . . . ] the interesting feature of the generalequilibrium formulation is not so much that it takes as given the mix of market and internal
transactions; rather, it is that the assumptions of general-equilibrium theory themselves
actually suggest that there need be no internal activity whatsoever. If all commodities
are predetermined for all time and the techniques for producing them are given and fully
known in all details, then one could easily conceive of a situation where every separate
part of the production process would be in the nature of a market transaction.
37
Williams (1978: 101-2) provides a diagram, based on Macgregor (1949: 44), which
illustrates the properties of the representative firm. In Figure 25.1 0M is the industry
supply, MP is the price which is sufficient to maintain the industry output indefinitely,
QR is the particular expenses curve (see Appendix 1, page 151, for a brief discussion of
this curve.), SR are the high cost producers with long-period marginal expenses greater
than marginal revenue (i.e. price), QS are the produces with long-run marginal expenses
below marginal revenue, S are the representative conditions.
R

Price/Cost
S

Q
0

M Output
Figure 25.1.

38

Williams (1978:101) explains that,

[t]he representative firm may be used in three ways:

26

The past

firm which is to be regarded as our unit is the representative firm, the

structure which is typical of a period of economic development, which has
access to all the normal economies of that period, and is of the size which
is suited to their most efficient use. It has had a fairly long life, and fair
success, is managed with normal ability, while its size takes account of
the class of goods produced, the conditions of marketing them, and the
economic environment generally (Macgregor 1906: 9). For Marshall his
analysis of the firm sort to rationalise his studies of real world firms while
the idea of the industry was an abstract concept under the umbrella of which
the various producers of goods and services could be grouped to facilitate
the analysis of the matter under investigation. The role of the representative firm was to link the dynamic view of the firm with the abstract view of
the industry.39 The representative firm has been seen as a forerunner of the
representative agent, the role of which is to stand in for the behaviour of the
group, meaning the industry for Marshall and the economy for those utilising the representative agent (Blankenburg and Harcourt 2007: 46, Hartley
1996).
Moss (1984a,b) argues that there were three crucial steps in the movement from the Marshallian to the now textbook view of the firm. The
first step began with the publication of Wealth and Welfare by A. C. Pigou.
Pigou utilised a formalisation of Marshalls industrial taxonomy, that is the
distinction between constant, increasing and decreasing returns to scale industries, to study the effect of these industries on the national dividend.
Pigou applied this taxonomy in Wealth and Welfare, published in 1912, and
the first, 1920, edition of The Economics of Welfare in a wholly abstract
In the first place, its output will alter if and only if the output of the industry alters.
Any change in output will be in the same direction for the representative firm as for the
industry. So if the industry output is to increase, this must mean that price exceeds the
representative firms unit normal expenses of production.
Secondly, a firms long-period supply price (average of normal expenses) includes income forgone by investing capital in this particular enterprise. So when industry output
is stable, the representative firm must be earning its opportunity income on capital. This
opportunity income is the definition of the normal rate of interest or, if earnings of management are counted in, of profit.
Finally, the representative firm will have a supply curve found by the vertical summation
of the supply schedules of the factors it uses, when the factor supply schedules plot the
amount of the factor needed to produce a unit of a given quantity of output against the
supply price of that quantity of the factor. This exercise does not give any indication
of the supply schedules of firms within the industry in question, but it possibly helps to
illustrate the meaning of the costs of particular factors per unit of output.
39
Hart (2003: 1140) writes,
[i]t [the representative firm] was an avenue through which Marshall conjectured a
notion of equilibrium at a point in time for the industry as a whole, while at the same
time individual firms were in disequilibrium, being subject to an organic process of
change. The Representative Firm therefore meets at the junction of Marshalls biological
and mechanical notions of opposed forces described in the introductory comments in book
4 of Principles.

The past

27

manner and this abstract analysis was the target of Claphams (1922) attack
on Marshall and Pigou. Clapham argued that it was not in general possible
to assign actual industries to any one of the three categories. If we were
to open these conceptual boxes, Clapham asked, would we find anything
real inside?
Sraffa (1926) also raised two objections to Marshalls theory.40 Robinson
(1971: 19) explains,
[w]e have already seen that supply-and-demand analysis, despite
its status as the textbook introduction to all price situations,
if taken literally, really applies only to the special case of pure
competition (that being the only case in which the back-ground
of the supply curve can be explained). In brief, Sraffas argument
was this: 1) this supply-and-demand, pure-competition package
relies excessively on the law of diminishing returns, while at the
same time it is blind to the observed fact of increasing returns;
2) the resulting analysis is based on such restrictive assumptions
as to have little application to real-life situations.
With regard to increasing returns Sraffa argued that Marshall failed to
show that increasing returns to scale are compatible with perfect competition. The problem for the static theory of the industry is that a firm that
faces a given price and produces under (internal) increasing returns to scale
will increase its output without limit. If one firm expands to the point that
it captures the whole market, What are we to make of perfect competition?
Assuming external increasing returns to scale meant reliance on a class of
returns that were seldom to be met with (Sraffa 1926: 540).
For the case of decreasing returns to scale Sraffa (1926: 538-9) argued
that such returns, and thus rising marginal cost and supply curves, are
incompatible with partial equilibrium analysis.41 First, he noted that for
perfect competition we require that it must be possible to draw each of
the demand and supply curves in such a manner that both the shape and
position of the curves are unaffected by movements along the other curve.
But this mutual independence of supply and demand curves can not be
assumed if the production of a given commodity employs a considerable part
of a input that is fixed in quantity. For any increase in the production of the
commodity there will be a corresponding increase the unit price of the fixed
factor due competition for that input from other goods that utilise it. Thus
the prices of these other goods, be they substitutes or complements, will
increase and this will alter the conditions of demand for the original good.
If, on the other hand, the first commodity employs just a small fraction of
40
Sraffa began this assault on Marshalls theory with a paper in Italian, Sraffa (1925).
The first few papers of Sraffas 1926 paper are a summary of the arguments made in the
1925 paper. An English translation of Sraffa (1925) appeared as Sraffa (1998).
41
See Robinson (1969: 116-9) and Shackle (1967: 13-21) for more detailed discussion.

28

The past

the available amount of the fixed factor, any increase in its use will have little
effect on the factors price or the average cost of production. This means that
under perfect competition it is difficult to account for either an increasing
average cost curve or an increasing marginal cost curve. This in turn implies
that upward sloping supply curves are difficult to rationalise under perfect
competition. A more modern way of saying this is to note that perfect
competition applies to the input markets as well as the output markets and
thus an industry is able to purchase its inputs at the market price which is
independent of that industrys output. If all industries expand output then
we get decreasing returns but this assumption violates the ceteris paribus
assumption because one thing being kept constant is the output of other
industries.42
As part of a response to Claphams claim of empirical irrelevance and
Sraffas claim of logical incoherence Pigou argued that for carrying out comparative static analysis Marshalls highly complex analytical starting point
in a population of heterogenous disequilibrium firms was, strictly speaking,
unnecessary. Pigou insisted on the possibility-and, indeed, desirability-of
eliminating this complexity (Foss 1994a: 1121). Pigous response is the
second of Mosss three steps and, importantly, involved Pigou introducing,
as a way to help eliminate complexity, the equilibrium firm.43 The con42

Robinson (1971: 20) writes:

At this stage, two points could be raised against Sraffa. First, at least in the short run,
each firms stock of plant and equipment is fixed, and this assures a diminishing returns
effect (higher per-unit cost) if output is sufficiently increased. Second, concerning the long
run, Sraffas argument seems to say only that the long-run pure-competition supply curve
is flat or approximately so.
Shackle (1967: 19) explains,
[i]f we allow ourselves to speak in modern terms of perfect competition, and mean
by this that prices of both product and factors to the individual firm are independent
of its output, then the conclusion of Mr Sraffas argument at this stage is the failure of
perfectly competitive assumptions to show any equilibrium of the individual firm. For
both the demand curve for its product and the curve relating unit cost to output would
be horizontal straight lines. This indictment of the perfectly competitive assumptions is
Mr Sraffas first objective.
43
In Pigou (1928: 239-40) he describes the equilibrium firm, at some length, as
[m]ost industries are made up of a number of firms, of which at any moment some are
expanding, while others are declining. Marshall, it will be remembered, likens them to
trees in a forest. Thus, even when the conditions of demand are constant and the output of
an industry as a whole is correspondingly constant, the output of many individual firms will
not be constant. The industry as a whole will be in a state of equilibrium; the tendencies
to expand and contract on the part of the individual firms will cancel out; but it is certain
that many individual firms will not themselves be in equilibrium and possible that none
will be. When conditions of demand have changed and the necessary adjustments have
been made, the industry as a whole will, we may suppose, once more be in equilibrium,
with a different output and, perhaps, a different normal supply price; but, again, many,
perhaps all, the firms contained in it, though their tendencies to expand and contract must
cancel one another, will, as individuals, be out of equilibrium. This is evidently a state of
things the direct study of which would be highly complicated. Fortunately, however, there

The past

29

struct of the equilibrium firm allowed Pigou to utilise marginal and average
cost curve diagrams to develop the idea of industries producing under increasing returns were characterised by economies of scale that are external
to the firm but internal to the industry. In his 1928 paper An Analysis of
Supply Pigou outlined the conditions for a firm being in equilibrium which,
significantly, involves all the internal economies of scale being exhausted so
that all economies had to be external. Pigou maintained that the equilibrium firm produced at its minimum efficient scale so that the output level of
the equilibrium firm, for a many-firm industry, would occur where the mar
ginal cost curve cuts the average cost curve (i.e. p = F y(y) = F (y)) (Pigou
1928: 254).44
The last of the three steps was to assume that industries are comprised entirely of equilibrium firms with identical cost curves, and to assume
that firms, as production functions,45 faced household preference (demand)
is a way round. Since, when the output of the industry as a whole is adjusted to any given
state of demand, the tendencies to expansion and contraction on the part of individual
firms cancel out, they may properly be regarded as irrelevant so far as the supply schedule
of the industry as a whole is concerned. When the conditions of demand change, the
output and the supply price of the industry as a whole must change in exactly the same
way as they would do if, both in the original and in the new state of demand, all the firms
contained in it were individually in equilibrium. This fact gives warrant for the conception
of what I shall call the equilibrium firm. It implies that there can exist some one firm,
which, whenever the industry as a whole is in equilibrium, in the sense that it is producing
a regular output y in response to a normal supply price p, will itself also individually be in
equilibrium with a regular output xr . The conditions of the industry are compatible with
the existence of such a firm; and the implications about these conditions, which, whether
it in fact exists or not, would hold good if it did exist, must be valid. For the purpose of
studying these conditions, therefore, it is legitimate to speak of it as actually existing. For
any given output, then, of the industry as a whole, the supply price of the industry as a
whole must be equal to the price, which, with the then output of the industry as a whole,
leaves the equilibrium firm in equilibrium. The industry, therefore, conforms to the law
of increasing, constant or decreasing supply prices according as the price which leaves the
equilibrium firm in equilibrium increases, remains constant, or decreases with increases in
the output of the industry as a whole.
On the relationship between the Marshalls view of industry equilibrium and firm equilibrium Foss (1994a: 1119) argues,
[ . . . ] Marshalls concept of industry equilibrium has no room for an equilibrium firm;
long run industry equilibrium is a matter of equality between aggregate market demand
and supply only. There is no pretension that individual firms are in equilibrium.
44
It was not Pigou alone who expunged Marshalls representative firm from the economic
record, Robbins (1928) was his accomplice. Marshalls conception of the representative
firm became virtually eliminated by Robbins [1928] and Pigou [1928]. Robbins pointed
out the unclear analytical status of the representative firm. But more fundamentally,
he made clear that (general) equilibrium was not inconsistent with variety among firms
(Foss 1994a: 1120-1). But as Quere (2006) makes clear there was a revival of interest in
Marshalls analysis in the 1950s.
45
Moss (1984a: 313) notes that Pigous analysis of the equilibrium firms gave us the
firm as a production function.
Whatever its relationship to the representative firm, Pigous introduction of the equilibrium firm gave us the firm as production function. In An Analysis of Supply, Pigou

30

The past

functions. This task was carried out by Robinson (1933) and Chamberlin
(1933)46 in their development of imperfect competition and monopolistic
competition, respectively.47 But as Moss (1984a: 314) points out,
[b]y assuming that every firm in the industry has an identical
cost curve, Robinson and Chamberlin stood Pigous construction
of the equilibrium firm on its head. Where Pigou argued that an
equilibrium firm could be derived from the laws of returns obeyed
by any particular industry, Robinson and Chanberlin defined the
industry on the basis of a population of equilibrium firms.
Thus, by the 1930s the neoclassical approach48 to the firm had developed.
But many economists would argue that the neoclassical model isnt a theory
demonstrated diagrammatically the various possible relationships between marginal and
average curves on the assumption, made clear in his algebraic analysis, that factor prices
were either unchanged or compensated. All changes in average and marginal costs were
due to technological factors alone, and since the equilibrium firm was characterized by
given average and marginal cost curves which did not shift as a result of any activity of
the firm, those technological factors were considered to be entirely exogenous to the firm.
Pigous technique here was analytically equivalent to the derivation of a cost curve from
the expansion path of a production function.
46
For a brief but enlightening essay on Chamberlins work see Robinson (1971).
47
Backhouse (2003: 315) writes that Robinsons Economics of Imperfect Competition
[ . . . ] virtually created the modern geometry of the theory of the firm, analyzing perfect and imperfect competition, monopoly, monopsony, and even the kinked demand curve
(conventionally attributed to Sweezy, 1939). Shackle (1967: 61-2) writes,[t]he two books
[Robinsons and Chamberlins] are very different in scope. Mrs Robinsons central concern
is with the effect of supposing the demand for firms output to be less than perfectly elastic,
so that each firm, though only one among a multitude of firms producing substitutes of
varying closeness for each others products, can exploit the essential position, powers and
policies of a monopolist. She eschews discussion of those markets where each firm reckons
on other firms active retaliation to its moves, and of expenditure on selling effort. [ . . . ]
Professor Chamberlin includes selling expenditure in his analysis with a most ingenious
formal precision. He also duplicates many arguments about price behaviour in order to
point out that the entrepreneur should consider the profit possibilities of all products and
choose in the end that output of that product which, with the optimal selling expenditure,
yields the biggest total profit. With these ostensibly large extensions of the field, compared
with Mrs Robinsons; with different emphases and a chief reliance on different diagrammatic tools; and especially with a personal interpretation of such words as supply and
with impalpable distinctions between his own and Mrs Robinsons use of the expressions
monopoly, imperfect competition and others, Professor Chamberlin is at great pains to
insist that the two approaches are essentially different. Almost all other students of the
matter have agreed with each other that in describing the structure and mechanism of
equilibrium in firms and groups of firms when oligopoly and selling expenditure are absent, the two books present identical theories. Chamberlin (1937) discuss the differences
between monopolistic and imperfect competition.
48
Or the marginalist theory of the firm as it was often referred to at this time. Mongin
(1997: 558) notes that marginalist was the commonly used term in the 1940s and 50s, as
the term neo-classical was not yet popular. The term marginalist was still being used
in the 1960s as witnessed by the title of Fritz Machlups 1967 American Economic Association Presidential Address, Theories of the Firm: Marginalist, Behavioral, Managerial
(Machlup 1967).

The past

31

of the firm in any meaningful sense.49 The output side of the standard neoclassical model is a theory of supply or production rather than a true theory
of the firm. In neoclassical theory, the firm is a black box there to explain
how changes in inputs lead to changes in outputs.50 The firm is a conceptualisation that represents, formally, the actions of the owners of inputs who
place their inputs in the highest value uses, and makes sure that production
is separated from consumption. The firm produces only for outsiders, there
is no on-the-job or internal consumption, no self-sufficiency. In fact there
are no managers or employees to indulge in on the job consumption and as
production is separated from consumption, no self-sufficiency. Production
for outsiders is, according to Demsetz (1995), the definition of a firm in the
neoclassical model:
[w]hat is needed is a concept of the firm in which production
is exclusively for sale to those formally outside the firm. This
requirement defines the firm (for neoclassical theory), but it has
little to do with the management of some by others. The firm in
neoclassical theory is no more or less than a specialized unit of
production, but it can be a one-person unit (Demsetz 1995: 9).
As inputs are combined in the optimal fashion by the actions of independent input owners motivated solely by market prices, there is no need for
management of some by others, there is no role for managers or employees.
Also note that as competition assures the absence of profits and losses in
(long-run) equilibrium, there is no need to have a residual claimant. This
means that, in one sense at least, there are no owners of the firm.51 As there
are no physical assets controlled by the firm, there are no (residual) control
rights over these assets to allocate. This implies there are no owners of the
firm in the Grossman-Hart-Moore sense.
The neoclassical production function is a way of representing the black
box conversion of inputs into outputs but tells us little about the inner
workings of the black box. The production function is independent of the
49

For a example of an approximation to what production could look like in a neoclassical

world see footnote 17, p.18.
50
It is a black box in the sense that inputs go in and outputs come out, without any
explanation of how one gets turned into the other. The firm is taken as given; no attention
is paid to how it came into existence, the nature of its internal organisation, where the
boundary between one firm and another is or between a firm and the market; or whether
anything would change if two firms merged and called themselves a single firm.
51
Hansmann (1996), for example, states [a] firms owners, as the term is conventionally used and as it will be used here, are those persons who share two formal rights: the
right to control the firm and the right to appropriate the firms profits, or residual earnings
(that is, the net earnings that remain with the firm after it has made all payments to which
it is contractually committed, such as wages, interest payments, and prices for supplies)
(p. 11) He later adds [n]ot all firms have owners. In nonprofit firms, in particular, the
persons who have control are barred from receiving residual earnings (p. 12).

32

The past

institutional framework of output creation. Thus it represents the firm

without explaining the firm.
That the theory cannot explain the boundaries of the firm has been noted
by several authors. Williamson (1993: 4), for example, asks,
[w]hat determines which activities a firm chooses to do for itself
and which it procures from others?
A simple answer to that question is that the natural boundaries
of the firm are defined technology-economies of scale, technological nonseparabilities, and the like. The firm-as-production
function is in this tradition. [ . . . ] In mundane terms, the issue is that of make-or-buy. What is it that determines which
transactions are executed how?
That posed a deep puzzle for which the firm-as-production function approach had little to contribute.
Hart (1995: 17) criticises the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores
incentive problems within the firm. The firm is a perfectly efficient black
box. Second, the theory has nothing to say about the internal organisation
of the firm. Nothing is said about the hierarchical structure, how decisions
are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as
much a theory of plant or division size as firm size. As Hart points out,
[t]o put it in stark terms [ . . . ] neoclassical theory is consistent
with there being one huge firm in the world, with every existing
firm [ . . . ] being a division of this firm. It is also consistent with
every plant and division of an existing firm becoming a separate
and independent firm (Hart 1995: 17).
But while the neoclassical model is certainly consistent with the two interpretations that Hart delineates, Foss (2000) points out that it is also
consistent with there being no firms, since consumers can do it all!
With perfect and costless contracting, it is hard to see room
for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and
wouldnt need the services of the intermediaries known as firms
(Foss 2000: xxiv).
Years before Foss wrote Cyert and Hedrick (1972) had addressed similar points. They argued that in the neoclassical system the firm doesnt
exist, that no real world problems of firms are considered, that there are no
organisational problems or any internal decision-making process at all.

The past

33

In one sense the controversy over the theory of the firm has
arisen over a non-existent entity. The crux of microeconomics is
the competitive system. Within the competitive model there is a
hypothetical construct called the firm. This construct consists of
a single decision criterion and an ability to get information from
an external world, called the market [8, Cyert and March,
1963, pp. 4-16]. The information received from the market enables the firm to apply its decision criterion, and the competitive
system then proceeds to allocate resources and produce output.
The market information determines the behavior of the so called
firm. None of the problems of real firms can find a home within
this special construct. There are no organizational problems nor
is there any room for analysis of the internal decision-making
process (Cyert and Hedrick 1972: 398).
Loasby (forthcoming: 2) makes clear that the neoclassical model of the firm
can not explain why firms exist:
What was ironically called the theory of the firm could give no
theoretical reason for the existence of firms, because it relied entirely on market transactions to explain the prices and quantities
of all goods and services. This theory simply required consumers
and producers, all conceived as individual agents: in the goods
market consumers provided the demand curve and producers the
supply curve, and in the labour market the roles were reversed.
Demand curves were conceived to be directly derived from individual preferences, which were subjective but well-ordered, and
supply curves from costs, which were determined by technology
and resources; and preferences, technology and resources were
all presumed to be objective data. The intersection of these
curves, properly defined, was then sufficient to determine outcomes; there was no need to explore market processes.
Thus within the neoclassical model of the price system, the firms only
role is to allow input owners to convert inputs into outputs in response
to market prices. Firms have no internal organisation since they have no
need of one, they have no owners since there is nothing to own. Questions
about the definition, existence, internal structure and boundaries of the
firm are to a large degree meaningless within this framework since firms, by
any meaningful definition of that term, do not exist. As Foss, Lando and
Thomsen (2000: 632) summarise it:
[t]he pure analysis of the market institution leaves almost no
room for the firm (Debreu 1959). Under the assumption of a
perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce

34

The past
efficient outcomes. The question how organizations should be
structured does not arise, because market-contracting perfectly
solves all incentive and coordination issues. By assumption, firm
behaviour (profit maximization) is invariant to institutional form
(e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous
agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal
structure, contracts, etc. disappear from the picture, there are
many other issues that the theory cannot address. For example,
the theory does not tell us why firms exist.

Despite the fact that by the 1930s the neoclassical approach was the
dominate theory of the firm, in its early years the basic tenants of this new
orthodoxy were the subject of a number of controversies leading to several
protracted debates in both the U.K. and the U.S.A. The most famous of
these debates were the full cost controversy52 in the U.K. and the related
marginalist controversy in the U.S. (Mongin 1992, 1998). The full cost
controversy was started by the publication in 1939 of a paper by R. L. Hall
and C. J. Hitch which looked at pricing policies of firms (Hall and Hitch
1939). On the basis of questionnaire data Hall and Hitch argued that firms
set prices in a full-cost way by estimating an average-cost amount at a reference level of output and adding to it a fixed percentage. Full-cost pricing
came to be seen as a challenge to the usual marginalist (neoclassical) profitmaximising view of the firm. Long-run profit maximisation would only be
achieved if the mark-up bore the correct relationship to the firms perceived
elasticities of demand. The most famous defense of the marginalist theory
came from Machlup (1946). Machlups response, however, want solely directed towards the full-cost arguments, he also attacked a paper by labour
economist R. A. Lester which argued that the theoretical predicts regarding
the relationship between wages and employment could not be found in the
data (Lester 1946). Lester argued that [ . . . ] his empirical research raised
grave doubts as to the validity of conventional marginal theory and the
assumptions on which it rests in the following ways: (1) market demand
was more important in determining a firms volume of employment than
wage rates; (2) the firms cost structure was not that suggested by conventional marginalism and its capital-labor ratio was not tied to its wage rate
structure; and (3) the practical problems involved in applying marginal
analysis to the multi-process operations of a modern plant seem insuperable, and business executives rightly consider marginalism impractical as
an operating principle in such manufacturing establishments [Lester 1946,
pp. 81-82] (Lee 1984: 1114). Lesters conclusion was that businessman did
52

Notes on the full cost controversy by G. B. Richardson appear as Appendix 12 of

Arena (2011).

The past

35

not adjust their employment levels in relationship to changes in wages and

productivity in a manner consistent with the marginal theory.
At this point it is difficult to separate out the full-cost controversy from
the Lester initiated marginalist controversy. In reply to both sets of arguments Machlup [ . . . ] managed to dispute the quality and relevance of the
evidence, and at the same time, to claim that data on price-setting were
compatible with several of the available models of imperfect competition; he
also sketched a general decision-theoretic argument to the effect that rules
of thumb (the expression in Hall and Hitch) often reflect an underlying
optimizing process. Most of the later neoclassical arguments are already
in Machlups proteistic plea. His general conclusion was that the current
theory of the firm hardly needed revising even if the allegedly damaging
findings were taken at face value (Mongin 1992: 314-5).
Effectively these controversies ended when Richard B. Heflebower presented a paper at the Conference on Business Concentration and Price Policy
in June 1952 (Heflebower 1955). Heflebower showed that full-cost pricing
could be viewed in marginalist terms. He argued that profit maximisation
should be understood in a long-run sense and that oligopoly should became the main theoretical focus for economists. He added that the full-cost
doctrine did not constitute a well developed body of price theory and that
the empirical work on which it was based was spotty in quality and in its
representation of situations (Heflebower 1955: 391).53
Importantly little changed because of these controversies. As Mongin
(1998: 280) notes, for the majority of economists [ . . . ] drastic adjustments in the theory of the firm were not needed to resolve the marginalist
controversy. Overall, [a]lthough no contribution to the AER controversy
[the marginalist controversy] can be said to be decisive, it can be conjectured that it influenced American economists into thinking that Robinsons
and Chamberlins initial models had to be refined, but that the profitmaximizing framework was flexible enough to accommodate the available
evidence (Mongin 1998: 279) and [i]t is clear from Heflebowers masterly
survey that many of the arguments used by supporters of the fullcost principle are in no way inconsistent with orthodox economic theory (Coase
1955: 393). In other words, these controversies had little impact on mainstream thinking about the theory of the firm.
Another, later, challenge to the neoclassical model came from the managerial and behavioural theories of the firm of the 1950s and 1960s. Below we
will briefly review each of these two approaches to the firm in turn. These
53

Earlier Haley (1948: 13) had also questioned the conclusions given the nature of the
survey data these studies utilised, [t]hose responsible for the studies have relied so heavily
upon the answers of their respondents alone, however, that it probably would be unwise
to give too much weight to their conclusions until these studies have been supplemented
by further research in the behavior and motivation of entrepreneurs with respect to price
policy.

36

The past

two sets of models are particularly significant since they represent some of
the first attempts to look inside the black box of the neoclassical firm, even
if their ultimate impact on mainstream economics has been limited.

Behavioural and managerial models54

Behavioural models
Behavioural models of the firm have been developed since the 1950s. In
these models it is assumed that there is a separation between ownership
and control. Behavioural theorists consider the consequences of conflict
between self-interested groups within firms for the way in which firms make
decisions on price, output etc. The emphasis in these models is on the
internal relations of the firm with little attention being paid to the external
relations between firms.
Although some of the seminal work on the behavioural theories can be
traced back to Simon (1955), the theory has largely been developed by Cyert
and March, with whose names it has been connected right up to today.55
In behavioural theory the corporation has a multiplicity of different goals.
Ultimately these goals are set by top management via a continual process of
bargaining between the groups within the firm. An important point here is
that the goals take the form of aspiration levels rather than strict maximisation constraints. Attainment of the aspiration level satisfices the firm: the
behavioural firms behaviour is satisficing in contrast to the maximising
behaviour of the traditional firm. The firm seeks levels of profits, sales, rate
of growth etc that are satisfactory, not those that are maxima. Satisficing
is seen as rational behaviour given the limited information, time and computational skills of the firms management. The behavioural theory redefines
rationality, rationality is now that of bounded rationality.
Cyert and March argue that there are two sources of uncertainly that
a firm has to deal with. The first is uncertainty that arises from changes
in market conditions, that is, from changes in tastes, products and methods of production. The second is uncertainty arising from the behaviour of
competitors. According to the behavioural theory the first form of uncertainty is avoided, as much as it can be, by search activity, by spending on
R&D and by concentrating on short-term planning. A difference between
the traditional and behavioural theories is the importance given in the behavioural theory to the short-run, at the expense of the long-run. To avoid
competitor-originated uncertainty, Cyert and March argue that firms op54
A good textbook discussion of these models is given in Sections E and F of Koutsoyiannis (1979).
55
The major reference for the behavioural model of the firm is Cyert and March (1963).
For a review of Cyert and March, after 50 years, from the perspective of organisational
economics see Gibbons (2013).

The past

37

erate within a negotiated environment, that is, firms act collusively with
their competitors.
The instruments the behavioural firm uses in decision-making are the
same as in the traditional theories. Both theories consider output, price
and sales strategy as the major instruments.56 The difference between the
theories lies in the way firm choose the values of these instruments. In the
neoclassical theory such values are selected so to maximise long-run profits.
In the behavioural theory the choice is made so that the outcome is the
satisficing level of sales, profits, growth etc.
The behavioural theory also assumes that the firm learns from its experience. In the beginning a firm isnt a rational institution in the neoclassical
sense of global rationality. In the long run the firm may tend towards global
rationality but in the short run there is an important adaptive process of
learning. Firms make mistakes, there is trial and error from which the firm
learns. In a sense the firm has memory and learns via its past experience.
An aspect of the firm neglected by the traditional theory is the allocation
of resources within the firm and the decision-making process that leads to
that allocation. In the neoclassical theory the firm reacts to its environment,
the market, while the behavioural theory assumes that firms have some
discretion and do not take the constraints of the market as definite and
impossible to change. The important point here is that the behavioural
theory looks at the mechanisms for the allocation of resources within the
firm, while the neoclassical theory examines the role of the market, or price,
mechanism for the allocation of resources between the different sectors of
the economy.
The concept of of slack is used by Cyert and March to refer to payments
made to groups within organisation over and above that needed to keep
that group in the organisation. Slack is therefore the same as economic
rent accruing to a factor of production in the traditional theory of the
firm. What is significant about the behavioural school is their analysis of
the stabilising role of slack on the activities of the firm. Changes in slack
payments in periods of good and bad business means that the firm can
maintain its aspiration levels despite the changes to its environment.
Managerial models57
Another group of models, from outside the mainstream, which have been
developed mainly since the 1960s in an effort to overcome some of the shortcomings of the neoclassical model are the managerial models of the firm.
These models are also based on the idea that there is a difference between
56

Sales strategy here includes all activities of non-price competition, such as, advertising,
salesmanship, service, quality etc.
57
For a full treatment of dynamic models of the managerial firm see Ekman (1978).

38

The past

ownership and control of the firm. It is argued that the managers of the firm
have taken control of the firm away from the owners. The common theme
running through this literature is that the managers of the firm pursue nonprofit objectives, generally subject to a performance constraint involving a
profit related variable.
One of the earliest and most influential works in the managerial revolution was Berle and Merns (1932). It was Berle and Merns who famously
argued that firms were becoming manager controlled rather than owner controlled, as had been the case in the past. De Scitovsky (1943) was a protomanagerial model of the firm. He modelled an entrepreneur whose utility
depends on income and leisure and who faces an income/leisure trade-off
given by the firms profit function. The entrepreneur maximises his utility
at a point involving more leisure, and less profit, than the profit maximising
point. More recent work, explicitly developing the managerial approach, are
Baumol (1959, 1962), Williamson (1964, 1970) and Marris (1964).58
The standard theory of the firm can be interpreted as assuming that the
mangers of the firm act purely for the good of the owners. Owners can control what the managers do and thus the managers maximise profits. There
are no principal-agent problems. Managerial models, on the other hand,
start from the twin ideas that ownership and control are separated and that
managers, just like other economic agents, act in ways that promote their
own interests. But within these models maximising assumptions are still
maintained. The obvious question this gives rise to is, What is maximised?
This question has been addressed by Baumol (1959) in which it is assumed that managers maximise sales subject to a profit constraint and by
Baumol (1962) in which he develops a dynamic model in which the firms
objective is to maximise the growth rate of sales. Marris (1964) also assumes
growth maximisation subject to a rate of return constraint. In the Marris
model a manager has an incentive to grow a firm past its profit maximising
size since mangers salaries are higher in larger firms. While it may seem
likely that profit maximisation and growth maximisation will lead to behavioural differences between the two, work by Robert Solow (Solow 1971)
argues that each type of firm would react in qualitatively similar ways to
parameter changes such as changes in factor prices, excise taxes or a profit
tax.
Williamson (1964, 1970) assumes a more general managerial utility function. His managerial discretion models let managers make a trade-off between slack and profits. In the static version, slack can be taken either as excessive administrative staff or as managerial emoluments (corporate personal
consumption). In the dynamic-stochastic version of Williamsons model,
slack comes as in the form of internal inefficiency, which has much in com58

Alchian (1965) gives a brief critique of the Marris (1964) and Williamson (1964)
models.

The past

39

mon with Leibensteins (1966) notion of X-inefficiency. Williamson claims

that behaviour in his discretionary models is qualitatively different from
that under profit, sales or growth maximisation, although Rees (1974), for
example, disputes aspects of this claim.
Fritz Machlup famously attempted to repel the managerial and behavioural attacks on the neoclassical model in his 1967 Presidential Address
to the American Economics Association. He firstly argued that there was
confusion as the role of the firm is price theory:
[m]y charge that there is widespread confusion regarding the
purposes of the theory of the firm as used in traditional price
theory refers to this: The model of the firm in that theory is
not, as so many writers believe, designed to serve to explain
and predict the behavior of real firms; instead, it is designed to
explain and predict changes in observed prices (quoted, paid, received) as effects of particular changes in conditions (wage rates,
interest rates, import duties, excise taxes, technology, etc.). In
this causal connection the firm is only a theoretical link, a mental
construct helping to explain how one gets from the cause to the
effect. This is altogether different from explaining the behavior
of a firm. As the philosopher of science warns, we ought not to
confuse the explanans with the explanandum (Machlup 1967:
9).
He then went on to argue that those behavioural and managerial theorists
who were attacking the neoclassical model were doing so erroneously since
they were working at a different level of analysis relative to that of the
neoclassical model. The behavioural and managerial theories are aimed
at the level of the individual firm whereas the neoclassical model concerns
the industry level and thus, Machlup argued, the former are not genuine
theoretical rivals to the latter.59
Lee (1984: 1122) argues that there is a connection between the behavioural and managerial models of the firm and the marginalist controversy
of the 1940s and 50s. He argues that economists, such as Baumol (1959),
Cyert and March (1963) and Marris (1964), were acquainted with and influenced by the marginalist controversy. While developing models of firm
behaviour based on nonprofit maximising objectives these authors showed
that an augmented neoclassical framework was compatible and consistent
with full cost pricing. Thus by generalising the neoclassical theory, albeit
in different ways, these authors were able to show that it was possible to
59
A related level of analysis attack has been made on the present theories of the firm
as has been noted by Foss and Klein (2008: 429): [ . . . ] the critics are protesting the
application of concepts designed for analysis of markets exchange to the study of firm
organization. That is, concepts appropriate at the market level are not appropriate at
the firm level.

40

The past

both make price theory look more realistic and reconcile it with the full
cost pricing theory. But the connection resulted in no real change within
the mainstream since as Mongin (1998: 280) notes [ . . . ] it would be a
mistake to believe that these writers [the behaviourists/managerialist] were
representative of the majority of the economics profession.
Summary
The behavioural and managerial theories can be seen as an early attempt
to develop a theory of the firm at the level of the individual firm, a theory
which, as Oliver Williamson has said of the Cyert and March (1963) book,
was an attempt to pry open what had been a black box, thereupon to
examine the business firm in more operationally engaging ways (Williamson
1996b: 150).60 But the success of this attempt was limited. Williamsons
interaction with people such as Herbert Simon, Richard Cyert and James
March while he was at Carnegie-Mellon University did play a role in the
development of the transaction cost theory of the firm (Williamson 1996b)
but outside of this the behavioural/managerial theories have had little effect
on the mainstream economic theories of the firm.61

Demsetz and the neoclassical model

As noted above the neoclassical model held sway in mainstream economics
up until 1970s and even today is still the one model of the firm that every
economist knows. In fact its likely to be the only model of the firm they
do know. The standard interpretation of the neoclassical model, due to
Coase (1937), is one in which firms do not exist, a point explained already.
The model is one of zero transaction costs in which agents interact with
each other only via the price mechanism and elaborate (complete) contracts.
Harold Demsetz is one author who disagrees with this interpretation of the
neoclassical model. For him the firm in the neoclassical model is a specialised production unit, specialised in the sense that it produces only for those
outside the firm.
Demsetz (1995: First commentary) argues that the neo-classical model
offers both a definition of the firm and a rationalisation for the existence
60

For retrospective look at A Behavioral Theory of the Firm after 45 years see Augier
and March (2008).
61
If you look at the standard microeconomics textbooks, both undergraduate and graduate, it is difficult to find a discussion of either behavioural or managerial models. Koutsoyiannis (1979) is one of the few that gives serious attention to these models, and it is now
more than 30 years old. The impact of these works may have been greater in management
than economics. Argote and Greve (2007: 337), for example, claim that A Behavioral
Theory of the Firm continues to be one of the most influential management books of all
time.

The past

41

of firms, but he admits that these are mostly implicit. Demsetz starts by
noting that the problem that the neoclassical model tackles is to see how
the price system works and how it is able to deal with the interdependencies
of the modern economy. The theory sets out to do this by envisioning a
hypothetical economy within which people must depend on others. Demsetz
(1995: 7) explains,
[t]he construction depends on two characteristics of economic
activity: extreme decentralization and extreme interdependency.
Extreme decentralization deprives all firms and households of
influence over price. So they do not set price; the system does.
This aspect of neoclassical theory is well understood. The need
for interdependency is not.
The opposite of interdependency is self-sufficiency, by which Demsetz means
production for ones own consumption. Robinson Crusoe stranded alone on
an island must be self-sufficient; there is no one else to depend on. The
neoclassical economy is one in which there is no self-sufficiency so that all
people in this hypothetical economy are dependent on all other people in
the economy. That is, there is extreme interdependency. Demsetz argues
that
[t]his is accomplished with the aid of two black boxes: the
household and the firm. The household sells its services to others
and buys goods from others. It does not self-employ resources
to produce goods for its own members; it offers its resources to
firms. Firms buy or rent these resources, and they produce goods
that are not for consumption by their owners and employees as
such, but are for exclusive sale to households. The role of prices
in accommodating this high degree of interdependency is of interest, not the manner in which households and firms manage
their internal affairs. The contribution made by the household
and the firm in this theory is to make the price system deal
with extreme interdependency and decentralization. In-thehousehold production and on-the-job consumption are ruled
out (Demsetz 1995: 8).62
62

This separation between the household and firm is also noted by Hicks (1946: 79):
[ . . . ] the enterprise (the conversion of factors into products) may be regarded as a
separate economic unit, detached from the private account of the entrepreneur. It acquires
factors, and sells products; its aim is to maximize the difference between their value.
Spulber (2009: 125) calls this separation of the firms objectives and the consumers
objectives the neoclassical separation theorem, which he says makes three assertions:
(1) firms maximise profits, (2) firms generate gains from trade compared to autarky,
and (3) firm decisions are separate from consumer decisions.
For expanded discussion see Spulber (2009: 127-32). For Spulber the firm is defined
to be a transaction institution whose objectives differ from those of its owners (Spulber

42

The past

The production unit in the neoclassical economy is specialised in the sense

that it produces for those outside the firm, so that the firm is not just a black
box, it is a specialised black box. There is no discussion of the managing of
production. The role of the firm in the neoclassical theory is to separate production from consumption so that there is no self-sufficiency. The coordination of production and consumption is achieved via two factors: first, impersonally determined market prices and second, personally defined tastes. The
neoclassical model lays out the nature of the interactions between these components. Thus the perfectly competitive firm is one important ingredient in
a scenario in which the price system is the only coordination mechanism for
harmonising production and consumption.
Demsetz goes on to note that the internal organisation of the firm is not
addressed in the neoclassical theory. The firm need not be an organisation
at all, a single owner/manager/employee is all that is required. For Demsetz
the neoclassical firm is no more or less than a specialised unit of production.
The important criterion for the neoclassical firm is that it separates production from consumption with production being exclusively for consumption
by those outside the firm.
In the neoclassical world in which everyone possesses perfect information
about prices and technologies, each owner of resources can manage their own
resources, placing them in their highest value uses in response to the prices
that they face. These resource owners can write any contracts needed to
coordinate their relationships.
Demsetz then makes the point that this view of the firm is very different
from that of either Knight or Coase or from the modern theory of the firm
literature, which follows, in the main, from Coase. In the Coaseian literature
markets and firms are seen as substitutes, in that as transaction costs fall
the market is used more and firms do less. In the limit as transaction costs
go to zero the firm ceases to exist and all activities take place via markets.
In the Demsetz framework the relationship between firms and markets is
complementary. As transaction costs fall, the costs to specialisation fall as
the use of the market becomes cheaper and more specialisation takes place
and thus more firms are created. As transaction costs increase, the use of
the market becomes more expensive and thus it is used less, self-sufficiency
become more common and the number of firms falls.
Demsetz sums up the specialisation theory of the firm as,
[t]he bottom line of specialization theory is that firms exist because producing for others, as compared to self-sufficiency, is
2009: 63). For more on Spulbers approach to the firm see the subsection beginning on
page 110 below. The importance of this separation is noted by Mas-Colell et al (1995: 153)
when they observe [i]f prices may depend on the production of the firm, the objective of
the owners may depend on their tastes as consumers. This implies that the objective of
profits maximisation by the firm may be lost.

The past

43

efficient; this efficiency is due to economies of scale, to specialized activity, and to the prevalence of low, not high, transaction
costs (Demsetz 1995: 11; emphasis in the original).
One interesting implication of the specialisation theory is that it guarantees profit maximisation. Given that firms only produce for sale to those
outside the firm, there can be no on-the-job consumption and thus the owner
of the firm maximises utility by maximising profits. As there can be no
utility gained from on-the-job consumption the owner maximises utility by
having the firm maximise profit and then saving or consuming this profit in
his role as consumer.

Conclusion
For the most part the classical economists utilised a theory of aggregate production, and distribution, not a theory of firm level production or a theory
of the firm. The neoclassical economists sort to develop a theory of firm
level production, but it can be seen as one without firms. While there was
clearly dissatisfaction with the neoclassical model earlier it was not until
the 1970s that this dissatisfaction reached the point where mainstream economists started to challenge the neoclassical model as the standard theory
of the firm.63 It was only then that the pioneering efforts of Knight (1921b)
and Coase (1937) were recognised and developed. It was work by Oliver
Williamson (see, for example, Williamson 1971, 1973, 1975), Alchian and
Demsetz (1972) and Jensen and Meckling (1976) that drove the upswing
in interest in the firm as an significant economic institution. The present
theories of the firm are an attempt to create a theory of the firm. To lay
a foundation for our review of the current approaches we first survey the
founding works on which they are largely based: Knight (1921b) and Coase
(1937).

63
As Aghion and Holden (2011: 181) note, [u]ntil the 1970s, the dominant theory of
the firm was the neoclassical theory: namely, there are economies of scale (or scope) which
justify that production activities up to some efficient scale (or up to efficient variety) be
concentrated within one firm rather than scattered across multiple producers.

The founding works

The contemporary mainstream theory of the firm is largely based on two

works. The majority of mainstream theories draw on Coases 1937 paper
The Nature of the Firm but the influence of Frank Knights 1921 book
Risk, Uncertainty and Profit is growing. Here we give brief overviews of
each of these works.

Knight - Risk, Uncertainty and Profit

Demsetz (1988b: 244) goes so far as to state [ . . . ] it can be said without
hesitation that Knight launched the modern theory of the firm in 1921.
However the primary motivation of Knight (1921b) wasnt to examine the
organisation of the firm or explain the existence of the firm, it was to explain the existence of profit. The theory of the firm was a byproduct of
his explanation of profit. Although as Foss (2000: xix) notes [ . . . ] the
connection between his theory of profits and his theory of the firm is not
entirely clear.
The standard view of Knights rationale for the existence of the firm,
see for example Demsetz (1995: 2-4), doesnt depend on profit, but on risk,
or more accurately, risk redistribution. The entrepreneur forms a firm as
a way of specialising in risk-taking. Employees receive a stipulated income
and the entrepreneur takes the residual income of the firm and thereby
bears most of the risk associated with uncertainty about the future. The
advantage of the firm, according to the standard view, is that there are
gains to be made from this redistribution of risk between the entrepreneur
and the firms employees. The profit and loss consequences of fluctuations
in the business outcomes can be better absorbed by the entrepreneur than
the employees. The entrepreneur contracts to pay a fixed wage to workers,
thereby protecting them from the fluctuations in business outcomes. Knight
sees this as efficient since the entrepreneur is less averse to bearing risk.
Presumably, risk is not handled as well without firms.

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45

Another view is offered by Boudreaux and Holcombe (1989).64 They see

Knights theory of the firm as stemming from the role of the entrepreneur
as the person who decides what to produce or whether or not to introduce a
new production process in a world of Knightian uncertainty. For Knight, the
goods and services to be produced are not given, as in the neoclassical theory, thus entrepreneurs must make a decision as to which goods to produce.
Given that the entrepreneurs face a world of uncertainty, such decisions
must be made on the basis of intuitive judgement. The need for judgement is due to the entrepreneur having to deal with uncertainty resulting
from the fact that prices of the outputs are unknown when the decisions
about production are made. This price uncertainty is the result of changing
consumer desires and the uncertainty as to the reactions of competitors. Entrepreneurs differ from non-entrepreneurs in that entrepreneurs receive the
return from judgement, that is, entrepreneurs receive the residual (positive
or negative) left after the costs incurred at the time the production decision
was made are subtracted from revenues.
For Boudreaux and Holcombe the distinguishing characteristic of the
Knightian entrepreneur [ . . . ] is that he makes decisions under uncertainty
about how resources will be allocated (Boudreaux and Holcombe 1989:
152). The Knightian firms primary function is, in Boudreaux and Holcombes view, entrepreneurial, decisions must be made without the guidance of market prices since the market doesnt exist yet. Entrepreneurial
activity is necessary for the development of markets. New goods create new
markets. For Knight, the products to be produced is a decision made within
the firm. The entrepreneur is the person in the firm who makes such decisions. Thus for Boudreaux and Holcombe the Knightian theory of the firm
is driven by a theory of the entrepreneur, this they claim differentiates the
Knightian theory from that of Coase, who they argue puts forward a theory of management that leaves no room for genuine entrepreneurship. For
Boudreaux and Holcombe, the Knightian firm exists in order to facilitate
decision making in a world of true uncertainty, that is, to facilitate true
entrepreneurial decision making.65 Presumably, such decision making is not
as efficient without firms.
Barzel (1987) and McManus (1975) put forward a moral hazard explanation for the Knightian firm. The firm arises here because, for certain kinds
of risks, the functions of risk taking and management are inseparable due to
the prohibitively high costs of enforcing constraints that would induce one
64

See Foss (1993) for criticism of Boudreaux and Holcombe.

Foss (1993: 273) conceptualises this as the firm and vertical integration exist because
entrepreneurs cannot communicatewithout exorbitant information coststheir idiosyncratic versions (innovations) to owners of assets necessary for realizing this vision; therefore, they integrate such activities. This inability to communicate with assets owners
means that it is difficult to hire assets on the market and thus the need for entrepreneurs
to supply the needed assets themselves by forming a firm.
65

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individual, the manager, to maximize the wealth of another, the risk-taker

(McManus 1975: 348). As noted in the redistribution of risk story above,
firms are one way of specialising in risk-taking. Knight was aware of contractual and insurance arrangements as alternatives to the firm as ways of
specialising in risk-taking but thought, because of the moral hazard problems, they were particularly costly to enforce in the case of risks of enterprise
and hence the need for the creation of a firm. Presumably monitoring the
manager is easier for the risk-taker in a firm that it is on the market.
An alternative view is given by Langlois and Cosgel (1993). Here it
is argued that Knights theory of organisation has things in common with
the more recent incomplete contracts approach to the firm.66 Langlois and
Cosgel summarise their view of Knights theory of organisation as
[b]ecause of the non-mechanical nature of economic life, novel
possibilities are always emerging, and these cannot be easily categorized in an intersubjective way as repeatable instances. To
deal with this uncertainty, one must rely on judgment. Such
judgment will be one of the skills in which people specialize,
yielding the usual Smithian economies. Moreover, some will
specialize in the judgment of other peoples judgment. As the
literature since Coase [1937] suggests, however, a theory of specialization is not by itself a theory of organization, since, in the
absence of transaction costs, there is no reason why the division
of labor could not be undertaken through markets rather than
within a firm. Knights answer is that the function of judgment
is ultimately non-contractible (Langlois and Cosgel 1993: 462).
The non-contractibility of judgement leads to the entrepreneurs skills
not being tradable on markets, thus the division of labour cannot be undertaken through markets rather than within a firm and hence the need for
the firm.67 The optimal organisational structure that results from this has
the entrepreneur being the residual claimant, and he hires the other agents
for a fixed payment. Langlois and Cosgel argue that incompleteness results
in the entrepreneur owning the other assets in the firm on the assumption
that the entrepreneurs participation is the most important to the resulting joint product. If we compare this case with that of the standard risk
redistribution case noted above, we see that the residual claimant doesnt
so much insure the other agents, as in the risk redistribution story, rather
it is simply that, due to the non-contractibility, the optimal arrangement is
for the entrepreneur to receive the residual and the other agent to receive a
fixed payment.
66

See Grossman and Hart (1986, 1987), Hart and Moore (1990) and Hart (1995).
Foss and Foss (2006: 2) note [ . . . ] there is no market for judgment that entrepreneurs
rely on, and therefore exercising judgment requires the person with judgment to start a
firm.
67

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47

Thus if one wished to write Whig History, Knights theory of the firm
would be a forerunner, not of the theory of moral hazard and asymmetric information, but of the incomplete contracts approach to vertical integration.
Langlois and Cosgel contend that Knight saw the causes of incompleteness in
the lack of knowledge of the categories of action and the consequent need for
judgement. For Knight incompleteness of contract was ultimately a matter
of uncertainty.

Coase - The Nature of the Firm

Coase opens the paper by pointing out that there has been, in economics,
a failure to clearly state the assumptions on which theories are built. He
notes that two questions can be asked of a set of assumptions: Are they
tractable? and Do they correspond with the real world? Coase argues
that it is important to have a clear definition of the word firm since much
economic analysis starts with the individual firm rather than the industry
and it is important to know the difference between the theoretic firm and
the real world firm. The aim of Coases paper was to provide a definition of
the firm that is not only realistic in that it corresponds to what is meant
by a firm in the real world, but is tractable by two of the most powerful
instruments of economic analysis developed by Marshall, the idea of the
margin and that of substitution, together giving the idea of substitution at
the margin (Coase 1937: 386-7).
Coase begins his search for a definition of the firm by pointing out that
the standard treatment of the economic system is one where the price mechanism provides all the coordination of resources required. Resource allocation is dependent directly on the price mechanism. But in the firm, Coase
notes, the price system does not allocate resources, authority does. The
use of authority to supersede the price mechanism is, in Coases view, the
distinguishing mark of the firm. Coase then asks, If all coordination can
be done by the price mechanism, why is the firm, with its coordination by
authority, necessary?
In Section II, Coase states the the task ahead is to explain why a firm
would emerge in a specialised exchange economy. He first points out that
it could emerge if it was desired for its own sake. It could arise if some
people preferred working under the direction of others or if some people
wished to control others. Also firms may arise if customers preferred goods
produced in this way to goods produced by other institutional arrangements.
However, Coase points out that these motivations can not explain all firms
we see, hence there must be other factors involved.
The, now, most famous other factor is that there are costs to using the
price mechanism. To quote Coase (1937: 390-2):
[t]he most obvious cost of organising production through the

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price mechanism is that of discovering what the relevant prices
are. [ . . . ] The costs of negotiating and concluding a separate
contract for each exchange transaction which takes place on a
market must also be taken into account. [ . . . ] It is true that
contracts are not eliminated when there is a firm but they are
greatly reduced. [ . . . ] There are, however, other disadvantagesor costs-of using the price mechanism. It may be desired to make
a long-term contract for the supply of some article or service.
[ . . . ] Now, owing to the difficulty of forecasting, the longer
the period of the contract is for the supply of the commodity
or service, the less possible, and indeed, the less desirable it is
for the person purchasing to specify what the other contracting
party is expected to do. [ . . . ] When the direction of resources
(within the limits of the contract) becomes dependent on the
buyer in this way, that relationship which I term a firm may
be obtained. A firm is likely therefore to emerge in those cases
where a very short term contract would be unsatisfactory. [ . . . ]
We may sum up this section of the argument by saying that
the operation of a market costs something and by forming an
organisation and allowing some authority (an entrepreneur)
to direct the resources, certain marketing costs are saved. The
entrepreneur has to carry out his function at less cost, taking
into account the fact that he may get factors of production at
a lower price than the market transactions which he supersedes,
because it is always possible to revert to the open market if he
fails to do this.

Coase also notes that the different treatment of in house and market transactions by Government and regulatory bodies could also explain why some
firms exist. Having explained why a firm could exist, Coase goes on to note
that a firm consists of the relationships that are brought into existence when
the control of resources is dependent on an entrepreneur.
An advantage of the approach just developed, claims Coase, is that it
is possible to give a meaning to a firm becoming larger or smaller. A firm
becomes larger when a transaction that could be carried out in the market, is
instead organised by the entrepreneur. The firm, therefore, becomes smaller
when the entrepreneur gives up organising such a transaction.
Next Coase considers the question as to why, if by creating a firm, the
costs of production can be reduced, are there are any market transactions
at all. Why is not all production carried on by one big firm? (Coase 1937:
394). The answer according to Coase is, first, that as a firm gets bigger there
may be decreasing returns to entrepreneurial activity. That is, the cost of an
additional transaction being organised within the firm may rise. Secondly,
as the number of transactions which are organised in house increases, the

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entrepreneur may fail to place the factors of production in the uses where
their value is maximised. This means the entrepreneur fails to make the best
use of the available factors of production. Finally the supply price of one or
more of inputs to production may increase, because the other advantages
of a small firm are greater than those of a large firm.68 As a result of these
factors, a firm will tend to expand until the costs of organising an extra
transaction within the firm become equal to the costs of carrying out the
same transaction by means of an exchange on the open market or the costs
of organising in another firm (Coase 1937: 395).
Coase (1937: 396-7) then notes that all other things being equal, a firm
will tend to be larger:
(a) the less the costs of organising and the slower these costs rise with an
increase in the transactions organised.
(b) the less likely the entrepreneur is to make mistakes and the smaller the
increase in mistakes with an increase in the transactions organised.
(c) the greater the lowering (or the less the rise) in the supply price of
factors of production to firms of larger size.
An additional reason for why efficiency will decrease as the firm grows
larger is that as more transactions are controlled by an entrepreneur, these
transactions are likely to be either different in kind or different in place.
Mistakes in decision making are more likely as there is an increase in the
spatial distribution of transactions, the dissimilarity of the transaction and
in the probability of changes in prices relevant to production. Changes which
lessen the spatial distribution between transactions will lead to an increase
in the size of the firm, as will improvements in managerial technique.
The ideas of combination and integration can be given precise meaning using the analysis presented above. Combination is when transactions
normally undertaken by two or more entrepreneurs are undertaken by one
and this turns into integration when the transaction was previously carried
out on the market. Firms can grow via either or both of these two ways.
In the last section of the paper Coase asks whether the concept of the firm
he has developed is realistic and manageable? As to realism, he contends
68

This point is explained by Coase in footnote 1 on page 395, which reads: [f]or a discussion of the variation of the supply price of factors of production to firms of varying size,
see E. A. G. Robinson, The Structure of Competitive Industry. It is sometimes said that
the supply price of organising ability increases as the size of the firm increases because men
prefer to be the heads of small independent businesses rather than the heads of departments in a large business. See Jones, The Trust Problem, p. 531, and Macgregor, Industrial
Combination, p. 63. This is a common argument of those who advocate Rationalisation.
It is said that larger units would be more efficient, but owing to the individualistic spirit
of the smaller entrepreneurs, they prefer to remain independent, apparently in spite of the
higher income which their increased efficiency under Rationalisation makes possible.

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the best way to see what constitutes a firm in practice is to look at the legal
relationship between the master and servant or employer and employee.69
The essentials of the employer and employee relationship is given by Coase
as follows:
1. The servant must be under the duty of rendering personal services to
the master or to others on behalf of the master, otherwise the contract
is a contract for sale of goods or the like.
2. The master must have the right to control the servants work, either
personally or by another servant or agent. It is this right of control or
interference, of being entitled to tell the servant when to work (within
the hours of service) and when not to work, and what work to do and
how to do it (within the terms of such service) which is the dominant characteristic in this relation and marks off the servant from an
independent contractor, or from one employed merely to give to his
employer the fruits of his labour. In the latter case, the contractor
or performer is not under the employers control in doing the work or
effecting the service; he has to shape and manage his work so as to
give the result he has contracted to effect (Coase 1937: 403-4).
It is noted by Coase that what distinguishes an agent from an employee
is not the presence or absence of a fixed wage or the payment only of commission, but rather the freedom with which an agent may carry out his
employment. Coase argues that it is the fact of direction that is the essence
of the legal concept of the employer and employee relationship just as it was
in the economic concept of the firm he developed. He concludes that his
definition is therefore realistic. The question is then asked, Is it manageable? Again the answer is yes, the principle of marginalism works smoothly.
The question is, Does it pay to organise an additional transaction under a
given entrepreneur? Should the transaction be undertaken by this firm or
some other firm or in the market. At the margin the cost of undertaking
the transaction in any given firm will equal the cost to either another firm
or in the market.
For some economists Coases questions about why firms and markets
co-exist are brilliant, but his answers are less satisfactory (Hart 2008: 405).
Hart (2008) refers to what are normally called transaction costs as haggling
costs. He criticises the Coaseian approach for three reasons: (i) it has proved
difficult to formalise or operationalise haggling costs.70 (ii) Coases costs of
69

In a footnote Coase explains that the legal concept of employer and employee and the
economic concept of a firm are not identical. He notes that the firm may imply control
over another persons property in addition to their labour. But the identity of these two
concepts is sufficiently close for an examination of the legal concept to be of value in
appraising the worth of the economic concept.
70
Transaction costs are appropriately made the centerpiece of analysis but these are

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51

using the firm are unconvincing.71 Why cannot an overstretched manager

just hire another manager to help him out? (iii) Hart thinks it optimistic
and unrealistic to suppose that placing a transaction inside a firm eliminates
all haggling costs.
The modern approach to the theory of the firm - see the section below has been developed to deal with issues like those raised by Hart and when
compared to the approach of Coase (1937) a number of differences become
apparent. For example, there is no notion of morally hazardous behaviour
or of differential attitudes to risk in Coase but these ideas are prominent
in the post-1970 theories. The reason for the importance of incompleteness
of contracts is also different in Coase than it is in the current theories. For
Coase incomplete contracts are important because they allow flexibility in
future decision making given that we have little knowledge today on which
to base decisions about tomorrows actions. An employment contract, for
example, is incomplete because the employer does not know today what
tasks he will want the employee to carry out tomorrow and thus the future
tasks cannot be specified in the contract. Within limits the employer has the
flexibility to be able to decide on the task tomorrow. In the current theories
incompleteness is important because in conjunction with relation-specific
investments and opportunistic/morally hazardous behaviour it helps specific
the patterns of ownership of, for example, the physical assets a firm utilises.
Such ownership effects the incentives that the various contracting parties
face. Foss (1996: 88) argues for another understanding of incompleteness:
[ . . . ] incompleteness may be of distinct value because it allows the firm to engage in organizational learning. In other
words, contractual incompleteness is an instrument of adaptation. For example, it allows the firm to adapt to partly unanticipated learning which the firm itself generates and of course also
to outside developments. That such an instrument is necessary
follows from the basic epistemological impossibility theorem, formulated by Knight (1921[b], p. 318): future learning and knowledge cannot be fully anticipated, for if it could, it would be
present knowledge and not future knowledge.
Foss claims that this interpretation moves Coase closer to Knight.
As I have interpreted Knight and Coases alternative theories,
they both center on knowledge and on the need for adaptation
not operationalized in a fashion which permits one to assess the efficacy of completing
transactions as between firms and markets in a systematic way (Williamson 1975: 3).
71
[ . . . ] his [Coases] theory of the costs of internal administration amounts to
little more than a claim that there are inevitably decreasing returns to the managerial
function (for reasons largely unspecified) and perhaps to other factors of production as
well (Langlois 2013: 248).

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in a hard-to-predict world, rather than on incentives, property
rights and transaction costs. In Knights theory, it is idiosyncratic knowledge-namely entrepreneurial judgment-that cannot
be traded. In Coases theory, incomplete contracts are important
because they allow us to wait and acquire more knowledge. This
suggests that we should look for modern counterparts to Coase
and Knights analyses in those contemporary theories of the firm
that are primarily concerned with the knowledge dimensions of
firms (Foss 1996: 88).

Garrouste and Saussier (2008: 26) criticise Coase for using a definition
of a firm which is too vague. It is difficult to give a precise meaning to
Coases notion that a firm is a place where coordination via authority replaces coordination by price since such authority relationships can be found
on markets as well. Insofar as Coase deals with the internal structure of a
firm he reduces it to authority and command but this only scratchers the surface of the true complexity of the internal organisation of the modern firm.
Garrouste and Saussier also argue that the relationships between firms and
markets are only weakly analysed. Finally they claim that the refutability
of the approach taken by Coase has been questioned on the basis that it is
impossible to accurately measure the transaction costs for alternative contractual arrangements, meaning that the ex post rationalisation of almost
any contractual choice is possible.
Cowen and Parker (1997: 44) suggest that from a contracts point of
view firms do not differ sharply from markets. While Coase distinguished
precisely between intra-firm and inter-firm transactions, with the former
taking more of a command view of the firm, the contracts approach to
the firm allows for the possibility that intra-firm transactions can be market
like. Jensen and Meckling (1976: 310-1) go so far as to say,
The private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and
which is also characterized by the existence of divisible residual
claims on the assets and cash flows of the organization which can
generally be sold without permission of the other contracting individuals. [ . . . ] Viewed this way, it makes little or no sense to
try to distinguish those things which are inside the firm (or
any other organization) from those things that are outside of
it. There is in a very real sense only a multitude of complex
relationships (i.e., contracts) between the legal fiction (the firm)
and the owners of labor, material and capital inputs and the
consumers of output.
Thus from this viewpoint72 Coase was wrong to emphasise the differences
72

This is referred to below as the nexus of contracts view.

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53

between firms and markets.

Another issue raised about Coases work is the role of the entrepreneur.
Foss and Klein (2005: 64) argue that Coases position with regard to the
entrepreneur is ambiguous. On the one hand his entrepreneur is a Robbinsian maximiser whose job is to decide how to organise transactions within
the firm and to make the make-or-buy decision. But on the other hand,
Coase also sees the entrepreneur as a speculating and coordinating agent.
His approach to the employment contract appeals to unpredictability and
the need for qualitative coordination in a world of uncertainty. Here there
is the possibility of genuine entrepreneurial activity.
Demsetz (1988a) argues that a more complete theory of the firm must
give greater weight to information costs than is given in Coase (1937). The
form that an economic organisation will take will depend, in Demsetzs
view, on the fact that knowledge is costly to produce, maintain, and use.
In all such aspects there are economies to be achieved through specialisation. Firms are, in part, repositories of specialised inputs required to make
use of knowledge that is specific to that firm or industry. Steel firms, for
example, specialise in different stocks of knowledge and equipment than do
firms involved in investment banking or firms producing chemical products
and even within a given industry firms will utilise different sets of knowledge
and equipment. Coase (1937) does not clearly articulate such a view.
The Nature of the Firm uses the employer-employee relationship as
the archetype of the firm. This emphasis on the employment contract has
been questioned by economists including Coase himself. He writes that this
concentration
[ . . . ] gives an incomplete picture of the nature of the firm. But
more important, I believe it misdirects out attention (Coase
1988a: 37).
The misdirection comes about because the emphasis on the employment
relationship leads to a concentration on firms as purchasers of inputs rather
than an emphasis on the main activity of the firm, the running of a business.
This has deemphasised the major point of The Nature of the Firm which
Coase sees as the comparison of the costs of coordinating the activities of
factors of production within a given firm with the costs of achieving the
same outcome by the use of market transactions or by the use of another
firm.73

Conclusion
It is normally the work of Knight and Coase that is credited with providing
the foundations for the development, starting around 1970, of the current
73

For a more severe criticism of Coase that sees The Nature of the Firm as a defense
of socialist economic planning see Bylund (2014a).

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theories of the firm. Knights work can be seen as, depending on interpretation, arguing that a firm is needed to facilitate risk redistribution or because
of the need for intuitive judgement in a world of uncertainty or as a catalyst
for moral hazard and asymmetric information theory or as a catalyst for
incomplete contract theory. So while many authors argue for Knight as a
founder of the modern approaches to the firm, they can not agree on why.
The importance of Coase (1937) stems from the fact that it was the starting
point for much of the contractual literature on the firm, and the theory of
economic organisations more generally, insomuch as it is in this paper that
we see the main questions underlying the modern theory of the firm being
raised together for the first time. Coase sets out to discover why a firm
emerges at all in a specialized exchange a question about the existence
of the firm; he also sets out to study the forces which determine the size of
the firm an issue to do with the boundaries of the firm; and he inquires
into the reasons for diminishing returns to management issues to do
with the internal organisation of the firm. It was the efforts to answer these
questions that initiated the charge from seeing the theory of the firm as just
part of price theory to seeing it as an important topic in its own right. Coase
also provides one of the main building block for answers to these issues, the
costs of using the price mechanism or transaction costs.
But as Coase notes [t]he article was not an instant success (Coase
1988a: 23). In fact it took nearly 40 years for it to become an instant
hit. Before 1970 the paper was, in Coases own words, an article much
cited and little used (Coase 1972: 63). Coase argues that this changed
both with the publication of The Problem of Social Cost (Coase 1960)
which helped rekindle interest in The Nature of the Firm via the greater
appreciation of transaction costs it brought about and with the writings of
Oliver Williamson who incorporated transaction costs into the analysis of
the distinction between hierarchy and markets (Coase 1988b: 34-5).
Interestingly, in the modern approach to the theory of the firm there is
no obvious Knightian research programme in the way that there is a Coasian
research programme. Despite this it can be argued that the post-1970 literature combines crucial elements from both Knight and Coase although it is
Coases influence that is seen as dominate (Foss 1996).
It is to the post-1970 literature we now turn.

The present

After a long delay the theory of the firm started to gather momentum in
the 1970s based upon, in the main, Coases work. The present of the
theory of the firm will be discussed below under three main headings. First
the post-1970 theory of the firm literature per se will be examined while
the second subsection considers the relationship between the three major
modern sets of theories: the reference point, property rights and transaction
cost approaches to the firm. The third subsection looks at the theory of
privatisation. Roughly, as presented here, the contemporary theory of the
firms focuses on questions to do with the existence, internal organisations
and boundaries of the firm while the theoretical privatisation literature looks
at issues to do with the boundary between state and private firms.

The post-1970 theories of the firm

Mainstream theories
Foss, Lando and Thomsen (2000: 634) offer an useful classification, which
we follow here, of the mainstream post-1970 economics literature on the
theory of the firm. They partition the theory into two general groups:
1. Principal-agent type models where agents can write comprehensive
contracts characterised by ex ante incentive alignment under the constraints imposed by the presence of asymmetric information.74
2. Incomplete contracts models which are based on the idea that it is
costly to write contracts and thus contracts will have holes or inefficient
provisions, and therefore there is a need for ex post governance.75
74
The standard practice of including agency theory as part of the theory of the firm is
followed here, although speaking speaking such theories are not about the existence and
boundaries of firms (Hart 1989).
75
More precisely, contracts can be incomplete for two reasons; the first is that the

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The present

This division can be seen as resulting from the breaking of two different
assumptions embedded in the general equilibrium (Arrow-Debreu) version
of the neoclassical model.76 The first group corresponds to the breaking of
the assumption that there are no asymmetries of information between parties
and thus no principal-agent problems, of either the adverse selection or moral
hazard kind. The second grouping results from breaking the assumption that
agents can foresee all future contingencies and can costlessly contract on all
such eventualities. We discuss each group in turn.
Principal-agent type models
Within this classification Foss, Lando and Thomsen (2000: 636-8) identify three sub-groups: 1) the nexus of contracts view, 2) the firm as a solution
to moral hazard in teams approach and 3) the firms as an incentive system
view.
The nexus of contracts view was developed in papers by Alchian and
Demsetz (1972), Jensen and Meckling (1976), Barzel (1997), Fama (1980)
and Cheung (1983). The important innovation here was the recognition that
it is difficult to draw a line between firms and markets, firms are seen as
a special type of market contracting. What distinguishes firms from other
forms of market contract is the continuity of the relationship between input
owners.
Most famously in the Alchian and Demsetz version of this approach, they
argue that the authority relationship between the employer and employee
is in no way the defining characteristic of a firm.77 In this approach there
is no essential difference between an employment contract - e.g. having an
employee produce some good - and, say, a spot contract - e.g. buying the
good from a grocer - or obtaining the good via a supply contract with an independent contractor. They are all contractual relationships. The employer
has no more authority over an employee than a customer has over his grocer.
Firing, of either the employee or grocer, is the ultimate punishment that
contract is insufficiently state contingent in that its terms are not optimal in all possible
states of the world, while the second is where the contract is obligationally incomplete in
that it has a gap or missing provision. For example, a contract may state that a supplier
must provide one widget in all states of the world rather than the optimal number of
widgets, which varies with the state of the world; or it may not specify what is to happen
if a suppliers factory is destroyed in an earthquake. Something not discussed here is the
question as to why parties would write an incomplete contract. See Halonen-Akatwijuka
and Hart (2013) for consideration of this point.
76
The Arrow-Debreu framework was not originally conceived as a theory of contracting per se, but rather it was seen as an analytical apparatus for modelling competitive
equilibrium. But the efficiency properties associated with trade involving complete contingent claims contracts - that is, contracts specifying the price, date, location and physical
characteristics of a commodity for every future state of nature - made such contracts the
standard against which other, more realistic, contracts are compared.
77
In later work Alchian has stated that this assertion is incorrect (Alchian 1984: 38)
while Demsetz (1995: 37) claims the idea is a mere aside in their paper.

The present

57

either the employer or customer can use in cases of disobedience. Alchian

and Demsetz argue that, in economic terms, the customer firing his grocer is no different from the employer firing his employee. In both cases one
party stops dealing with the other, terminating the contract between them.
In this approach the firm is seen as little more than a nexus of contracts,
special in its legal standing and characterised by long term nature of the
relationship between the input owners. In this approach it is not generally
useful to talk about firms as distinctive entities, a nexus of contracts could
be called more firm-like if, for example, the residual claimants belong to a
concentrated group but the term firm has little meaning beyond this.
Roberts (2004: 104) responds to this line of argument:
[w]hile there are several objections to this argument, we focus on
one. It is that, when a customer fires a butcher, the butcher
keeps the inventory, tools, shop, and other customers she had
previously. When an employee leaves a firm, in contrast, she
is typically denied access to the firms resources. The employee
cannot conduct business using the firms name; she cannot use
its machines or patents; and she probably has limited access to
the people and networks in the firm, certainly for commercial
purposes and perhaps even socially.
Another counter argument follows from Coase (1937), see above, and Simon
(1951), see below. Both authors emphasise fiat; the idea that employers
can, within bounds, control an employees activities by directive. Employment contracts are open-ended, they are incomplete in that not all situations
are covered by the contract and employers and employees do not fill the
gaps by negotiating over which task is to be carried out at any given time,
as would happen with an independent contractor; the employer simply instructs the employee as to what is to be done. Oliver Williamson, see below,
argues that the legal distinction between the manner of dispute resolution
within versus between firms demonstrates a critical difference between employment and market contracts.
The second grouping, the firm as a solution to moral hazard in teams
approach, was developed by Alchian and Demsetz (1972) and Holmstr
om
(1982). Alchian and Demsetz (1972) extend their discussion, outlined above,
by noting that the firm is more than just a special legal arrangement, it is
also characterised by team production. The problem that arises here is that
with team production, the marginal products of the individual members of
the team are hard to measure. This means that free-rider behaviour is now
possible since team production can act as a cover for shirking. The Alchian
and Demsetz solution is to give the right to hire and fire the members of the
team to a monitor who observes the employees and their marginal products.
To ensure that the efficient amount of monitoring takes place, the monitor
is given the rights to the residual income of the team.

58

The present

Holmstr
om (1982) looks at the incentive problems to do with teams and
identifies possible solutions.78 Holmstr
om assumes that the members of the
team each take actions which are unobservable to the monitor but the overall
result of the combined actions is observable. What Holmstr
om shows is that
it is only under very restrictive assumptions that the monitor can ensure that
efficient effort levels will be provided by each team member. The way the
monitor would ensure this is to design a sophisticated incentive scheme. But
Holmstr
om shows that given unobservable effort levels, the requirements of
the incentive scheme being a Nash equilibrium, budget balancing and Pareto
optimality, can not be met.79 More specifically, a budget-balancing incentive
scheme can not reconcile Nash equilibrium and Pareto optimality. This is
because each team member will equalise the costs and benefits of extra effort:
that is, if the team revenue is increased by the efforts of a single member,
that member should receive that revenue to ensure that they are properly
motivated. But as the monitor only knows that team revenue has increased
and not the effort levels of each individual member, all members of the
team would have to each receive the extra revenue to ensure that the hard
working member is rewarded for his efforts. But this will, obviously, violate
the balanced budget condition. This suggests that there is an advantage, in
terms of incentives, in the team not having to balance their budget.80
Clearly the role of the monitor in the Alchian and Demsetz model is very
different to their role in the Holmstr
om model. For Alchian and Demsetz,
the monitor oversees the behaviour of the team members, in the Holmstr
om
model, the monitor injects the capital needed so that the team members do
not have to balance their budget.
A more formal, but still straightforward, discussion of the Holmstr
om
model is given in Border (2004). Border starts by noting that Holmstr
oms
problem is to find a scheme to compensate members of a team where the
78

Importantly Holmstr
om ignores team synergies by assuming an additive production
function.
79
Budget balancing means that the incentive scheme has to fully distribute the revenues
among the team members.
80
McAfee and McMillan (1991: 562) describe the problem and one solution mechanism
as,
[t]he principal offers to pay each of the n agents 100 percent of any marginal increase
in team output. Clearly this gives each agent the appropriate incentive to exert effort.
It does, however, result in the principals total variable payment being n times the value
of output. To balance this, the fixed part of the payment function must be negative: in
fact, in this case each agents fixed payment is set equal to the expected value of output
minus the agents production cost, so that the agents earn zero rents on average. Thus
the optimal contract has the principal initially (before production takes place) collecting
money from the agents, and then (after the production process) paying each agent the full
value of the teams output. In other words, in the presence of moral hazard, the principal
achieves his ideal outcome by, at the margin, breaking the budget: by eliminating the
requirement that the marginal payments sum to one, and by manipulating the lump-sum
payments instead of the marginal payments [ . . . ].

The present

59

individuals effort levels of each team member can not be observed by the
others, only the total output of the team is known.
We start by assuming that there are n > 1 team members. Each member
i chooses an action or effort level ai + . The teams output x depends on
the effort of each member so that,
x : n+ + .
It will be assumed that x is continuous, strictly increasing (and the strictly
bit will matter see the proof to Theorem 1), concave and differentiable.
As far as the members of the team are concerned each of them cares only
about his effort level and his monetary compensation. It will be assumed,
for simplicity, that each team member has a quasi-linear utility function:
ui (mi , ai ) = mi vi (ai ),
where mi denotes the members monetary compensation and ai is effort. The
value vi (ai ) can be interpreted as giving the minimum compensation needed
to induce member i to exert the effort level ai . It will assumed that each vi
is continuous, strictly increasing, convex, and differentiable.
An allocation is an ordered list
(m, a) = ((m1 , . . . , mn ), (a1 , . . . , an ))
that satisfies the condition
n
X

mi = x(a1 , . . . an )

(59.1)

i=1

Condition 59.1 can be interpreted as saying that the teams compensation

is derived from the teams output.
An allocation is said to be efficient if there is no other allocation that
gives every member greater utility. Border now states, and proves, the
proposition that an allocation is efficient if and only if it maximises the
total surplus.
Proposition 1 Due to the quasi-linearity of utility, the allocation (m , a )
is efficient if and only if a = (a1 , . . . , an ) maximizes the total surplus
S(a) = x(a)

n
X

vi (ai )

(59.2)

i=1

and the total reward is fully distributed:

n
X
i=1

mi = x(a ).

(59.3)

60

The present

Borders proof proceeds in two steps.

Proof. Step 1: only if. Assume that (m , a ) maximises 59.2 and satisfies

59.3. Then for any other allocation (m , a ) we have

" n
#
# "
# "
n
n
X
X
X

mi vi (ai ) x(ai )
vi (ai )
vi (ai ) x(ai )
i=1

i=1

i=1

"

n
X

mi vi (ai )

i=1

which implies that we cant have ui (mi , ai ) = mi vi (ai ) > mi vi (ai ) =

ui (mi , ai ) for each i. In other words, (mi , ai ) is efficient.
Step 2: if. Assume by way of contraposition that either a does

not maximize 59.2) or violates (59.3). That is, there is some a (possibly

a = a ) satisfying

x(a )

n
X

vi (ai ) >

c = x(a )

mi

i=1

i=1

so define

n
X

vi (ai ),

i=1

n
X

(mi vi (ai ) + vi (ai )) > 0

i=1

vi (ai ) + vi (ai ) + nc gives ui (mi , ai ) = mi

P

ui (mi , ai ) for each i, and ni=1 mi = x(a ). That

mi

vi (ai ) >
Setting mi =

mi vi (ai ) =
is, (m , a )
is not efficient.
Next another important assumption is added. It is a non triviality
assumption. It is assumed that a surplus maximiser,
a 0, exist and
P
n
that the surplus obtained is positive, that is, x(a ) i=1 vi (ai ) > 0. The
following conditions are sufficient to ensure that if a maximiser, a , exists
i (0)
=0
then it must be such that ai > 0: 1) x(0) = 0, 2) vi (0) = 0 and 3) dvda
i
for all i. In addition to ensure the existence of a maximiser the following
i (ai )
conditions are sufficient: 1) dvda
as ai , for all i and 2) x(a)
ai 0
i
81
as ai for all i.
Now we look at the incentives that a member of the team faces via
their compensation package. Given that only team output is observable
compensation must depend on total output, not individual output. Let a
sharing rule be a function such that
s : + n
and s satisfies the balanced budget condition:
n
X

si (x) = x

i=1

81

Consider the following diagram,

for all x +

(60.1)

The present

61

These two conditions just mean that si (x) is member i s compensation when
total output is x and that total compensation equals total output so that
output is divided among the team members. Note that si (x) could be negative which would amounts to fining member i.
A sharing rule defines a game among the team members where the
strategies are the effort levels and the payoff functions are given by
i (a1 , . . . , an ) = si (x(a1 , . . . , an )) vi (ai )
An ordered strategy list, a
= (
a1 , . . . , an ), is a Nash equilibrium if for
every member i and every effort level ai
si (x(
a)) vi (
a) si (x(
ai , ai )) vi (ai )
where (
ai , ai ) = (
a1 , . . . , a
i1 , ai , a
i+1 , . . . , a
n ). This means that no member of the team can unilaterally deviate from a
and get a larger payoff. If
we have such a Nash equilibrium we say that the sharing rule s implements
the effort vector a
.
Next Border looks at the trade off between incentives and efficiency. He
states the following theorem.
Theorem 1 Under the assumptions we have made, if a 0 maximizes
surplus (59.2), then there is no sharing rule satisfying budget balance (60.1),
for which a is an equilibrium.
Borders proof begins by giving an intuitive outline followed by the detailed
argument.
Proof. The idea is this. If s implements a , then any member i must
be deterred from cutting his effort from ai by a loss in compensation. So
consider a reduction in member i s effort by ai that reduces output by .
His compensation must fall more than his utility gain vi (ai ) vi (ai ai ).
But here is the key: since effort is not observable, we dont know who
shirked, so everyones compensation must be cut, and by enough to deter
v(), x(),
S()

v(a)
x(a)

S(a ) = x(a ) v(a )

62

The present

each
of them. That is, total compensation must fall by at least
Pn and everyone
) v (a a ). Now we ask, how much does output fall when
v
(a
j j
i
j=1 j j

)
only person i shirks? The answer is approximately x(a
ai ai . How much
P

must compensation fall? By approximately nj=1 vj (aj )ai . But heres the

rub, since a maximizes surplus, the first order conditions imply

x(a )
aj

vj (aj ).

Now think of the person i who gains least by deviating by ai . The

total compensation must fall at least n times as much as for that individual.
But now the budget balance condition kicks in. Total compensation falls
only by the reduction in total reward, which is approximately proportional
to the agents individual utility gain, not n times as much.
The detailed argument is: for convenience set x = x (a ). Since x
is continuous and strictly increasing, and a 0, for every > 0 small
enough,82 by the Intermediate Value Theorem,83 for each j there is some
aj () satisfying
0 < aj () < aj
and
x(aj , aj ()) = x
Note that it is important that the right-hand side is independent of j.
If a is an equilibrium, then by definition, for each j, it can not pay
member j to switch from a to aj (), so
sj (x(a )) vj (aj ) sj (aj , aj ()) vj (aj ())
or
sj (x(a )) sj (aj , aj ()) vj (a ) vj (aj ())
or using the fact that x(aj , aj ()) = x , independent of j, we have
sj (x(a )) sj (x ) vj (a ) vj (aj ())

(62.1)

Summing over j gives

n
X

sj (x(a ))

n
X

sj (x )

vj (x ) vj (aj ())

j=1

j=1

j=1

n
X

P
so using the balanced budget condition ( nj=1 sj (x) = x)

x (x )

n
X

vj (x ) vj (aj ())

j=1

82

For each j, we know that x(x ) x(aj , 0).), so setting m = minj x(a ) (xj ), we
have m > 0. Any satisfying 0 < < m is small enough.
83
The intermediate value theorem states: Let f be a continuous function on the closed
interval [a, b]. Let = f (a) and = f (b). Let be an intermediate number between
and , i.e. < < or > > depending on which of or is the larger. Then
there exists a number c such that a < c < b and such that f (c) = .

The present

63

Now let i be an/the member for whom the gain in utility (reduction in
disutility) from changing his effort level is the smallest, that is,
vi (ai ) vi (ai ()) vj (aj ) vj (aj ())

for all j.

Summing over j gives

n(vi (ai ) vi (ai ()))

n
X

vj (aj ) vj (aj ()) x (x )

j=1

x (x ) n(vi (ai ) vi (ai ())) > 0.

(63.1)

(Note that i may depend on but the notion used here does not reflect this.)
Using Taylors Theorem84 (or the definition of a derivative) we get

vi (ai ) vi (ai ()) = vi (ai )(ai ai ()) ri ()

(63.2)
ri ()
0 as 0.
where

(a ai ())

84

Youngs Form of Taylors Theorem: Let f : (, ) be n 1 times continuously

differentiable on (, ) and assume that f has an nth derivative at the point x in (, ).
For any v such that x + v belongs to (, ),
f (x + v) = f (x) +

n
X
f k (x) k r(v) n
v +
v
k!
n!
i=1

where the remainder term r(v) satisfies

lim r(v) = 0.

v0

Here we have f () = v(), k = 1, x+v = xi (), v = (ai ()ai ) < 0 and x = ai . Substituting
in to the formula above we get

vi (ai )
(ai () ai ) + ri ()
1!

vi (ai ())

vi (ai ) +

vi (ai )(ai () ai ) ri ()

vi (ai ) vi (ai ())

vi (ai ) vi (ai ())

vi (ai )(ai ai ()) ri ()

64

The present

Similarly,85
x(ai ) x(ai , ai ()) =

x(a )
(ai ai ()) ri ()
(64.1)
ai
ri ()
0 as 0.
where
(a ai ())

Since a maximises total surplus it is the solution to the problem:

max S(a) = x(a)
a

n
X

vi (ai )

(64.2)

i=1

which means it satisfies the first order considtions

x(a )

= v (ai )
i = 1, . . . , n
ai
This means we can rewrite 64.1. Remember that x = x(ai , ai ()) so
that
x(a )
(ai ai ()) ri ()
x x(ai , ai ()) = x (x ) =
ai
which means
x(a )
(ai ai ()) ri () = x (x )
ai
n(vi (ai ) vi (ai ()))


x(a )
(ai ai ()) ri ()
= n
ai
Dividing by ai ai () and gathering the remainders gives
x(a )
x(a ) ri () n
ri ()
n
+
ai
ai
ai ai ()
Letting 0 gives86


x(a )
x(a )
=n
ai
ai

(utilising equations 63.2 and 64.1).

85
Here we have f () = v(), k = 1, x + v = x(ai , ai ()), v = (ai () ai) < 0 and x = a .
Substituting in to the formula above we get

86

x(a )
ai

x(ai , ai ())

x(ai ) +

x(a )
(ai () ai ) ri ()
ai

x(ai ) x(ai , ai ())

x(ai ) x(ai , ai ())

x(a )
(ai ai ()) ri ()
ai

1!

(ai () ai ) + ri ()

Now there is a caveat here: Remember that i in (63.1) depends on , so as 0, the

index i may change. Nevertheless, since there are only n choices for i, some index i must
occur infinitely often, so for such an index the equation above must hold.

The present
But this equation can only hold if n = 1 or

65
x(a )
ai

= 0. However n > 1 by

)
assumption and x is strictly increasing and concave so x(a
ai 6= 0 Thus the
equation can not hold, a contradiction.
Such a contradiction proves that no sharing rule (even a non-differentiable rule)87 can implement the efficient effort vector, a .
But what
P if we are willing to work with the weaker balanced budget
condition ni=1 si (x) x for all x + ? That is, What if we are willing
to throw money away? If we are, then there are many sharing rules that
implement a . Border gives a typical example:
Choose bi , i = 1, . . . , n to satisfy

bi > vi (a )
and

n
X

bi < x(a )

i=1

and define

si (x) =

bi if x x(a )
0 otherwise

(65.1)

This rule, s, implements a . It is interesting to note that s is not even

continuous, let alone differentiable everywhere and that unless a = 0, the
team always produces more than its members receive in compensation.
The third subgroup is the firms as an incentive system view. This
approach to the theory of the firm was developed by Holmstr
om and Milgrom
(1991, 1994); Holmstr
om and Tirole (1991) and Holmstr
om (1999) and has
been described by Gibbons (2005: 206) as an accidental theory of the
firm. The reason for Gibbons description is that focus of these papers was
not on the make-or-buy problem of the transaction cost or Grossman Hart
Moore approaches but rather on a multi-task, multi-instrument principalagent problem and its application to the firm was an accidental outcome
of this endeavour. In their view the firm is characterised by a number of
factors: 1) the employees do not own the non-human assets of the firm; 2)
the employees are subject to a low-powered incentive scheme (see below);
and 3) the employer has authority over the employee.
Holmstr
om and Milgrom (1991) make two observations. First, they note
that there are a number of ways that an employee can spend their time,
many of which can be of value to an employer. But if these multiple activities
compete for the workers attention then the incentives offered for each of the
activities must be comparable. Otherwise, the employee will put most effort
into those things that are most well compensated and put less effort into the
87

3).

If we restrict ourselves to differentiable rules there is a simpler proof, see Border (2004:

66

The present

others activities. The second observation relates to the provision of strong

incentives to a risk-averse employee. Providing strong financial incentives
is costly because it loads extra risk into the workers pay. In addition, the
cost is greater the more difficult it is to measure performance. This means
that, other things being equal, tasks where performance is hard to measure
should not be given as intense incentives as ones that are more accurately
observed. But having low-powered incentives means that the employer needs
to be able to exercise authority over the use of the employees time, since
the employee will not have the proper incentives to be productive.
This logic suggests that, conversely, an independent contractor should
face the opposite combination of instruments. The choice between having
an employee or using an independent contractor depends on the ability of
the principal to measure each dimension of the agents contribution. Thus,
in the Holmstr
om and Milgrom approach, measurability of performance is
one important determinant of the boundaries of the firm. In addition their
approach incorporates the importance of the allocation of property rights to
the physical assets in determining incentives via determination of bargaining positions as is the case with the Williamson and Grossman-Hart-Moore
approaches, both of which are discussed below.
To analyse the application of this theory to the knowledge firm we will
take advantage of Gibbons (2005: 210-2) stick-figure rendition of the theory. In the simple Gibbons model there is a technology of production which
is a linear combination of the Agents actions: y = f1 a1 + f2 a2 + where
the ai s are actions chosen by the Agent and is a noise term. Evaluation of
performance by the Agent is based upon the indicator p which is a different
linear combination of the Agents actions: p = g1 a1 + g2 a2 + , where is
another noise term. Gibbons assumes that both parties are risk-neutral,
is the total compensation paid by the Principal to the Agent and c(a1 , a2 )
represents the Agents cost function. Gibbons makes the assumption that,
1
1
c(a1 , a2 ) = a21 + a22 .
2
2
In addition Gibbons assumes that the Principal and the Agent sign a linear
contract, = s + bp, based upon the performance indicator p.
To provide a theory of the firm, this model has to be extended to include physical capital, a machine, which is used by the Agent during the
production of y. Post production this capital has a value determined by a
third linear combination of the Agents actions: v = h1 a1 + h2 a2 + where
is a third noise term. The choice variables in the model are therefore the
Agents actions ai , i = 1, 2 and b the slope of the optimal contract. As a
point of comparison note that the first-best actions of the Agent are those
which maximise the expected total surplus, that is, they will maximise the
expected value of the sum of the Principals payoff, y , the Agents payoff,

The present

67

c(a1 , a2 ) and the value of the physical asset, v.

T S F B = E(y + c(a1 , a2 ) + v)
= E(y + v) c(a1 , a2 )
= E(f1 a1 + f2 a2 + + h1 a1 + h2 a2 + ) c(a1 , a2 )
= f1 a1 + f2 a2 + h1 a1 + h2 a2 c(a1 , a2 )
(assuming E() = E() = 0)
1
1
= f1 a1 + f2 a2 + h1 a1 + h2 a2 a21 + a22
2
2
and therefore aF1 B = f1 + h1 and aF2 B = f2 + h2 .88 T S F B is independent of
the value of b.
If the Principal owns the machine then the Agent is an employee of his
firm and the Principals payoff is y + v , while the Agents payoff is c.
In this case the Agents optimal actions maximise
1
1
E() c(a1 , a2 ) = E(s + bp) a21 + a22
2
2
1
1
= E(s + b(g1 a1 + g2 a2 + )) a21 + a22
2
2
1
1
= s + bg1 a1 + bg2 a2 a21 + a22 assuming E() = 0.
2
2
The optimal actions are therefore, a1E (b) = bg1 and a2E (b) = bg2 .89 The
efficient contract slope, bE , maximises the expected total surplus, E(y + v)
C(a1 , a2 ) or
1
1
T SE (b) = (f1 + h1 )a1E (b) + (f2 + h2 )a2E (b) a1E (b)2 + a2E (b)2 .
2
2
Alternatively the machine can be owned by the Agent. Gibbons interprets this case as the Agent being an independent contractor. In this
situation the payoffs for the Principal will be y w and for the Agent
88

T S F B
=
ai
fi + hi ai =
B
aF
=
i

0
0
fi + hi

89

E() c(a1 , a2 )
=
ai
bgi ai =

ai (b)

0
0
bgi

68

The present

they are w + v c. The optimal actions for the Agent will therefore be,
a1C (b) = g1 b + h1 and a2C (b) = g2 b + h2 .90 For this case the efficient slope,
bC , will maximise the expected total surplus of
1
1
T SC (b) = (f1 + h1 )a1C (b) + (f2 + h2 )a2C (b) a1C (b)2 + a2C (b)2 .
2
2
Gibbons (2005: 211) summaries the analysis so far as
[ . . . ] having the Agent own the asset causes the Agent to
respond to a given contract slope (b) differently than when the
Agent does not own the asset [i.e. aiE (b) 6= aiC (b)], so the makeor-buy problem amounts to determining which of the Agents
best-response functions that of the employee, (a1E (b), a2E (b)),
or that of the independent contractor, (a1C (b), a2C (b)) allows
the parties to achieve greater total surplus.
The discussion so far has relied on an unspecified assumption; that the
value of the asset is not contractible and therefore the owner of the asset
receives its value. Since the assets value is not contractible, putting ownership in the hands of the Agent provides him with incentives that cannot
be replicated via a contract. But providing the Agent with the incentive to
increase the value of the asset may or may not help the Principal control
the Agents incentives via contract. That is, if the Agent owns the asset
he has two sources of incentives, the assets post-production value and contracted for performance. Without ownership he concentrates solely on the
contracted for performance. Integration would be efficient, that is, having
the Principal own the asset is efficient, when having the Agent do so hurts
the Principals efforts to create incentives via contract.
Incomplete contracts models
In the incomplete contracting theories group Foss, Lando and Thomsen
(2000: 638-43) identify five subgroups: 1) the authority view, 2) the firm
as a governance mechanism, 3) the firm as an ownership unit, 4) relational
(or implicit) contracts and 5) the firm as a communication-hierarchy. In the
next subsection we will add a sixth group, the reference point approach.
As noted in the following section the theory of privatisation also relies on the
90

E( + v) c(a1 , a2 )

E(s + b(g1 a1 + g2 a2 + ) + h1 a1 + h2 a2 + )

s + bg1 a1 + bg2 a2 + h1 a1 + h2 a2

1 2 1 2
a + a
2 1 2 2

1 2 1 2
a1 + a2
2
2

assuming E() = E() = 0.

The first order conditions are therefore of the form, bgi + hi ai = 0 which gives aiC (b) =
gi b + hi , i = 1, 2.

The present

69

incomplete contracts framework to explain why ownership makes a difference

to the performance of firms.
In the authority view, the firm is seen as being defined as an employment
relation. This view is one example were an approach to the firm founded
in the pre-1970 period - this approach is most closely associated with Coase
(1937) and Simon (1951) - is still being developed in the current mainstream. As was noted in more detail in the section above which discussed
Coase (1937), for Coase a firm will arise when it is cheaper to carry out a
transaction in a firm than it is to do so over the market. Given it costs
something to enter into a market contract, that is, there are transaction
costs, firms will emerge to carry out what would otherwise be a market
transaction when it is cheaper for the firm to handle that transaction. The
size of the firm (the boundaries of the firm) will be determined when the
cost of organising a transaction within the firm equals the cost of using
the market. Coase notes that within the firm contracts are not eliminated
but are greatly reduced and the nature of the contract changes. When a
factor of production is employed within the firm the contract controlling it
is incomplete. The factor (or its owner) agrees, for remuneration, to obey
the directions of the manager of the firm, within certain limits. In the last
section of Coase (1937), it is noted that the relationship that constitute the
firm corresponds closely to the legal concept of the relationship between the
employer and employee. Coase explains that direction is the essence of the
legal concept of the employment relationship, just as it is for the concept of
the firm that he developed.
It is often suggested that the first formal model of an incomplete contracting problem was Simon (1951)91 and thus we start our more detailed
discussion of incomplete contracting models with a look at Simons paper.92
For Simon (1951) the issue is a comparison of an employment contract
against a contract between two autonomous agents. A contract between
autonomous agents specifies an action to be taken in the future along with
its price while an employment contract specifies a set of acceptable instructions that the employee has to accept if asked to carry them out by the
employer. The advantage of the employment contract is its flexibility, the
employer does not have to pre-commit to an action and can adapt the choice
of action to the state of the world that occurs.
Simon opens his paper by pointing out that in standard economic theory
employees (those people who contract to exchange their services for a wage)
enter into the system in two sharply distinct roles. Initially, they are owners
their own labour, which is a factor of production, which they sell for a definite
price. Having done so, they become completely passive factors of production
91

See, for example, Bolton and Dewatripont (2005: 37) and Buhai (2003: 3).
For a discussion of an updated theory of the employment relation see Bolton and
Dewatripont (2005: 490-8).
92

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employed by the entrepreneur in such a way as to maximise his profit. Next

Simon notes that this approach to the employment contract and to the
management of labour involves a very high order of abstraction. He argues
that it abstracts away the most obvious peculiarities of the employment
contract, those which distinguish it from other kinds of contracts; and it
ignores the most significant features of the administrative process, i.e., the
process of actually managing the factors of production, including labour.
Simon states that the aim of his paper is to put forward a theory of the
employment relationship that reintroduces some of the more important of
these empirical realities into the economic model.
What, Simon asks, is the nature of the authority relationship between
an employer and an employee. This relationship, which is created by the
employment contract, plays a central role in Simons theory.
Simons notion is to denote the employer, or boss, B and the worker
or employee W . The collection of actions taken by the worker on the job
is called his behaviour. The set of all possible behaviour patterns of W is
considered and we will let x designate an element of this set. A particular
x might then represent a given set of tasks, performed at a particular rate
of working, a particular level of accuracy, and so on.
Authority, in Simons, view is exercised by B over W if W permits B
to select x. In other words, W accepts authority when his behaviour is
determined by Bs decision. In general, W will accept authority only if
x0 , the x chosen by B, is restricted to some given subset (W s area of
acceptance) of all the possible values.
Simon states that W enters into an employment contract with B when W
agrees to accept the authority of B and B agrees to pay W a stated wage,
denote by w. Here Simon notes the difference between this contractual
form and that of a sales contract. In the sales contract, each party to the
contract promises a specific consideration in return for the consideration
promised by the other. The buyer (like B) promises to pay a stated amount
of money; but the seller (unlike W ) promises in return a specified quantity
of a completely specified commodity. Also the seller is not interested in how
the commodity is used after it is sold, unlike the worker who is interested in
how the entrepreneur will use him in the future (what x will be chosen by
B).
An attempt is made to answer two questions. 1) Why is W willing to
sign a blank check by giving B authority over his behaviour? 2) Given
that both parties behave rationally, under what circumstances will a sales
contract be signed and when will an employment contract be signed?
The suggestion is then made by Simon that two conjectures, if true, offer
possible answers to these questions.
1. W will be willing to sign an employment contract with B only if he is
indifferent to the x that is selected by B, out of the areas of acceptance.

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71

or if W is compensated in some way for the possibility that B will

choose an x that is not desired by W that is, B will ask that W
undertake an unpleasant task.
2. It will be to Bs advantage to offer W additional compensation for
agreeing to an employment contract if B is unable to predict with
certainty, at the time the contract is agreed to, which behaviour x will
be the optimum one. That is, B will pay for the privilege of postponing
the selection of x until after the contract is signed.
Simon assumes that W and B are each trying to maximise their respective satisfaction functions. Each persons satisfaction will depend upon: (a)
the particular x that is chosen the Fi () function can be thought of as the
payoff, positive or negative, for each party from x being chosen93 and (b)
the particular wage w that is received or paid. It is also assumed that these
two components of satisfaction enter the satisfaction function additively:
S1 = F1 (x) a1 w

(71.1)

S2 = F2 (x) + a2 w

(71.2)

where S1 and S2 are the satisfactions of B and W respectively and w > 0

is the waged paid by B to W . Each parties opportunity cost of agreeing to
a contract can be used to define the zero point of his satisfaction function.
In other words, if B does not contract with W then S1 = S2 = 0. For the
circumstances relevant here it is reasonable to assume F1 (x) 0, F2 (x)
0, a1 > 0, a2 > 0 for the relevant range of x.
As we have S1 = S2 = 0 if no agreement can be reached between B and
W it will be assumed that if an agreement is reached then S1 0, S2 0.
If an x and w can be found satisfying these two equations then the system
is said to be viable. The conditions for a viable system can be rewritten as:
F1 (x) a1 w

(71.3)

F2 (x) a2 w

(71.4)

Equations 71.3 and 71.4 imply that

a2 F1 a2 a1 w a1 F2

(71.5)

Conversely, if for some x, a2 F1 (x) a1 F2 (x), then it is always possible

to find a w 0 such that 71.5 holds. Thus 71.5 is a necessary and sufficient
condition for the system to be viable.
93

For W this will affect, say, the pleasantness of the work while for B this will determine
the product to be produced involving W s labour.

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So far the only thing imposed on an agreement between B and W is

that it satisfy the viability condition. This amounts to saying that the
agreement is advantageous to both parties. Simon notes that in general if
there is any agreement then it will not be unique. That is, if there exists a
viable agreement then there will be a region in the (x, w)-space satisfying
71.5 and it will be only in rare cases that this region will be a single point.
In figure 1 below, the set of xs has been represented by a scalar; F1 and F2
are continuous in x, and reach extrema at x = x1 and x = x2 , respectively.
The gray shaded area is the region of viability.
w
S2 0

S2 = 0

S1 0
x1 x0

x2

S1 = 0
Figure 72.1
Simon now considers a stronger notion of rationality. The requirement
here is that when one agreement (a point in {x, w}) yields the satisfactions

(S1 , S2 ) and a second agreement the satisfactions (S1 , S2 ) to B and W , the

first agreement will be preferred to the second if S1 S1 and S2 S2 with

at least one of the two inequalities being a strict one.
If this requirement holds then we say that the second solution is an
inferior one. The subset of solutions that are not inferior to any solutions
is called the set of preferred solutions.
A function, T (x, w), is now defined by Simon:

T (x, w) = a2 S1 (x, w) + a1 S2 (x, w) = a2 F1 (x) + a1 F2 (x) = T (x) (72.1)

Theorem 72.1 The set of preferred solutions is the set {x, w} for which
T (x) assumes its greatest value.
Proof See Appendix 2, page 153.
The argument Simon has used thus far suggests that the rational procedure for B and W is to first determine a preferred x and then to bargain
over the size of w so to fix S1 and S2 . The result of this type of procedure

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73

would be a sales contract of the kind where W agrees to perform a specific,

determinate act x0 for which he would be paid a price w0 .
Now Simon assumes that F1 (x) and F2 (x), the satisfactions associated
with x for B and W , respectively, are not known with certainty when B and
W must negotiate an agreement. All we know is that W is to undertake
some activity for B at some point in the future. The issue here is that at
the time B and W make their agreement, it is not known what activity will
be optimal. Under such circumstances Simon agues there are two ways in
which the parties could proceed:
1. From a knowledge of the probability distributions functions of F1 (x)
and F2 (x), for each x, they estimate what x would be optimal in the
sense of maximising the expected value of, say, T (x). They could
then contract for W to perform this specified x for a specified wage,
w. This is essentially the sales contract procedure with mathematical
expectations substituted for certain outcomes.
2. B and W could agree on a wage, w, to be paid by B to W and in
addition upon a procedure to be followed at a later date when the
actual values for all x of F1 (x) and F2 (x) are known, for selecting
a specific x. Of the many conceivable procedures for selecting x the
simplest is for W to alow B to select x form some specified set X
that is, for W to accept Bs authority. Given that w is fixed, B would,
we assume, select the x from X which maximises F1 (x). But this kind
of arrangement is what has been defined as an employment contract
above.
At the time when contract negotiations are carried out, F1 and F2 have
a known joint probability density function for each element x:
p(F1 , F2 ; x)dF1 dF2 .
Defining the expectation operator, E, in the usual manner, we have for fixed
x:
E[T (x)] = E[a2 F1 (x) + a1 F2 (x)] = a2 E[F1 (x)] + a1 E[F2 (x)]

(73.1)

Alternative 1 Sales Contract.

Assume that a the time of contract negotiations B and W agree on
a particular x that will maximise E[T (x)] and agree on a w that divides
the total satisfaction between them. The measure of the advantage of this
procedure is given by maxx E[T (x)].
Alternative 2 Employment Contract.
Here it is assumed that at the time of the negotiations B and W agree
upon a set X from which B will choose x and upon a wage w that divides
the total satisfaction between them. In a later time period, when F1 (x) and

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The present

F2 (x) become known with certainty, B will choose x as to maximise F1 (x),

that is B chooses maxx in X F1 (x). The advantage from this procedure is
given by
TX = E[a2 F1 (xm ) + a1 F2 (xm )]

(74.1)

where xm is the x in X which maximises F1 (x).

Simon now points out that the concept of preferred solutions can be
generalised with the preferred set, X, being a set for which TX assumes its
maximum value. Theorem 72.1 can be extended to show that if B and W
agree upon an X which is not preferred, the expected satisfactions of both
can be increased by substituting a preferred X and adjusting w appropriately.
The idea of a preferred set provides a rational theory for the determination of the range of authority of B over W , that is, W s areas of acceptance.
Moreover the sale contract can be seen as a special case in which X contains a single element. Hence the difference between max TX for all sets
and max TX for single-element sets provides a measure of the advantage
of an employment contract over a sales contract for specified distribution
functions of F1 (x), F2 (x).
Here Simon uses an example as an illustration of the theory. In this
example W s behaviour choice is restricted to two elements, xa and xb . If
W s behaviour pattern is xa then B and W will receive the satisfactions
S1 (xa , w) and S2 (xa , w), respectively, where
S1 = F1 (xa ) a1 w

(74.2)

S2 = F2 (xa ) + a2 w

(74.3)

Let us assume that at the time of contracting, F1 (xa ) and F1 (xb ) have a
joint probability density function94 given by
94

F1 (x)

F13 (x)

F13 (xb )

F12 (x)
F11 (x)

F12 (xb )
F11 (xb )
F1 (xa )

xa

xb
Figure 74.1

To understand the joint probability density function first consider Figure 74.1. Let us
assume that F1 (x) can take three different functional forms, F11 (x), P
F12 (x) or F13 (x). The
3
1
2
3
i
probabilities for each of these forms are P1 , P1 and P1 respectively.
i=1 P1 = 1. We can
fix x at xa and assume that all three of the functions pass through the point (xa , F1 (xa )).

The present

75

p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

(75.1)

Also assume that F2 (xa ) and F2 (xb ) have known fixed values:
F2 (xa ) =

F2 (xb ) =

(75.2)

If B and W are to sign a sales contract, they will need to choose between
xa and xb . Based on our previous assumptions of rationality, they will choose
xa iff:
 Z Z

E[T (xa )] = a2
F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

a2

+ a1

F1 (xb )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )
+ a1

= E[T (xb )]

(75.3)

Assume that 75.3 does hold. Simon asks the question, Will the parties
gain anything further by entering into an employment contract instead of
a sales contract? This question amounts to asking is there any advantage
to giving B the right to choose between xa and xb when F (xa ) and F (xb )
become known with certainty. To answer this question Simon compares
E[T (xa )] (equation 75.1) with TX (equation 74.1), where X consists of the
set xa and xb .
But the values of xb for each of the three functional forms are different and they occur
with probabilities P11 , P12 and P13 respectively. Thus for a given xa - and hence F1 (xa ) we get a probability distribution over the value of F1 (xb ): F11 (xb ) occurs with probability
P11 , F12 (xb ) occurs with probability P12 and F13 (xb ) with probability P13 .
The above gives us the conditional probability for each value of F1 (xb ) assuming a
given value of F1 (xa ). To obtain the joint distribution P (F1 (xa ), F1 (xb )) we multiply the
conditional probability, P (F1i (xb )|F1 (xa )) = P1i , by the marginal probability, P (F1 (xa )).
Each P1i P (F1 (xa )) result gives us one of the black dots in Figure 75.1. As we increase
the range of values of F1 (xa ) and F1 (xb ) considered, to (-, +), the black dots merge to
form a the probability surface giving the joint probability distribution, P (F1 (xa ), F1 (xb )).
Prob(F1 (xa ), F1 (xb ))

F1 (xb )

Figure 75.1

F1 (xa )

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The present

We know


Z
E max F1 (x)
=
xX

F1 (xa )=

F1 (xb )=

F1 (xb )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

F1 (xb )=F1 (xa )

(76.1)

F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=F1 (xb )

where p(F1 (xa ), F1 (xb )) is the joint probability density function of F1 (xa )
and F1 (xb ). This means that
Z
Z
TX =
(a2 F1 (xb ) + a1 )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )=

F1 (xb )=F1 (xa )

(76.2)

F1 (xb )=

(a2 F1 (xa )
F1 (xa )=F1 (xb )

+ a1 )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

and to choose between an employment contract and a sales contract Simon

notes that the sign of TX E[T (xa )]95 must be determined where
Z
Z
(a2 (F1 (xb ) F1 (xa )) + a1 ( ))
TX E[T (xa )] =
F1 (xa )=

F1 (xb )=F1 (xa )

p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

(76.3)

Given that we know that (F1 (xb ) F1 (xa )) 0 in the region of integration,
we can conclude that the employment contract is preferable to the sales
contract with x = xa , if > (i.e. if W prefers xb to xa ) and even if
( ) < 0 but not too negative. Since (F1 (xb ) F1 (xa )) 0, B prefers
xb to xa and if W also prefers xb to xa then the employment contract is
preferred to the sales contract since the sales contract results in xa while the
employment contract puts positive probability on getting xb , the preferred
outcome.
Simon now considers a special case of equation 157.1 in which W is indifferent between xa and xb , i.e. = , and F (xa ) and F (xb ) are independently
normally distributed:


1
1
exp
P (F1 (xa ), F1 (xb )) =
2a b
2

2 
 #)
F1 (xa ) A
F1 (xb ) B 2
+
(76.4)
a
b
where A and B are the means and a and b the standard deviations of
F1 (xa ) and F1 (xb ) respectively.
95

See appendix 2, page 153, for the derivation of TX E [T (xa )].

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77

Given 76.4, equation 157.1 can be written as:

Z
Z
a2
(F1 (xb ) F1 (xa ))
TX E[T (xa )] =
2a b F1 (xa )= F1 (xb )=F1 (xa )
(
"


 #)
1
F1 (xa ) A 2
F1 (xb ) B 2
exp
+
(77.1)
2
a
b
dF1 (xb )dF1 (xa )
The situation described by equation 77.2 is pictured in Figure 77.1 below.
Here is it assumed that A = 0 and B < 0. The ellipses about the point (0, B)
are the contours of the probability function and the region of integration is
above, to the left, of the line F (xa ) = F1 (xb ).96
From Figure 77.1 it should be clear that TX E[T (xa )] will increase if
there is an increase in a or b and with a decrease in the absolute value of
B. This tells us that an increase in the uncertainty of either F1 (xa ) or F1 (xb )
when the contract is made will increase the advantage of the employment
contract over the sales contract, while a decrease in average disadvantage of
xb as compared to xa will have the same result.
F1 (xb )

F1 (xa )

(0,B)
Figure 77.1
Simon now notes that it is clear that these results will hold, qualitatively,
even when F1 (xa ) and F1 (xb ) are not independently distributed, or when
the distribution is not exactly normal. Thus it is concluded that both the
conjectures set forth at the end of second section prove to be correct.
96

Remember that the bivariate normal distribution can be represented as a bell-shaped

surface z = f (x, y) as in the diagram below. Any plane parallel to the xy plane which
cuts the surface will intersect it in an elliptic curve.

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The present

Next Simon argues that one objection to his analysis needs to be raised
and disposed of. He has assumed so far, that in the employment contract,
that B, when F1 (xa ) and F1 (xb ) become known will choose the larger of the
two. Why does B not choose the larger of (a1 F1 (xa ) + a2 ) or (a1 F1 (xb ) +
a2 )? If he did this the employment contract would always be preferred to
the sales contract. This would maximise the sum of the satisfactions. w
could be used to split this satisfaction between B and W to their mutual
advantage. In this situation there would be no advantage to limiting X.
The problem with such an agreement is that once B and W have agreed
on a w, there is no way for W to enforce the understanding that B will
choose x on the basis of maximising (a1 F 1() + a2 F2 ()) rather than F1 ().
Moreover it is to Bs short-run advantage to maximise F1 () rather than
(a1 F 1() + a2 F2 ()) once w is determined. In other words, the worker has
no assurance that the employer will consider anything other than his own
profit when deciding on what action he will ask the worker to carry out.
Simon then argues that if the worker had a responsible expectation that
the employer would take account of his satisfactions, the worker would presumably be willing to work for a smaller wage than if he thought these satisfactions were going to be ignored in the employers exercise of authority and
only profitability to the employer taken into account. On the other hand,
unless the worker is thereby induced to work for a lower wage, the employer
has no incentive to use his authority in any other way than to maximise F1 ().
Hence, we might expect the employer to maximise (a1 F 1() + a2 F2 ()) only
if he thought that by so doing he could persuade the worker, in subsequent
renewals of the employment contract, to accept a wage sufficiently smaller to
compensate him for this. Otherwise, the employer would rationally maximise F1 (). The interpretation that Simon gives to this is that the maximising
F1 () behaviour represents short-run rationality, whereas the maximising
(a1 F 1() + a2 F2 ()) behaviour represents long-run rationality when a relationship of confidence between employer and worker can be attained. The
fact that the former rule leads to solutions that are preferable to those of
the latter shows that it pays the employer to establish this relationship.
In section above the situation considered was limited to having only two
behaviour alternatives available for W . This analysis can be interpreted as
answering the following question:
Suppose that B and W have already agreed to enter into an
employment contract, with B to choose x from some subset, Xa
that does not include xb . Is it now advantageous to the parties
to enlarge W s area of acceptance to include xb ?
Simon interprets xa to mean the element of Xa which maximises F1 (x) for
x in Xa . Assume that the joint probability distribution p[F1 (x1 ), F1 (x2 ), . . . ]
for x1 , x2 . . . in Xa is known and therefore we can calculate the probability

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79

distribution of Fa = F1 (xa ). This is, in fact, the distribution of the maximum of a sample where each element of the sample is drawn from a different
population. Placing this interpretation of the Fa that enters 157.1, we see
that it will be advantages to enlarge Xa to include xb iff
T(Xa +Xb ) TXa .

(79.1)

Simon notes that any actual employment contract specifies more than
the wage to be paid by B to W and the authority relationship. When
the employer will not exercise his authority is often spelled out in great
detail; e.g., hours of work, nature of duties (in general or specifically) and
so forth. For a relationship which endures over time, all sorts of informal
understandings grow up in addition to formal agreements that are made
when the contract is periodically renegotiated. Given the involvement of
labour unions in negotiations many of these contract terms are spelled out
specifically and in detail in the union agreement. Simon deals with this fact
by recognising that authority is accepted within limits, but such limits can
be introduced in a different manner.
So to extend the model in this direction Simon assumes that the behaviour of the worker, or group of workers, is specified not by a single, x,
element but by a sequence of such elements (x, y, z, . . . ). In addition assume that each of these determines a separate component in the satisfaction
functions and that these components enter additively:
S1 = f1x (x) + f1y (y) + aw

(79.2)

and similarly for S2 .

The parties now enter into a contract in which some of the elements,
say x, , are specified as terms in the contract; a second set of elements,
say, y, , is subject to the authority of the employer; and a third set of
elements, say, z, , is left to the discretion of the workers. Analogously to
the assumptions made above, Simon assumes that if the element y is subject
to the authority of B, he will fix it so as to maximise f1y (y), while if z is
left to the discretion of W , he will fix it so that f2z (z) is maximised. It is
now possible to derive inequalities analogous to 157.1 that will show which
of the elements should fall into each of these three categories.
Reviewing the results obtained above, it is clear that the conditions
making it advantageous to (1) stipulate the value of a particular variable in
the contract are
(a) sharp conflict of interest with respect to the optimum value of the
element (f1 high when f2 low and vice versa);
(b) little uncertainty as to the optimum values of the element (f1 and
f2 small).
The conditions making it advantageous to (2) give (B) authority over an
element or (3) to leave it to the workers discretion are just the opposite of

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The present

those noted above. Moreover (2) will be preferable to (3) if Bs sensitivity

to departures from optimality turn out to be greater than those of W .
A number of limitations of Simons paper have been noted. First Simons comparison of the two contracts is only in terms of ex post efficiency.
There is no consideration of ex ante investment or ex post renegotiation by
Simon.97 A criticism, made by Alchian and Demsetz (1972), of the masterservant relation implicit in the employment relationship is that there is no
difference between the relationship between an employer and his employee
and the relationship of a customer with his grocer. In other words there is
no difference between a sales and an employment relation contract as
seen by Simon. But as has been noted above this argument itself has been
criticised. But perhaps the most serious limitation of the model lies in the
assumption of rational utility-maximising behaviour by the players.
A more modern approach that builds on Simons ideas is Wernerfelt
(1997). Wernerfelt portrays governance mechanisms as game forms chosen
by rational agents to regulate their relations. He compares three alternative
game forms for situations where a buyer needs a sequence of human asset
services: 1) the hierarchy game form, 2) the price list game form and 3)
the negotiation-as-needed game form.98 An employee is defined as someone
who sells his services in a specific game form characterised by the absence of
bargaining over adaptations to changing circumstances. The firm is seen as
consisting of the buyer of human asset services, along with a set of sellers,
provided that the human services are traded in the employment relationship or hierarchy game form. The hierarchy game form is defined as the
situation in which the parties engage in once-and-for all wage negotiation,
the manager describes desired services sequentially, and either party may
terminate the relationship at will. In this model, the boundaries of the firm
are given by the set of agents employed by the buyer. Whether one uses the
employment relationship or an alternative game form depends on the nature
of the expected adaptations. If many diverse and frequent adjustments are
97

The model in Bolton and Dewatripont (2005: 490-8) introduces both these ideas.
Wernerfelt (1997: 490) introduces the game forms with three simple examples:
1. As a typical day unfolds, you learn that you will need several services from your
secretary. In principle, the two of you could contract over the provision of each service
as its nature becomes clear. However, under such an arrangement you would spend a lot
of time negotiating. We therefore have the institution normally called the employment
relationship under which the secretary has agreed to supply ex ante unspecified services
for a certain number of hours.
2. Consider what happens if a general contractor remodels your house. You may
change your mind during construction, but because these adaptations are infrequent they
are typically handled through negotiation on an as-needed basis.
3. Suppose next that you are at H & R Block getting help with your tax return. While at
the store, you may realize that you need additional services: there may be more schedules
to file or you may want to prepay part of next years taxes. In this case you know the
price of each adaptation ex ante and no new negotiation is needed. Since the number of
possible adjustments is small, the price list governs adaptation cheaply.
98

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81

needed, the employment relationship involves lower adjustment costs than

any of the other governance structures. The price list game form is better
when the list of possible adjustments is small and the negotiation-as-needed
game form is better when adjustments are needed infrequently.
In a more recent paper, Wernerfelt (forthcoming), Wernerfelt asks why
all of firms (an employment relationship), contracts and markets are used
as trading mechanisms. He notes that we dont have a theory that can
explain the use of each of these mechanisms within a unified framework. His
proposed theory is based upon the interaction of four factors: the advantages
of specialisation, workers costs of switching between entrepreneurs, the size
of entrepreneurs, and the frequency with which entrepreneurs requirements
change.
Most importantly for our purposes the employment contract (a firm) occurs when the entrepreneur has many, frequently changing needs, it is costly
for workers to switch from one entrepreneur to another, and the advantages
of specialisation are small. Wernerfelt (forthcoming: 2) illustrates the effects of specialisation, switching costs and adjustment frequency with the
example of the maintenance of a medium-sized apartment building,
[t]he owner [of the building] will typically have an employee-the
superintendent-to perform minor repairs (the toilet leaks). The
building generates a steady flow of small problems that tend to
be urgent, and the superintendent can solve each of them pretty
well. On the other hand, certain minor renovations, such as those
having to do with electricity (install LED light bulbs in public
spaces), are normally done through the market. The jobs are
often larger, specialists can do them better, and the building does
not need a full time electrician. Major renovations, for which
advance planning reduces the need for in-process changes, are
typically governed by a bilateral contract subject to occasional,
though typically costly, renegotiations.
The same example can illustrate the effects of size. A landlord
who owns just one or two units will typically go to the market even for minor repairs because these units do not generate
enough work to support a superintendent. On the other hand,
very large landlords, such as universities, typically use specialist employees (their own electricians) for both repairs and minor
renovations.
The firm as a governance mechanism approach is most commonly associated with the work of Oliver Williamson (see, for example, Williamson
1971, 1973, 1975, 1979, 1985, 1996a). Williamsons work is based on the twin
notions of bounded rationality, which results in contractual incompleteness,
and opportunism, thought of as self-interest with guile. An upshot of these

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ideas is that contractual agreements need various kinds of safeguards built

into them. For example, contractual agreements could involve hostages,
that is, one party may post a bond with the other. The contractual arrangements and their associated safeguards are referred to as governance
structures by Williamson. This basic idea is that transactions can be assigned to governance structures on the basis of their transaction properties.
Gibbons (2005: Sections 1.1, 1.4, 2.2, 3) argues that Williamsons works
can be read as suggesting two elemental theories of the firm rent-seeking
and adaptation. In the rent-seeking theory of the firm integration can be
the efficient governance structure because integration can put a stop socially
destructive haggling over appropriable quasi-rents (or AQRs). Williamson
argues that within firms conflicts are settled by fiat, which can be a more
efficient way to handle such issues than haggling. The basic logic is that,
in the presence of AQRs, non-integration cannot avoid inefficient haggling
because even though the haggling is jointly and socially unproductive, it
is a source of private pecuniary gain, and thus integration, which brings
with it dispute-resolution by fiat and thus less haggling can be more
efficient. Note also the result that the larger are the AQRs the more likely is
integration, presumably because the socially unproductive haggling is either
more likely or more costly (or both) the larger are the AQRs.
In Gibbons adaptation version of Williamsons theory of the firm, integration can be the optimal governance structure for transactions that require
adaptive, sequential decision-making in situations where uncertainty is resolved over time. To formulae an adaptation theory, a setting in which
uncertainty is endemic must be created such that neither ex ante contracts
nor ex post renegotiation can achieve post-uncertainty first-best adaptation.
A second-best solution may be to concentrate authority in the hands of a
boss who makes decisions albeit self interested decisions after the resolution of any uncertainty. Thus for the adaptation (and the rent-seeking)
theory the emphasis is on authority and control, where the boss makes any
necessary decisions. This is in contrast to the firm as a solution to moral
hazard in teams approach which concentrates on incentives and thereby
ignores control and the firm as an ownership unit approach which blends
the two but it does mean that the adaptation theory shares similarities
with the authority view discussed above.99 Williamson argues that it is
only when there is a need to make unforeseen adaptations does the market
versus internal organisation question become an interesting issue.
Within the rent seeking framework it is often argued that AQRs arise
because of relationship specific investments and asset specificity. Assets are
specific to a transaction when they have great value within the context of
a particular transaction but little value outside it. This leads to the possibility of (ex post) opportunism. Insofar as contracts are incomplete, as
99

Williamson (1975), for example, makes use of Simon (1951) in Chapters 4 and 5.

The present

83

uncertainty unfolds and unanticipated events occur, the contract will need
to be renegotiated and if one party has made a sunk investment via the
development of assets specific to the relationship then the other party could
attempt to opportunistically appropriate an undue part of the payoffs to
this investment by threatening to withdraw from the relationship. Significantly Gibbon sees the adaptation interpretation as being independent of
these hold-up type issues, which makes the adaptation view a non-standard
interpretation of Williamsons work.
Williamson can be seen as proposing that both asset specificity and
adaptation are necessary if a theory of the firm is to be realistic.
While Williamsons work has explained why there are benefits to integration, Aghion et al (2014b: i2) argues it still leaves at least two important
questions unanswered: 1) how does integration succeed in eliminating ex
post opportunism and 2) what are the costs of integration. The GrossmanHart-Moore approach to the firm, see below, offers a model that addresses
these questions.
Tadelis and Williamson (2013: 170-9) offer a simple formal model of
transaction cost economies (TCE). Their model considers two modes of governance: market and hierarchy and asks, When does each mode enjoy an
advantage over the other? The basic features of the Tadelis and Williamson model are: (l) exchange takes place between successive (technologically
separable) stages of production (2) spot markets aside, all contracts are incomplete to varying degrees; (3) the critical attributes of transactions are
asset specificity and contractual incompleteness (disturbances), where the
former is responsible for bilateral dependency and the latter creates a need
for adaptation; (4) if the parties are independent and if a disturbance occurs for which the contract is not adequate, adaptation is accomplished by
renegotiation and/or court ordering; and (5) efficiency is served by aligning transactions with governance structures in a way that economizes on
transaction costs.
Two points about the formal model, which analyses a relationship between a buyer and a seller of an intermediate good, are worth noting at this
point. First, adaptation costs are incurred only by the buyer. Second it is
assumed, for simplicity, that asset specificity is treated as a probability of
finding an alternative seller without incurring adaptation costs, rather than
as an actual loss in surplus if the seller is replaced. More on these points
below.
Tadelis and Williamson consider a transaction between a buyer and a
seller where the buyer obtains a value v > 0 if he procures a good (or
service) from the seller and incorporates that good into his own output.
The transaction is characterised by both asset specificity and contractual
incompleteness.
Asset specificity is modelled by [0, 1], where higher values of represent higher degrees of asset specificity. Tadelis and Williamson interpret

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as the probability that the seller can not be replaced when disruptions
in supply occur and adaptation costs are therefore incurred. (1 ) is the
probability that another supplier will perform any necessary adaptations and
adaptation costs will be avoided. Note that when is higher, the expected
loss from having to switch suppliers will be larger, making the fundamental
transformation more severe.100
Next, the probability that renegotiation of the contract will be required
due to some significant disruption is modelled as [0, 1]. Should disruption
occur then enforcement of the ex ante design of the contract will not result in
the value v being obtained. Achieving v will then require ex post adaptation,
at some additional cost. is interpreted as a measure of the contractual
incompleteness of the transaction and is assumed to be exogenous.
As noted above two forms of governance are considered. The first being
the market and the second hierarchy. Transaction cost economies associates
two basic properties with the market: 1) high-powered cost incentives and
2) retentions of controls rights by each party. Hierarchy, on the other hand
is identifies with low-powered cost incentives and the parties relinquishing
control to a third party. In their model Tadelis and Williamson formally
define market versus hierarchy along only one of these dimensions: the allocation of administrate control over production and adaptation processes,
and they assume that the strength of incentives is endogenously derived.
Market governance, denoted M , is defined to be the situation in which
each of the parties retains autonomy over its own production process decisions and the supplier is expected to provide a product inline with conditions as specified in the contract. Importantly any adaptation of the ex
ante design that becomes necessary due to disturbances has to be negotiated between the two autonomous parties. For simplicity it is assumed
that adaptation will only be required with recept to the sellers production
process.
Hierarchy, denoted H, is defined to be the situation in which each party
forgo their administrative control in favour of a third part, called the interface coordinator. This is to say that routine tasks are followed as planned
but should a disruption occur any necessary decisions are made by the interface controller who has unified ownership and thus control over production
and adaptation stages for both the buyer and the seller. The notion of
hierarchy Tadelis and Williamson use is different from that of the Property Rights Theory (PRT) associated with Grossman-Hart-Moore in that
100

The Fundamental Transformation is perhaps the most distinctive intertemporal regularity within the TCE setup. It refers to the transformation of a large numbers bidding
competition at the outset into a small numbers supply relation during contract implementation and at contract renewal intervals for transactions that are supported by significant
investments in transaction specific assets. Such bilateral dependencies present the parties
with contractual hazards for which, as discussed above, governance supports are introduced to effect hazard mitigation in cost effective degree (Williamcon 2007: 11).

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85

Tadelis and Williamson assign responsibility for implementing routines to

the managers at each stage and only assign responsibility for coordinated
adaptations arising from disturbances to the interface coordinator. Tadelis
and Williamson (2013: 172) write,
TCE identifies this interface coordinator as often being a third
party whose incentives are aligned with total profit maximization. That is, instead of a preexisting buyer and supplier, the
transaction is a de novo investment whose governance needs to
be determined. Efficiency considerations will determine whether
the transaction is integrated (controlled by an interface coordinator) or not integrated (controlled by the contract and mutually
agreed-upon adaptations). PRT, in contrast, identifies integration with the situation in which one of the two parties becomes
the owner of all productive assets and controls the decisions related to their use. The predictions of PRT are as much about
which of the two parties maintains control as about when unified
ownership is called for.
In addition to the allocation of administrative control, the interfirm contract (or intrafirm compensation scheme) must also include a compensation
mechanism which is utilised by the buyer (or interface coordinator) to determine payment to the supplier. This scheme will, of course, affect the
incentives the seller has to reduce costs. Let c denote the sellers production cost which includes items such as materials, lost opportunities, labour
costs etc faced by the seller. Attention is restricted to linear compensation schemes of the form F + (1 z)c where F is a fixed component and
(1 z) [0, 1] a share of production costs. Thus, a supplier who incurs a
cost c receives a payment of F + (1 z)c where z [0, 1] is the share of
production costs borne by the seller. An important interpretation of z is
as a measure of the strength of the cost reduction incentives the supplier
faces. For example, when z = 1 and F > 0 the seller is paid a fixed-price
payment and bears all of the production costs. This seems to be the standard for market transactions and provides the seller with strong incentives to
reduce production costs. On the other hand, a cost-plus contract would be
one where F > 0 and z = 0 so that the seller bears none of the production
costs and just receives a fixed payment. This seems more like what we find
in hierarchial structures and, importantly, it provides little, or no, incentive
to engage in cost reductions. Note that the F in the two situations will be
different. For the Tadelis and Williamson model both F and z are chosen
endogenously.
The production costs of the seller are given by the function c(e, G) =
c Ge where e 0 is the intensity of effort expended by the seller and G
{M, H} is a number that denotes the mode of governance where M > H > 0.
This last requirement just means that for a given level of effort M e > He

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and thus c(e, M ) < c(e, H). This amounts to saying that more effort reduces
production costs, and effort is more effective in reducing production costs
under market governance than under hierarchy. The opportunity cost of

effort e to the seller is y(e) where y (e) > 0, y (e) > 0 and y (e) 0. To
ensure an interior solution to the sellers optimisation problem it is assumed

that y (0) = 0. It is also assumed that contracting on e is impossible.

Should a disruption occur, then additional costly adaptations must be
made in order to secure the value v.
Adaptation costs can have at least two sources. The first involves
activities that were wasted and redone, or modifying initially
planned production processes that fit the original design. These
adaptation costs stem from contractual incompleteness and could
have been spared if a complete contract and accurate design
were in place. The second source of adaptation costs results
from haggling, rent seeking, and other renegotiation costs that
parries expend to get a better deal, which are a pure dead-weight
loss (Tadelis and Williamson 2013: 174).
These two costs are combined to give total adaptation costs denoted k(z, G)
> 0.
These adaptation costs are incurred if and only if two events occur. First,
obviously, a disruption must occur, an event which happens with probability
, the incompleteness of the contract. But also it must be the case that
new supplier from the competitive market can not step in and supply the
modified good. This occurs with probability , the measure of specificity.
Tadelis and Williamson assume, for simplicity, that any adaptation costs are
borne by the buyer alone. It is also assumed that v k(z, G) > 0 meaning
that the adaptation costs are worth incurring ex post to gain v. Thus the
expected gross benefit from the transaction is v k(z, G) > 0 and the
expected adaptation costs are increasing in both and .
Tadelis and Williamson (2013: 175-6) make three assumptions about
adaptation costs:
Assumption 1 Adaptation costs are lower in hierarchy: k(z, M ) > k(z, H)
for 0 z 1.
This says that adaptation costs are greater under market governance than
hierarchy.
Assumption 2 Adaptation costs are lower when cost incentives are weaker:
k(z,M )
> 0.
z
This simply states that adaptation costs are increasing in seller cost reduction incentives.

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87

Assumption 3 Reducing adaptation costs by weakening incentives is more

)
> k(z,M
> o.
effective under hierarchy: k(z,H)
z
z
This can be seen as saying that the slope of the hierarchy function is greater
than that of the market function.
If we take, as an example, the two functions k(z, H) and k(z, M ) to
be affine then these three assumptions mean that the two function can be
represented as:
k()
k(z, M )
k(z, H)

1 z
The implication of assumptions 1-3 is that market governance reduces
production costs but increases adaptation costs. Hierarchy, as you may
expect, works in the opposite way. There seems an obvious solution to
this trade-off between these costs, let the seller control decisions to do with
production of the original design and have the interface coordinator control
adaptation retain decisions. This type of selective intervention is ruled out
by assumption 87.4
Assumption 4 Administrative control is allocated over both production and
adaptation, and the two processes cannot be separated to allow for selective
intervention.
Now Tadelis and Williamson turn to analysing the endogenous determination of governance and incentives. First the objective of the seller is
studied.101
max uS (e; z, G) = F z(
c Ge) y(e)
e0

Tadelis and Williamson (2013: 177) state Lemma 1:

101

Remember that a seller who incurs a production cost c is paid F + (1 z)c, and
c = c Ge. The sellers payoff is equal to the payment he receives less production and
effort costs, that is
uS (e; z, G)

F + (1 z)c c y(e)

F + c zc c y(e)

F zc y(e)

F z(
c Ge) y(e).

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Lemma 1 Given the pair (z,G), the sellers optimal choice eG (z) is increasing in z, eG (0) = 0 for G {M, H}, and eM (z) > eH (z) for any z (0, 1].
H
M
Furthermore, de dz(z) > e dz(z) for any z [0, 1].
The proof to the lemma is provided in the appendix to Tadelis and Willi
amsons chapter.
y (e)
zG

eG

Proof: The first order condition,102 zGy (eG (z)) = 0, to the sellers problem
can be represented by the diagram above.

Given that y (0) = 0 and y(e) is convex, y (e) must start at the origin

and be an increasing function of e. (The condition Y (e) < 0 means it

is concave.) This means that it must intersect the zG line and do so only

once. Note that if z = 0 then zG = 0 and thus y (eG (0)) = 0 which implies

eG (0) = 0 as y (0) = 0. As M > H > 0 it follows zM > zH

y (eM (z)) > y (eH (z)) eM (z) > eH (z) > 0 as y (e) is increasing that
eM (z) > eH (z) > 0 for all z (0, 1]. See the diagram below.

y (e)
zM
zH

102

eH eM

Solving
max uS (e; z, G) = F z(
c Ge) y(e)
e0

gives
uS (e; z, G)
e

y (eG (z))

zG y (e) = 0

zG

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89

Now take the derivative of the first order condition with respect to z.103
deG (z)
dz
deG (z)

dz

G y (eG (z))

= 0
=

G
y (eG (z))

Because M > H > 0 the numerator in the righthand side of the above

equation is greater in the M case than the H case and y (e) 0 tells us

that y (e) is a decreasing function of e and thus eM (z) eH (z) implies

that y (eM (z)) y (eH (z)) which makes the denominator in the H case at
least as large as in the M case. The combination of these conditions on the
M
H
numerator and the denominator mean that de dz(z) > de dz(z) .
Given the optimal response of the seller, surplus maximisation requires
the choice of G and z to maximise the objective function, S(z, G; , ), as
given below.104
Total transaction costs
z
}|
{
G
G

y(e
(z))

k(z,
G)
max S(z, G; , ) = v (
c Ge (z))
{z
} | {z } | {z }
G{H,M }
Value |
z[0,1]

to
Production costs Compensation
Expected
buyer
adaptation costs

eG (z) has been substituted in the objective function in place of e to take

into account the sellers incentive compatibility constraint. This is just to
103

The first order condition is,

uS (e; z, G)
= zG y (eG (z))
e

and so

2 uS (e; z, G)
deG (z)
= G y (eG (z))
ez
dz
G

de
(z)
y (eG (z))
dz
deG (z)

dz

104

G
y (eG (z))

The buyers utility is given by

uB (z, G; ) = v F (1 z)c k(z, G)
{z
} | {z }
Value |

Social surplus is given by,

S()

to Payment to seller
Expected
buyer
adaptation costs
to the buyer

uS + uB

[F zc y(e)] + [v F (1 z)c k(z, G)]

F F zc + zc c y(e) k(z, G) + v

v c y(e) k(z, G)

v (
c Ge) y(e) k(z, G)

given that c = c Ge.

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make sure it is in the sellers best interests to provide the assumed level of
effort.
Solving the above maximisation problem results in Tadelis and Williamsons central result.
Proposition 2 When asset specificity increases (higher ), or when contracts are more incomplete (higher ), the relative benefits of hierarchy over
markets increase. Furthermore, optimal incentives become weaker.
The proof comes from the appendix to Tadelis and Williamson (2013).
Proof: The proposition states that as or increase, both solutions z (, )
and G (, ) will (weakly) decrease. Decreasing z implies that the strength
of cost saving incentives for the seller are decreasing while decreasing G implies a change from M to H. It therefore suffices to prove that the objective
function of maximizing total surplus exhibits decreasing differences. In par2S
S
2S
< 0 and z
< 0 and that S
ticular we need to show that z
and
105 First note that,
are decreasing in G and that S
z is increasing in G.
S
eG (z)
eG (z)
k(z, G)

=G
y (eG (z))

z
z
z
z
and therefore

2S
k(z, G)
=
<0
z
z

and

k(z, G)
2S
=
<0
z
z
These last two inequalities hold since and are probabilities and from
assumption 86.2 we have that k(z,G)
> 0.
z
S
Next we need to show that is decreasing in G. To do so it is sufficient



S 

< 0 since M > H. Using the expression

to show that S



G=M

G=H

for S(z, G; , ) given above we see that



S 
S 

= k(z, M ) + k(z, H) < 0, due to asumption 86.1.

G=M
G=H

To show that S
is decreasing in G we just follow the same procedure
to obtain,


S 
S 

= k(z, M ) + k(z, H) < 0, due to asumption 86.1.

G=M
G=H
105

See Appendix 3, page 159, for a very brief discussion of some of the relevant aspects
of monotone comparative statics and why the conditions given here are what they are.

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91

Lastwe need to show that S

z is increasing in G. For this we must show
S 
S 
that z G=M z G=H > 0 where M > H.
Utilising the expression for S
z derived above we get that,
eH (z)

[H y (eH (z))]
+
z


k(z, H) k(z, M )

> 0.
z
z


k(z,M )

Assumption 87.3 tells us that the term k(z,H)

is positive so
z
z
we are left with showing that

[M y (eM (z))]

eM (z)
z

[M y (eM (z))]

eM (z)

eH (z)
[H y (eH (z))]
>0
z
z

From the first order conditions of the sellers maximisation problem we know

that y (eM (z)) = zM and y (eH (z)) = zH. Substituting these expressions
into the inequality directly above gives,
(1 z)M

eH (z)
eM (z)
(1 z)H
>0
z
z

This is true because M > H and from Lemma 88.1 we know that
eH (z)
z .

eM (z)
z

>

What we can conclude from the results presented so far is that as contractual incompleteness, , increases, total transaction costs increase for
both markets and hierarchies. Importantly, however, market transaction
costs are increasing faster than those for hierarchies, resulting in hierarchies
being better for a larger range of specificity, , a point made by Proposition
2, see the diagram below. In the model and are multiplied implying that
contractual incompleteness and asset specificity are complements. This tells
us that an increase in adaptation costs resulting from contractual incompleteness is larger the higher is asset specificity.
transaction
costs

market hierarchy

specificity

(Figure 2 from Tadelis and Williamson (2013).)

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What Foss, Lando and Thomsen refer to as the firm as an ownership

unit approach to the firm is the property rights theory or incomplete contracts theory of the firm due to Grossman and Hart (1986, 1987), Hart and
Moore (1990) and Hart (1995) (denoted GHM from now on).106 The central idea in the property rights approach is that as contracts are incomplete
the allocation of control rights107 affects the incentives that people face and
thus their behaviour and the allocation of resources. This theory defines
ownership of an asset as the possession of the residual control rights over
that asset.108 A firm is defined as a collection of jointly-owned assets. This
means, for example, that the distinction between an independent contractor
and an employee turns on who owns the non-human assets with which the
agent works. An independent contractor owns his own tools while an employee does not.
But, How and why does ownership matter? The answer is that in a
world of incomplete contracts, ownership (i.e. having residual control rights)
can serve as a source of power. Given that incomplete contracts contain
gaps (or ambiguities) the question arises of who gets to make decisions in
these noncontracted for situations? For the property rights theory it is the
owner. This matters since if there are two separate firms, A and B say,
then the management of each firm can make decisions for their firm in the
uncontracted for situations. If, on the other hand, A was to take over B then
As management could make decisions for both A and B in the uncontracted
for cases. To see the implications of this imagine that B supplies A with an
input for As production process. If A and B are separate firms then Bs
management could threaten to withdraw both its assets and its own labour
if the firms can not, say, agree on the terms for an increase in the supply
of the input. If A owns B then B can only threaten to withhold its labour.
The latter threat is normally weaker than the former. Such differences in
power will effect the distribution of surplus generated by the relationship
between A and B. If the firms are separate then A may have to pay a lot to
induce B to supply the increased level of inputs whereas if A owns B it can
enforce the supply at a much lower cost since Bs management has reduced
threat, and thus bargaining, power.
Determining the boundaries of the firm requires balancing the advantages of integration against its disadvantages. The benefit of integration is
that the acquiring firms, A above, incentives to make relationship-specific
106

See Aghion and Holden (2011), Bolton and Dewatripont (2005: chapter 11), Hart
(1989) and Moore (1992) for more detailed introductions. See Aghion, Dewatripont,
Legros and Zingales (2014a) for five survey papers presented at a conference in the honour
of the 25th anniversary of the publication in 1986 of the paper A Theory of Vertical and
Lateral Integration by Grossman and Hart.
107
Having control rights over an asset means you can decide all uses of the asset that are
not inconsistent with prior contracts, custom or law.
108
Residual control rights are those rights associated with being able to use the asset
under conditions not specified in the contract.

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93

investments is stronger because it now has greater residual control rights

and thus can command a larger share of the ex post surplus created by such
investments. The disadvantage of integration is that the incentives of the
acquired firm, B, to make relationship-specific investments is reduced since
they now have fewer residual controls rights and thus are able to capture
less of the ex post surplus that their investments creates. To put this in employee/independent contractor terms, the optimal size of a firm trades off
the fact that hiring an employee means hiring someone who lacks optimal
incentives since they risk being held up by the firm because they can be fired,
and thereby separated from the assets they need to be productive, versus
using an independent contractor who could hold-up the firm by threatening
to quit the relationship and taking his assets with him.
An implication of this is that if a non-contractible, specific to a particular
set of assets, investment is undertaken then a non-owner risks being held-up
by the owner. Thus the property rights theory would say that whoever makes
the most important, non-contractible, asset-specific investment should be
the owner of the asset.
A simple, more formal, version of the GHM approach, based on incompleteness due to both a lack of foresight and verifiability of actions to third
parties, is presented in a model by Tirole (1988: 31-3).109 The Tirole model
is a simplified version of the model presented in Grossman and Hart (1986).
The time line is given in Figure 93.1.
Buyers
specific
investment

Recontracting?

Trade
Time

Design changed
by seller
at cost c?

Parties
learn design
improvement

Contract to
exchange
basic good

{z
A

(ex ante)

}|

{z
B

(ex post)

Figure 93.1. GHM time line.

Here we see that there is a Buyer and a Seller who agree - at time A
- to trade - at time C - a basic design of some commodity. These parties
know that at time B the opportunity to improve the goods quality may
arise but at time A they do not know what the quality improvement will
be. This means that at time A the parties can not make their contract
contingent on a design change at time B. At time B, however, they learn
about the quality change and can at this point contract on it. To implement
the quality change costs the Seller a noncontractible amount c > 0. It will
be assumed that the cost c is independent of the nature of the improvement.
109

For additional discussion of this model see Furubotn and Richter (2005: 251-8).

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The present

The probability, , that the improvement comes about can be increased

by the Buyer making a relationship-specific investment in period A. The
2
cost of the Buyers specific investment is I = 2 . The Buyers valuation of
the improvement in time B is v which can take on just two values: either
v = v > c - so the improvement should be implemented - occurring with
probability or v = 0 - so the improvement should not be implemented occurring with probability (1 ). These values for v and the cost c are
known to both the Buyer and Seller at time A but can not be contracted on.
The Seller can observe the Buyers investment and thus its level is known to
both parties at time B. However such investments can not be contracted on.
Note that v and c are extra valuation and costs, that is, beyond the values
corresponding to the basic design. Trade takes place at time C. Finally it is
assumed the both parties are risk neutral.
For purposes of comparison we will first determine the first-best outcome, that is, the outcome that maximises the expected additional joint
profit of the two firms with no consideration given to the distribution of the
surplus.110 Obviously the quality improvement should be made if and only
if the buyers valuation is v. Denote the expected additional joint surplus
E(S) = (v c) + (1 )(0 0)

2
.
2

(94.1)

The optimal level of is determined by:

max E(S)

which results in the first order condition,

E(S)
= (v c) = 0

= vc
(> 0).
The optimal level of investment in time A is therefore
I =
=

2
2
(v c)2
2

(94.2)

and thus the maximin joint profits are

S = (v c)

2
2

= (v c)(v c)
=
110

S E(S)
(v c)2
2

(v c)2
> 0.
2

It could be assumed that time A lump-sum payments are used to allocate the surplus.

The present

95

This gives the first-best optimum.

But in general we can not achieve the first-best. We will consider three
second-best cases (three ownership structures). From now on we assume that
the firms act as self-interested organisations and that the quality improvement, although unable to be contracted upon at time A, becomes known at
time B and thus can be contracted for. It is worth remembering that the
cost c is incurred by the Seller while the valuation v and investment I are
related to the Buyer. Also both parties know that should a situation where
v > c occur then the improvement will be implemented.
Case I: Separate firms and thus both firms can block any change in design.
The Buyer and the Seller are nonintegrated but the can bargain in period
B over whether or not to make the quality improvement. If they fail to agree
then the improvement is not implemented as it can not be specified in the
contract.
It will be assumed that any extra surplus generated by carrying out
the design modification are allocated via the Nash-bargaining solution. In
this, simple, case this means that any additional profits will be split 50-50.
Anticipating this the Buyer maximises his ex ante expected profits:
max SB =

The first order condition is

SB

2
1
[(v c)]
2
2

1
(v c) = 0
2
1
=
(v c)
2
which results in specific investments of
=

2
2
2

1 1
(v c)
=
2 2
(v c)2
=
< I
8
Clearly the Buyer underinvests when compared to the first-best case. The
Buyers expected payoff is
I =

=
SB

=
=
=

2
1
[(v c)]
2
2
( 1 (v c))2
1 1
[( (v c))(v c)] 2
2 2
2
1
1
(v c)2 (v c)2
4
8
1
2
(v c)
8

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The present

while the Sellers payoff (his half of the Nash bargaining solution) is
SS =
=
=

1
[(v c)]
2
1 1
[ (v c)(v c)]
2 2
1
(v c)2
4

This results in an expected joint surplus of

S = SB
+ SS
1
1
(v c)2 + (v c)2
=
8
4
3
2
(v c)
< S
=
8

which means the surplus is less than the social optimum.

Case II: Seller ownership, which means the Seller can carry out (or not carry
out) the design change by fiat.
The two firms integrate and the Seller has the right to decide whether
or not the quality improvement is made. If the value of the improvement is
v then both parties want the design change to take place and tus there will
be no renegotiation. If the value of the improvement is zero then the Seller
will not make the improvement since by not doing so he avoids the cost c.
This means that the Buyer will reason as in Case I which results in the same
results as Case I. There will be under investment by the Buyer and the total
surplus will be less than the social optimum.
Case III: Buyer ownership, which means the Buyer can carry out (or not
carry out) the design change by fiat.
Again the two firms integrate but this time the Buyer has the right to
decide on the implementation of the quality improvement, without compensation being paid to the Seller. For this right he pays the Seller a sum at
date A. Importantly the Buyer will implement the improvement under both
valuations of v. Clearly if v = v it is in the Buyers interest to implement
the change but it is also in his interest (or at least he is indifferent about
implementation) to do so even if v = 0. This is because the Buyer does not
pay c and when v = 0 he sets his investment level at zero so implementing
the design change even in these circumstances does not make him worse off.
In short the Buyer gets zero if he implements the quality change and zero if
he doesnt. The Seller, on the other hand, is made worse off if v = 0 since
he would incur cost c, without compensation, and thus he would wish to
renegotiate ex post (at time B) his original promise to spend c at time B.
Should v = v if is obvious that it is obvious that total surplus is maximised with the design change being implemented, which is the status quo.
Thus there will be no renegotiation and the Buyer will gain the full amount

The present

97

v since he can impose the improvement on the Seller, that is, he can get the
Seller to pay the improvement costs, c, without having to compensate him.
If v = 0 then the status quo is not efficient since it would be better if
the quality improvement did not take place. This means that renegotiation
will take place. The Seller wants to avoid paying c. Here it is assumd that
the Nash bargaining solution determines the division of c. The Seller pays
the Buyer one half of c, which clearly is better than paying all of c.
Therefore the Buyer can determine his level of specific investment by
maximising his expected surplus with respect to :
c 2
max SB = v + (1 )

2
2
The first order condition reduces to
v

c
=
2

> .

This gives the optimal investment of the Buyer as,

I =
=

( )2
2
(v 2c )2
2

> I .

This shows that the Buyer now overinvests. The reason being that when
the value of the improvement is v the buyer does not have to pay the cost c,
the Seller bares this cost without compensation, and given that the Buyer
doesnt internalise this production cost he overinvests in the activity that
makes production more likely.
The expected joint surplus is

S = [SB
] + SS


( )2

c
= v + (1 )
2
2

c
2
is a negative number)

c (1 )

(note that S
S
)2
(
= (v c)
.
2

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The present

substituting in the value for gives,111

3
1 2
v vc + c2
2
8

S =

< S

Note that if v 2 2c then S S .112

This means that if the gains that result from the improvement in quality
are large enough Buyer control is preferred to both Seller control or having
separate firms. The advantage of Buyer control is that it encourages investment by the Buyer. But as he doesnt take into account the costs, c, the
Buyer overinvests relative to the first best outcome.
111

This follows from the fact that

S

=
=
=
=
=
=
=

( )2
(v c)
2 

1

vc
2


1
1
v c v + c
2
4


1
3

v c
2
4



1
3
1
v c
v c
2
2
4
1 2 3
1
3
v vc vc + c2
2
4
4
8
1 2
3 2
v vc + c .
2
8

S can be written
S

=
=
=

112

1
(v c)2
2
1 2
(v 2vc + c2 )
2
1
1 2
v vc + c2
2
2

> S

To see this note that

which

S
1 2
3
v vc + c2
2
8
1 2
3
v vc + c2
2
8
1 2
3
v vc + c2
2
8
1
v 2 vc
2
1
(v 2 2vc)
2
is true when v2

S
3
(v c)2
8
3 2
(v 2vc + c2 )
8
3 2 6
3
v vc + c2
8
8
8
3 2 6
v vc
8
8
3 2
(v 2vc)
8
2vc.

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99

In the special case of v 2 2vc the Buyer will be willing, and able, to pay
the Seller a fixed amount at time A to obtain the right to make the decision
about the improvement. That amounts to the Buyer buying the Sellers
firm. The Seller will be able to demand amount equal to the difference in
his expected profits, SS SS , in return for letting the Buyer make the
improvement decision.
1
SS SS = (v 2 + 2c)113
4

(99.1)

Here we can think of this outcome as resulting from the Buyers firm purchasing the Sellers firm for a price of 14 (v 2 2c) in period A. Ownership
in the sense of GHM means the Buyer gains residual control rights over
the Sellers firm, or more precisely the residual control rights over the nonhuman assets of the Sellers firm. The residual control right are, however,
limited in this case to deciding whether or not to make the quality improvement in period B. The fact that the Buyer can make this decision by fiat
means that the Sellers improvement costs, c, are not being internalised in
Case III as they were in equation 94.1 of Case I. This explains why despite
the fact that the two firms are integrated joint profits are less than in the
first-best outcome (Case I ).
113

This follows from,

SS

=
=
=

SS

=
=
=
=
=
=
=

SS SS

=
=
=

1
(v c)2
4
1 2
(v 2vc + c2 )
4
1 2 1
1
v vc + c2
4
2
4
1
c (1 ) c
2
1
c (c c)
2
1
1

c (c (v c)c)
2
2
1
1
c (c vc + c2 )
2
2
1
1
1
c(v c) (c vc + c2 )
2
2
2
1 2 1
1
1
vc + c c + vc c2
2
2
2
4
1 2 1
1
vc + c c
2
4
2
1 2 1
1 2 1
1
1
v vc + c + vc c2 + c
4
2
4
2
4
2
1 2 1
v + c
4
2
1 2
(v 2c).
4

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The present

A crucial assumption for the model just presented is the noncontractibility of the cost c and the value of the improvement v. If we were to make
the assumption that either c and/or v were contractible then, despite the
nonverifiability of the Buyers specific investments, we could still write a
complete contract on c and v which would result in the first-best optimum
given by 94.2 being achieved. The contract would allow the Buyer the right
to enforce a design change whenever he pays for the production costs c.
The basic assumption defining this grouping is that in many cases it is
difficult, if not impossible, to write complete state-contingent contracts. In
such circumstances, people will often rely on informal agreements sustained
by the value of future relationships, that is, relational contracts. These theories form the fourth subgroup of the incomplete contracts category. The
underlying idea in the relational contract theory of the firm is that there are
differences in the way relational contracts function between firms (outscoring) and within firms (an employment agreement).
Baker, Gibbons and Murphy (2002) (BGM) make this point that relational contracts occur both within and between firms and argue that the
difference between them lies in what happens if the relational contract breaks
down. An independent contractor can leave the relationship and take the
assets belonging to it with him. This an employee cannot do. In BGM, an
independent contractor can, if he wants, sell the finished product elsewhere
while an employee does not own the finished product and thus cannot leave
the relationship with the asset or the product. The strength of the threat
to discontinue the relationship determines the implementability of relational
contracts. As an example consider the situation where the market for the
good is highly volatile. In this case, a relational contract may be unworkable
since the supplier has an incentive to violate the relational contract when
the market price is high. If the supplier is part of the firm, such an option
does not exist and the relational contract that holds the internal transfer
price constant may be self-enforcing.114 The relational contracting theory
can be seen as being related to Williamsons idea that the resolution of disputes is more easily achieved within firms them between firms in the sense
that mechanisms for dispute resolution can be seen as a feature of a system
of self-enforcing relational contracting within the firm.
The last of the subgroups identified by Foss, Lando and Thomsen is
the the firms as a communication-hierarchy subgroup. Work within this
category exploits the idea that one function of the firm is to adapt to and
process new information. Marschak and Radner (1972) is the seminal contribution on team theory that offered a new approach to economic organisation.
For Marschak and Radner, incentive conflicts were of little concern with the
emphasis in their theory being on coordination and communication. Radner
114

Self-enforcing here means that each party lives up to the other partys expectation in
fear of retaliation and the breaking down of cooperation.

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101

(1992) is a classic summary of work on coordination in a team environment.

Here, the firm is viewed as a communications network designed to minimise
both the cost of processing new information and the costs associated with
the dispersing information among the members of the firm. Clearly, communication is costly in that it takes time for people to absorb new information
that they have been sent. But this time can be reduced by having particular
agents specialising in the processing of particular types of information. In
the model from Bolton and Dewatripont (1994), for example, each agent
handles a particular type of information with the different types being aggregated via the communications network. Teams, firm-like structures, arise
when the benefits to specialisation are greater than the costs of communication. Garicano (2000) argues that a knowledge-based hierarchy is a way to
organise the acquisition of knowledge when matching problems with those
who know how to solve them is costly. In such an organisation, production
workers acquire knowledge about the most common problems confronted,
and specialised problem solvers deal with the more exceptional cases.
The major problem with this approach to the firm is that it cant explain
the boundaries of the firm. The theory does not explain why communication
hierarchies can exist within firms but not between firms.
In addition to the criticisms that have been levelled against each of the
theories discussed in this section separately, there have been a number of
more fundamental arguments made against the general approach underlying
these theories. One of the most common of these is that the incentive-based
transaction costs theory has been made to carry too much of the weight of
explanation in the theory of the firm. Most of the attention in the above
approaches has been on the hold-up problem and its ex-ante consequences
but coordination problems not involving incentive conflicts are surely of
equal important for the design of organisations. Team theory attempts
to develop a formal treatment of some topics not well-treated within the
contemporary economics of organisations. Considerations of issues like the
costs of communicating, communication channels, on delays in information
transmission and the such like help explain things like the economic function
of corporate culture. Relational contract theory also, to a degree, takes up
the challenge of dealing with these softer type issues.
Bounded rationality in an important unresolved issue in much of the material discussed above. One obvious question to do with bounded rationality
is: How are efficient types of organisation selected? One common approach
is to assume that agents can rationally calculate pay-offs associated with
alternative types of economic organisations and choose the efficient one. An
obvious problem with this is that such an assumption is hard to square with
the idea of incomplete contracts. As incompleteness of contract often relies
on some form of unforeseen contingencies people are boundedly rational it
is not clear how the necessary payoffs can be calculated.
Another issues raised by critics involve the fact that the differences in

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The present

productive capabilities of firms have been suppressed in the modern theory.

While the neoclassical approach of seeing the firm as a production function
is inadequate so is the idea that technology can be ignored altogether. The
critics emphasise that firms have differential productive capabilities and that
this may influence economic organisation. In short, the contemporary theory
of the firm ignores technology.
Last, there are the implications of the Maskin and Tirole (1999) critique
of the incomplete contracts for the theory of economic organisation. These
are discussed next.
The reference point approach
We now add another group of papers to the Foss, Lando and Thomsen
incomplete contracting classification: the reference point theory.115 This
approach arose, in part, from the Maskin and Tirole (1999) critique of theory
of incomplete contracts.116 Maskin and Tirole argue that information which
is observable to the contracting parties but not to a third party, e.g. the
courts such, so-called, non-verifiable information is normally assumed to
be the reason for contractual incompleteness in the firm as an ownership
unit approach can be made verifiable to the third party by the use of
ingenious revelation mechanisms. The contracting parties write into their
contract a game which when played gives the appropriate incentives for them
to truthfully reveal their private information in equilibrium.
Here we give greater detail about the use of mechanisms to overcome
problems of incomplete contracts due to the indescribability or unforeseeable
nature of the state of the world. The illustrate model discussed below comes
from Maskin (2002: 727-30).
Consider a situation where two agents wish to trade a single indivisible
good for which agent 1 is the producer and agent 2 is the consumer. The
time line for the relationship between the agents consists of 3 periods. At
date 0 the agents meet and formulate a contract which delineates the terms
on which the good will be produced and traded. Then at date 1, agent 1
undertakes R&D, denoted e1 , which determines the properties of the good
and thus determines the value of the good to agent 2. Denote this value
as v(e1 ). Also at this time agent 2 undertakes the development of an intermediate input, e2 , that will assist in the production of the good in such a
way as to decrease the costs of production, c(e2 ), for agent 1. Assume that
dc(e2 )
dv(e1 )
de1 > 0 and de2 < 0, that is, an increase in R&D by one agent helps the
other agent. At the final date, date 2, the properties of the good and the
characteristics of the intermediate input are realised with agent 1 producing
115

Hart (2008) is offers an intuitive introduction to the reference point approach to the
theory of contracts.
116
See Maskin (2002) and Aghion and Holden (2011: 190-3) for non-technical discussions.

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103

the good using the input and agent 2 taking delivery of it and paying agent
1 in accordance with the contract.
The payoffs for the two agents are given by their von Neumann-Morgenstern utility functions: payoffs for agent 1 are given by u1 (p c(e2 ) e1 )
and for agent 2 they are denoted u2 (v(e1 ) p e2 ) where p is the price of
the good.
Maskin makes the standard assumption that the R&D investments, e1
and e2 , the private benefits, v and the costs, c are not verifiable to an outside
party but are symmetric information to the contracting agents at date 2. A
state of the world is the combination of the properties of the good and the
characteristics of the intermediate input. As is usual in the literature the
state of the world is assumed to be verifiable to a contract enforcer ex post,
that is, it is verifiable at date 2.
Maskin denotes the efficient levels of investment by agents 1 and 2, assuming that trade takes place, as e1 , e2 , respectively. e1 and e2 are defined
as
e1 = arg max v(e1 ) e1 and e2 = arg min c(e2 ) + e2
e1

e2

Assume v(e1 ) e1 > c(e2 ) + e2 which implies that production and trade
are optimal. In a world of complete contracts agents 1 and 2 could foresee
the state of nature corresponding to e1 , e2 and write it into the contract
along with penalties large enough to ensure both agents complied with the
contract. That is, in a complete contract, the agents could describe the characteristics of the intermediate input corresponding to e2 and the good with
the properties corresponding to e1 . Penalties sufficient to induce compliance
with these conditions would also be part of the complete contract.
The motivation for the incomplete contracts approach is the inability
to describe the appropriate properties and characteristics in advance and
thus the inability to write a compete contract. The major point of the
Maskin and Tirole critique is that despite contractual incompleteness the
optimal outcome can be reached via the design of a suitable mechanism.
The idea is to induce the two agents to reveal the values of v and c and
to use this information as a substitute for information about the physical
characteristics. Maskin gives the following mechanism as an example of a
contract that the agents could negotiate and sign at date 0 and implement
at date 2.
Stage (i): Agent 1 announces c and agent 2 announces v (where
the hats denote the possibility that the agents may not announce
truthfully, i.e., we may have c 6= c(e2 ) or v 6= v(e1 )).
Stage (ii): Agent 1 can challenge agent 2s announcement. If
the challenge is made,
(a) agent 2 must pay a fine f to agent 1, and then
(b) agent 1 offers agent 2 the choice between

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The present
(q , p ) and (q , p );
where
q , q {0, 1}
and
() q v p > q v p
Note that () implies that agent 2 will choose (q , p ) if he has
been truthful (i.e., v = v(e1 )).
The challenge succeeds if agent 2 chooses (q , p ) (since agent
2 is then shown to have lied), in which case (q , p ) is implemented. That is, agent 1 produces and delivers q units of the
good (with characteristics corresponding to the realized state of
the world, assumed to be verifiable) for price p . In this case,
the mechanism concludes at this point.
The challenge fails if agent 2 chooses (q , p ) (since agent 2
is then shown to have told the truth), in which case (q , p )
is implemented, i.e., agent 1 delivers q units of the good with
characteristics corresponding to the realized state and receives
price p . Furthermore, agent 1 must pay a fine of 2f for having
challenged unsuccessfully. In this case, the mechanism concludes
at this point.
If agent 1 does not make a challenge, then the mechanism moves
to Stage (iii).
Stage (iii): Agent 2 can challenge agent 1s announcement. Such
a challenge is handled completely symmetrically to that of Stage
(ii). And if it occurs, the mechanism then concludes.
If neither agent makes a challenge, then the mechanism moves
to Stage (iv).
Stage (iv): Agent 2 delivers the input with properties corresponding to the realized state. Agent 1 produces and delivers a
unit of the good with characteristics corresponding to the realized state and receives price p(
v , c), where
p(
v , c) = v + c + k
and k is a constant. The mechanism then concludes. (Maskin
2002: 728-9)

To see how this mechanism works note that if v 6= v(e1 ), that is, v is not
truthful, then there exists (q , p ) and (q , p ) satisfying () such that
() q v(e1 ) p < q v(e1 ) p
which means agent 1 can successfully challenge a claim by agent 2 if and
only if 2 has in fact been untruthful. From () it is clear that agent 2 will

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105

pick (q ). In addition if the fine f is large enough agent 1 does have an

incentive to challenge successfully. Remember agent 1 is paid f by agent 2.
On the other hand if agent 2 is truthful 1 will not challenge given that if he
does he would expect the challenge to fail. In this case he would receive f
from agent 2 but would now have to pay 2f .
This means that should agent 2 be untruthful he would expect to be
challenged and thus he has the incentive to announce v = v(e1 ). Similarly
agent 1 has the incentive to be truthfully and set c = c(e2 ).
What remains is to show that the agents will be willing to agree to the
contract and that it induces an optimal allocation. To demonstrate this we
just need to show that each agent wishes to set ei = ei and that they receive
a nonnegative payoff from doing so.
We know that each agent will be truthful at date 2 and thus agent 1 will
maximise
p(v(e1 ), c(e2 )) c(e2 ) e1
at date 1. Given the definition of p(v, c) this equals
( ) v(e1 ) + k e1 ,
for which the maximum is e1 regardless of e2 and k. Furthermore as we
have v(e1 ) e1 c(e2 ) e2 > 0 we can set k to be such that both agents
get positive payoffs in equilibrium. This completes the argument.
Such results undermines the non-verifiability approach to incomplete
contracts. To deal with this Hart and Moore (2008) developed the reference
point approach to contracts. The basics of the application of the reference
point theory to theory of the firm can be seen in the model of Hart and
Moore (2007) (HM). We deal with this paper in some detail as the reference
point literature is still relatively new and thus is not as well known as the
theories considered up to this point.117
The basic ideas underlying the reference point theory can be outlined as
follows. Consider a situation where a buyer B wants a good from a seller
S at some future date 1. Assume the good is a homogeneous widget. Also
assume that there is a fundamental transformation between dates 0 and 1,
that is, what starts as a situation of perfect competition at date 0 evolves
into one of bilateral monopoly by date 1. The parties meet and contract at
date 0 but there is uncertainty about the state of the world at this time. This
uncertainty is resolved shortly before date 1. There is symmetric information
thought-out but the state of the world is not verifiable. A date 0 contract can
be thought of as specifying a set of possible price-quantity pairs which form
the set of possible outcomes of B and Ss date 1 transaction. Note that the
outcomes cannot be state contingent since the state itself is not verifiable.
A mechanism for choosing from among the set of possible outcomes may
also be included as part of the date 0 contract.
117

For a more detailed discussion of the reference point literature see Walker (2013).

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The present

Importantly for the HM story, the date 0 contract acts of a reference

point for the contracting parties feelings of entitlement at date 1. Neither
party feels entitled to an outcome not included in the contract. The contract
is seen as fair since it was negotiated under the competitive conditions prevailing at date 0.118 Problems can arise, however, when choosing among the
different outcomes allowed under the contract. HM suppose that each party
feels entitled to the best possible outcome allowed under the contract.119
This means that it is likely that at least one of the parties, if not both, will
feel disappointed or aggrieved by the actual outcome.
A second important assumption built into the HM theory is that outcomes are not perfectly contractible even at date 1. Each party has the
freedom to choose between perfunctory performance and consummate performance but only perfunctory can be contracted on. Consummate performance will be provided if the party feels well treated but each party will
shade if they feel aggrieved.120
To make matters a little more precise, suppose that if the outcome that
is chosen from those available under the contract causes S to feel aggrieved
by $k, that is, Ss actual payment is $k less than the best possible outcome,
then S will shade on her performance to such a degree that Bs payoff falls
by k. being an exogenously given parameter where 0 < 1. A similar
situation with regard to shading pertains to B. There a symmetry here,
both B and S can shade and is the same for both. Shading can not occur
if there is no trade.
Assume further that Bs value of the widget at date 1 is v and that Ss
cost of production is zero but there is an opportunity cost of r. That is,
trade with B means S foregoes an alternative income of r. Thus, trade is
efficient if and only if v r. At date 0, v and r are random variables with
a probability distribution which is common knowledge. Also no third party
is able to tell who is at fault if trade does not take place at date 1. This
means that trade is voluntary. Given these assumptions Hart and Moore
(2008) are able to show that it is only the difference between the trade price
and the no-trade price that matters and that is possible to normalise the
no-trade price to be zero. HM also assume that lump-sum transfers can be
used to carryout any redistribution of surplus at date 0.
The simplest case to consider is that where there is no uncertainty as to
the value of v and r, that is, they are constants, and v > r. In this situation
the first-best can be achieved. All that has to happen is that the parties
agree, at date 0, that S will supply the widget to B at date 1 for a given
118

This is an important point for all the papers in the reference point approach. See
Fehr, Hart and Zehnder (2011) for experimental evidence related to this issue.
119
Such an extreme assumption not necessary for the analysis but does simplify the
workings.
120
Shading is where a party chooses to perform at the lower, perfunctory, level rather
than the higher, consummate, level.

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107

price, p, where r < p < v. This contract would ensure trade and would result
in no aggrievement because both parties receive the best outcome permitted
under the contract. Note that the contract only specifies one outcome, trade
at price p.
While this form of contract achieves the first-best not all contracts, even
in this no uncertainty world, do so. For example, consider a contract that
specifies that the trade price can be anything in the range [r, v] and that B
will choose the price. Here B will choose the lowest price possible, p = r,
at date 1. Note however that this will cause S to be aggrieved since the
best possible price for her, p = v, was not chosen and thus she will shade
resulting in a deadweight loss of (v r).121
Things are more interesting, however, if v and r are uncertain. In this
case any contract which specifies a single trading price, p, will ensure trade
if and only if v p r, that is, if and only if both parties gain from trade.
The problem is that as v and r are now stochastic, it can not be guaranteed
that it is possible to find a single p that lies between v and r whenever v > r.
HM point out that under such conditions a contract that specifies a range
of trading prices [p, p] can be superior to a single price contract. Hart and
Moore (2008) show that it is not necessary to go beyond a contract which
specifies a no-trade price of zero, as above, a trading price range of [p, p]
and lets B choose the price. The advantage of the large price range is that
it makes it more likely that B can find a price between v and r whenever
v r. The cost is that there are typically many feasible prices between v
and r when v r and B will pick the lowest price. This means that S will
feel aggrieved that B did not pick the highest price and will therefore shade,
resulting in a deadweight loss. The optimal contract will trade off these two
effects.
Thus far one important issue has been ignored. If v > r but there is no
price in the range [p, p] such that v p r, it would be expected that the
parties would renegotiate their contract. But renegotiation doesnt change
the analysis in any fundamental ways as is shown in Hart and Moore (2008).
Next HM turn to the issue of ownership. Up to this point HM have
implicitly assumed that B and S are separate entitles, that is, they are
nonintegrated. Now suppose that B acquires Ss firm (Ss non-human
assets) at date zero. This is interpreted as integration. It amounts to
saying that B now owns and possesses the widget. HM take this to mean
that B can get someone other than S to produce the widget, at zero cost,
at date 1. It is assumed that Ss human capital, along with the widget, is
still needed to realise the opportunity cost, r.122 Effectively for S to earn
121
Ss best outcome is p = v while the actual outcome is p = r and thus S is aggrieved
by the amount v r which means she shades, thereby lowering Bs payoff, by an amount
(v r). This is the deadweight loss. B does not shade as she receives her best outcome.
122
S gets zero if she has only their own human capital to work with. To get r, S requires
both her human and non-human assets (or equivalently the widget).

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r, B must sell the widget back to S. If no trade occurs B earns v since she
already owns the widget, while if trade does occur, S earns r but pays p.
Trade is now efficient if and only if r v; trade is still voluntary. In this
situation a contact consists of a zero no-trade price and a range of trading
prices [p, p], with S choosing the price. S will choose the smallest price such
that r p v, whenever r > v.
In place of a complete analysis of nonintegration versus integration HM
makes a number of observations on the difference between them. Assume
that v > r with probability 1. Then as was noted above, it may be impossible
to achieve the first-best. The reason being that in order to ensure trade with
probability 1 it may be necessary to have a range of trading prices, but this
results in aggrievement and shading whenever there is more than one price
satisfying v p r. On the other hand integration can achieve firstbest because the status-quo has been transformed into one where B owns
the widget, which is the efficient outcome. S is irrelevant and does not or
cannot shade.
The situation is reversed if v < r with probability 1: now integration is
inefficient as a range of prices is required to ensure that B trades the widget
to S. This results in aggrievement and thus shading whenever there is a
number of feasible prices in the range while for nonintegration the statusquo point has S possessing the widget which is efficient and does not give
rise to shading.
The HM model can be thought of as capturing the idea that integration
is useful for ensuring input supply in an uncertain world. When v > r but v
and r vary, nonintegration is usually inefficient, that is, either trade will not
take place when it should or there will be shading, while integration results
in the first-best outcome.
The papers making up the reference point approach to the firm have
demonstrated that the trade-off between contractual rigidity and flexibility
has important implications for the organisation of firms. The unifying feature shared by the reference point papers is the application of the idea that
contracts act as a reference point for feelings of aggrievement and thus acts
of shading. The Hart and Moore (2008) theory and its extensions provide
an explanation for the existence of long-term contracts in the absence of
relationship-specific investments, which are assumed in most of the incomplete contracts approaches to the firm. Also the reference point theory can
shed new light on the roles of the employment relationship and authority. In
work extending the theory, Hart (2009) reintroduces assets into the model
and shows that previously hard to explain observations in the empirical literature on contracting and integration can be explained by the reference point
approach. Hart and Holmstr
om (2010) offers a theory of firm scope. They
provide an analysis that moves the focus of the theory away from the role
of non-human assets in determining a firms boundaries towards a theory
where the activities undertaken by the firm determine the firms scope.

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The papers utilising the reference point approach rest on strong (ad-hoc)
behavioural assumptions which have only limited experimental support and,
thus far, no direct empirical backing. There are concepts in the behavioural
literature, such as reference dependent preferences, the self-serving bias or
reciprocity, which are broadly consistent with the reference point model but,
as already noted, the experimental/empirical support for the model is, at
best, limited. An important topic for future work in the reference point
literature on contract theory is to show that the ad-hoc nature of the behavioural assumptions used within it are consistent with utility-maximising
behaviour.
An empirical issue with the reference point literature is that it is that
aggrievement and shading are hard to measure empirically. This makes
empirical evaluation difficult, at least.
In addition, on the theory side, an assumption made with regard to
shading is that the reason for aggrievement does not affect the amount of
shading that takes place, clearly it could. If one party thinks another agents
behaviour is opportunistic they may react differently than if they feel the
other agents action is the result of external factors. The first case could
result in more shading than the second.
Also the theory has an inherent human capital bias. The reliance on
aggrievement and shading could be seen as limiting the applicability of the
theory to areas relatively dependent on human capital. In firms in which
production is mainly dependent on non-human capital, which cannot be
aggrieved and cannot shade, the theory may be of less value. Also for
areas where it is possible to write contracts that cover most of, if not all
of, the relevant actions thereby reducing the likelihood of aggrievement
and the ability to shade if aggrievement does occur the theory would be
of more limited usefulness. In other words the theory is less applicable to
situations where the set of actions which defines consummate, as opposed
to perfunctory, performance is small. Thus the theory seems to have greater
potential when applied to firms who have a greater dependence on human
capital and where monitoring is ineffective.
This human capital bias is important when, to take one example, Hart
and Holmstr
om (2010: 511) state that giving private benefits a pivotal
role in the analysis moves the focus of attention away from assets toward
activities in the determination of firm boundaries. More properly they
have moved the focus of attention away from asset ownership to human
capital utilisation. They tie the unit to the manager in such a way that
an expansion of activities requires the addition of extra managers (human
capital). What happens if, for example, the activities the firm undertakes
can be expanded by simply expanding the range of physical capital the firm
employs? There is no basis for an increase in the level of aggrievement
and shading and therefore Hart and Holmstr
oms reference point model
would say the boundaries of the firm would not have changed but the firms

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activities have increased.

Within the reference point approach, firms or divisions within firms, are
fundamentally individuals and thus a question that can be asked is, Can it
be applied to more sophisticated organisational firms? Questions also have
to be asked about where does a reference point come from and how can we
pin it down? Do reference points have to be the same at the contractual
performance stage as they were at the contractual negotiation stage? If they
can change, when, how and why do they?
Spulber 2009
Another recent contribution to the theory of the firm, but one which can
be seen as being outside even if related to the post-1970 mainstream,
and thus a contribution that does not fit neatly into the Foss, Lando and
Thomsen classification, is Spulber (2009). If we think of the mainstream
theory of the firm as being concerned with three basic topics to do with the
existence, boundaries and internal organisation of the firm then Spulbers
book is somewhat outside of the mainstream but the issues it deals with are
related closely enough to those of the mainstream to justify a brief overview.
Spulbers framework offers insights into a number of important issues missing
from the mainstream and thus lays the groundwork for future research in
both the theory of the firm and industrial organisation more generally. The
three mainstream topics are mentioned in Spulbers book but they are not
the main focus of his analysis. For Spulber The Theory of the Firm seeks
to explain (1) why firms exist, (2) how firms are established, and (3) what
firms contribute to the economy (Spulber 2009: ix). Particular issues which
are a focus of Spulbers framework but with which the mainstream does not
deal, or at least does not deal with fully, include a theory of the entrepreneur
and a theory of market creation. Spulbers book in an attempt to create a
general approach to microeconomics in which entrepreneurs, firms, markets,
and organizations are all endogenous. This makes his intended contribution
wider than that of the mainstream theory of the firm.
To start Spulber defines a firm [ . . . ] to be a transaction institution
whose objectives differ from those of its owners. This separation is the
key difference between the firm and direct exchange between consumers
(Spulber 2009: 63).123 Note that under this definition organizations such as
123
This suggests that some form of trade is a necessary, but not sufficient, condition for
a firm to exist since without trade consumption and production must coincide, that is, the
objectives of the producer and consumer will be the same. The coincidence of consumption
and production in a world without trade, or at least a world with little trade, was noted
as a potential problem by McDonald and Snooks (1986) in their analysis of manorial
production in Domesday England: In the absence of trade, all the goods produced on
the manor will he consumed on the manor. Such a situation makes it difficult lo interpret
the results of our production function estimates, because it becomes difficult to draw a

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clubs, basic partnerships, many family firms, worker cooperatives, non-forprofit organisations and public enterprises are not firms. The fundamental
reason being that the objectives of these types of organizations cannot be
separated from those of their owners. This separation of the objectives of
owners and the firm also justifies the profit maximisation objective. Consumers who are the owners of the firm, obtain income via the firms profits
and thus want profit maximisation so they can maximise their consumption
(utility).
Spulber has three additional players in his story: consumers, organisations and markets. Consumers are individuals who consume the goods and
services generated within the economy. Organisations are transaction institutions whose objectives cannot be separated from those of their owners.
Markets are transaction mechanisms that bring buyers and sellers together.
For Spulber the entrepreneur is important because it is their efforts that
leads to the creation of firms. The interaction of available market opportunities and the individuals preferences, endowments and other such characteristics leads the consumer to take on the role of entrepreneur. The individual
is an entrepreneur for the time it takes to establish the firm. Assuming that
the firm is successfully established, the entrepreneurs role changes to that
of an owner of the firm. Ownership is valuable insofar as it provides returns
to the (former) entrepreneur. This change from entrepreneur to owner is
in Spulbers terms, the fundamental shift (Spulber 2009: 152). The important point is that before the change from entrepreneur to owner, the
objectives of the organisation cannot be separated from those of the (then)
entrepreneur. The start-up enterprise is not a fully formed firm because of
this. After the fundamental shift has occurred, the entrepreneur is now the
owner and the firms objectives are separate from those of the owner, which
means a firm has now been fully established.
In addition to firms other organisations can be formed that allow consumers to take advantage of joint production. Such advantages include economies of scale, public goods, common property resources and externalities.
Unlike the firm, the objectives of the consumer organisation reflect the consumption objectives of the members of the organisation. A problem with
a consumer organisation is that it can experience inefficiencies due to free
riding. Firms overcome such problems by separating the objectives of the
organisation from the consumption objectives of its owners and thereby inducing profit maximisation. Profit maximisation may not, however, achieve
full efficiency due to problems such as allocative inefficiencies that result
distinction between the manor as a unit of production and as a unit of consumption:
manorial production behaviour will be inextricably combined with the lords consumption
preferences (or utility function). The underlying reason is that the implicit prices of output
reflect both the production and the consumption behaviour of the manor, rather than just
the costs of manorial production (McDonald and Snook 1986: 99). In such a situation
the manor could not be considered a firm under Spulbers definition.

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from market power. Thus the comparison between a firm and a consumer
organisation depends on the trade-off between profit maximisation and free
riding. When the number of consumers is small, free riding problems tend
to be small and thus a consumer organisation may be more efficient than
the firm.
Given we have firms, firms can create markets. Firms can act as intermediaries and in doing so they increase the gains from trade and reduce
transactions costs when consumers are separated by time, distance and uncertainty. Firms create markets by providing centralised mechanisms for
matching consumers in their roles as buyers and sellers in a more efficient manner than decentralised exchange can achieve. Market making firms
are required to buy and sell at any moment meaning that buyers and sellers
avoid the costs involved with trading delays and the risk of being unable
to find a trading partner. In the world of financial markets, market-making
firms provide liquidity by being ready to buy and sell financial assets. Addition transaction efficiencies are bought about by market-making firms being
able to consolidate trades which allows traders to reduce the costs involved
with having to find multiple trading partners or with having mismatched
trades. Firms can also avoid the problems inherent with complex bartering
arrangements by simplifying the trading process via the use of posted prices.
Supply and demand can be equated in a market by firms adjust their buying and selling behaviour thereby reducing potential losses due to market
imbalances. Thus market creation is endogenous.
Spulber offers insights into a number of issues that the mainstream theory of the firm does not deal with well, if at all. The discussion of issues such
as the role of the entrepreneur and the creation of markets are important
issues that lie outside of the mainstream of the theory of the firms, at least
as far as the mainstream is conceived of here. Such issues do however raise
questions for the future of the theory of the firm and the theory of industrial
organisation.
There are a number of issues that have been raised about the Spulber
approach to the firm. Hart (2011), for example, notes that there are a number important institutions that would be considered firms by most people
but may not pass Spulbers requirement that to be a firm the firms objectives differ from those of its owners. Bill Gates is still a significant owner of
and quite involved in Microsoft, so is Microsoft a firm? Also there is the
question of how do we determine that the objectives of the firm do differ
from those of the owners? How can we learn what the objective function of
a firm is? Who do we ask?
Hart also asks is the Spulber requirement empirically relevant?
Suppose that I want to know whether a public company A is
likely to engage in value-reducing acquisitions. We know from
much research in corporate finance that it may be significant

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whether company A has a large shareholder or whether company

As CEO has substantial stock options, but whereas the first may
disqualify the company as a firm according to Spulbers test, the
second does not (Hart 2011: 109).
In addition Hart asks if Spulbers approach yields any useful theoretical insights. For example, Spulber sees a standard worker cooperative as
not being a firm since its objectives cannot be separated from those of its
owners, but a cooperative with a membership fee is a firm because the two
objective functions can be separated. Hart argues that both forms of worker
cooperative are firms, but one turns out to be more efficient than the other.
What are the advantages of Spulbers argument? There is also the issue
of the difference in primitives between the standard literature and Spulber.
Spulber supposes that different organisations have different objective functions whereas the standard approach is to derive an organisations behaviour
from primitives such as governance structure, managerial incentives, culture
etc.
Foss and Klein 2012
A second recent approach to the firm that doesnt fit well into the Foss,
Lando and Thomsen classification, but which also emphasises the entrepreneur, is that of Foss and Klein (2012) (FK).124 FK see their work as offering
a theory of the entrepreneur125 centred around a combination of Knightian
uncertainty and Austrian capital theory. While such a basis places their
work outside the conventional theory of the firm, FK see themselves not as
radical, hostile critics, but as friendly insiders (Foss and Klein 2012: 248).
To understand the FK theory first consider the one-person firm. For
FK it is the incompleteness of markets for judgement that explains why an
entrepreneur has to form their own firm. Here judgement refers to business decision making in situations involving Knightian uncertainty, that is,
circumstances in which the range of possible future outcomes, let alone the
likelihood of any individual outcome, is unknown. Thus decision-making
about the future must rely on a kind of understanding that is subjective
and tacit, one that can not be parameterised in a set of formal, explicit
decision-making rules. But then how can we tell great/poor judgement
from good/bad luck? A would-be entrepreneur may not be able to communicate to others just what his vision of a new way to satisfy future
consumer desires is in such a manner that other people would be able to
assess its economic validity. If the nascent entrepreneur can not verify the
nature of his idea then they are unlikely to be able to sell their expertise
124

For a more complete survey see Foss, Klein and Linder (2013).
Here an entrepreneur is seen as a businessman who invests financial and non-human
resources in the hope of gaining profits.
125

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across the market - as an consultant or advisor - or become an employee

of a firm utilising his expertise due to adverse selection/moral hazard
problems and thus he will have to form his own firm to commercialise this
vision. This reasoning for the formation of a firm is not entirely without
precedence. Working within a standard property rights framework Rabin
(1993) and Brynjolfsson (1994) show that an informed agent may have to set
up a firm to benefit from their information for adverse selection and moral
hazard reasons respectively. In addition to this the inability to convey his
vision to capital markets will limit an entrepreneurs ability borrow to finance the purchase of any non-human assets the entrepreneur requires. This
means the the entrepreneur can not be of the Kirznerian penniless type.
Non-human assets are important because judgemental decision making is
ultimately about the arrangement of the non-human capital that the entrepreneur owns or controls. Capital ownership also strengthens the bargaining
position of the entrepreneur relative to other stakeholders and helps ensure
the entrepreneur is able to appropriate the rents from his vision.
Turning to the multi-person firm FK argue that the need for experimentation with regard to production methods is the underlying reason for the
existence of the firm. Given that assets have many dimensions or attributes
that only become apparent via use, discovering the best uses for assets or the
best combination of assets requires experimenting with the uses of the assets
involved. Thus entrepreneurs seek out the least-cost institutional arrangement for experimentation. Using a market contract to coordinate collaborators leaves the entrepreneur open to hold-up, collaborators can threaten
to veto any changes in the experimental set-up unless they are granted a
greater proportion of the quasi-rents generated by the project. By forming
a firm and making the collaborators employees, the entrepreneur gains the
right to redefine and reallocate decision rights among the collaborators and
to sanction those who do not utilise their rights effectively. This means that
the entrepreneur can avoid the haggling and redrafting costs involved in
the renegotiation of market contracts. This can make a firm the least-cost
institutional arrangement for experimentation.
With regard to the boundaries of the firm, FK argue that when firms
are large enough to conduct activities exclusively within its borders - so
that no reference to an outside market is possible - the organisation will
become less efficient since the entrepreneur will not be able to make rational
judgements about resource allocation. When there are no markets for the
means of production, there are no monetary prices and thus the entrepreneur
will lack the information they need about the relative scarcity of resources
to enable them to make rational decisions about resource allocation and
whether entrepreneurial profits exists. This implies that as they grow in
size, and thus do more internally, firms become less efficient due to the
increasing misallocation of resources driven by the lack of market prices.
But the boundaries of firms seem to be such that firms stop growing before

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outside markets for the factors of production are eliminated and market
prices become unavailable. So while this idea can explain why one big firm
can not produce everything it seems less able to tell us why the boundaries
of actual firms are where they are. Real firms seem too small for the lack of
outside markets and prices to be driving large efficiencies.
For FK the internal organisation of a firm depends on the dispersion of
knowledge within the firm. The entrepreneur will typically lack the information or knowledge to make optimal decisions. So the entrepreneur has to
delegate decision-making authority to those who have, at least more of, the
necessary information or knowledge. In doing this the firm is able to exploit
the locally held knowledge without having to codify it for internal communication or motivating managers to explicitly share their knowledge. But
the benefits of delegation in terms of better utilising dispersed knowledge
need to be balanced against the costs of delegation such as duplication of
effort - due to a lack of coordination of activities, moral hazard, creation of
new hold-up problems and incentive alignment.
The things that sets the FK apart from the mainstream is the importance given in their theory to the entrepreneur and that they develop their
theory utilising a combination of Knightian uncertainty and Austrian capital theory. But, unlike Spulber (2009), the questions they set out to answer
are standard in that they want to explain the existence, boundaries and
organisation of the firm.
Summary
The classification utilised above is based upon that of Foss, Lando and
Thomsen (2000) and partitions the post-1970 mainstream theory of the firm
into two general groups: 1) Principal-agent type models and 2) Incomplete
contracts models. Each of these general groups can be subdivided to give
an elementary organisational structure for the contemporary theory of the
firm. The principal agent groups contains three sub-groups: 1) the nexus of
contracts view, 2) the firm as a solution to moral hazard in teams approach
and 3) the firms as an incentive system view, while the incomplete contracts
group contains five subgroups: 1) the authority view, 2) the firm as a governance mechanism, 3) the firm as an ownership unit, 4) implicit contracts
and 5) the firm as a communication-hierarchy.
We expanded the incomplete contracting group by adding a new sixth
subgroup: the reference point approach. Two other new approaches to the
theory of the firm, which dont fit easily into the Foss, Lando and Thomsen
classification but can be seen as being closely related to the contemporary
theories, where then discussed: Spulber (2009) and Foss and Klein (2012).
The Foss and Klein approach to the firm, like that of Spulber but unlike the

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more standard approaches, emphasises the role of the entrepreneur.126 Foss

and Klein wish to explain the formation of, determination of the boundaries of and the internal organisation of the firm. Spulber seeks to explain
why firms exist, how firms are established, and what firms contribute to the
economy. He sets out to create an approach to microeconomics in which
entrepreneurs, firms, markets, and organisations are all endogenous. The
Spulber and Foss and Klein contributions open important new lines of inquiry for the theory of the firm since Hamlet really does need the Prince of
Denmark.127

Reference points, property rights and transaction costs

Among the contemporary mainstream economic approaches to the theory of
the firm, the transaction costs and property rights theories are the dominant
frameworks, with the reference point approach representing the major challenger to their status. In this section we consider the relationships between
these theories and the newer reference point approach. To begin, it has
been argued that modelling shading costs is an attempt to model transaction costs. For example, in Hart (2008: 406) it is argued that the shading
costs utilised in the reference point approach are akin to haggling costs
a kind of transaction cost and in Hart and Moore (2008: 4-5) it is stated
that shading costs can be seen as a shorthand for other kinds of transaction costs, such as rent-seeking, influence, and haggling costs. But just how
fully shading costs capture transaction costs and thus how well the reference
point approach formalises the transaction cost theory is open to debate.
Williamson (2000: 605-6) argues that one of the most important differences between the property rights approach to the theory of the firm and the
transaction cost theory is that the property rights theory introduces inefficiencies at the ex ante investment stage while the transaction-cost approach
emphasises inefficiencies due to ex post haggling and maladaptation.128 In
the property rights approach there are no ex post inefficiencies due to the
assumption of common knowledge and costless ex post bargaining. The
difference is summarised by Gibbons (2010: 283) as:
[t]he model in question is Grossman and Harts (1986) [the
property rights model], which explores an alternative to Williamsons (2000, p. 605) emphasis that maladaptation in the
contract execution interval is the principal source of inefficiency.
126

For more on the relationship between the theory of the firm and entrepreneurship see
Foss, Klein and Bylund (2012).
127
For any clarification that is needed see the conclusion (page 146) for William Baumols
famous comment.
128
Holmstr
om and Roberts (1998: 75-9) and Tadelis and Williamson (2013: 183-4) also
discuss the differences between transaction cost economics and the property rights theory.
Whinston (2003) looks at the empirical differences between the two theories.

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Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency
is in endogenous specific investments.
It is striking how different the logic of inefficient investment can
be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example,
the lock-in necessary for Williamsons focus on inefficient haggling could result from contractible specific investments chosen
at efficient levels. But by assuming efficient bargaining and hence
zero maladaptation in the contract execution interval, Grossman
and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the
make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives
to invest; in Williamsons argument, an important cost of nonintegration is inefficient haggling. In short, the two theories are
simply different.
This emphasis on ex post haggling and maladaptation can be interpreted
as reflecting a view that internal organisation is better at reconciling the
conflicting interest of the parties to a transaction and facilitating adaptation
to changing supply and demand conditions when such cost are high.
In so much as contracting in the reference point approach is imperfect
even ex post, the reference point theory can be seen as a movement away
from the ex ante inefficiencies of the property rights theory and back towards
the ex post efficiencies of the transaction cost theory. The imperfect nature
of ex post contracting in the reference point approach is as Hart (2008: 294)
points out [ . . . ] a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex
post (e.g. by a court of law). Here we are assuming that only perfunctory
performance can be enforced: consummate performance is always discretionary, and thus inefficiencies can arise ex post. The development of a
tractable model of contracts and organisational form that exhibits ex post
inefficiency is one of motivations for advancing the reference point approach
in the first place (Hart and Moore 2008: 4). Harts interpretation of the
reference point theory is that this theory can, in a sense, [ . . . ] be viewed
as a merger of the transaction cost and property rights literatures (Hart
2011: 106).
The fact that the reference point approach does not assume that relationship specific investments are made by the contracting parties is another
difference between the property rights theory and the reference point approach. Invoking relationship specific investments is standard in the property rights theory. This is not to say that relationship specific investments
can not be introduced into the reference point theory, they can, Hart (2013)

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is an example where this is done, but, in general, the reference point theory
does not rely on such investment.
Williamsons concept of the fundamental transformation is of prime
importance for the reference point approach.129 The change from an ex
ante competitive market to an ex post bilateral setting is what Williamson
(1985: 61-3) terms the fundamental transformation. Hart and Moore argue
that such a transformation provides a rationale for the idea that contracts
are reference points. A competitive ex ante market adds objectivity to the
terms of the contract because the market defines what each party brings
to the relationship. HM assume that the parties perceive a competitive
outcome as justified and accept it as a salient reference point (Fehr, Hart
and Zehnder 2009: 562). This is an idea which finds experimental support:
see Fehr, Hart and Zehnder (2009), Fehr, Hart and Zehnder (2011) and
Hoppe and Schmitz (2011).
But we must also be aware that important features of the transactioncost theory may still have been left out. How fully shading costs capture
the costs of ex post maladaptation and haggling is an open question. When
discussing some opportunities for the future of transaction-cost economics,
Robert Gibbons (2010: 283) notes that [ . . . ] it may be that Hart and
Moores (2008) reference points approach is a productive path. Time will
tell [ . . . ]. Hart (2011: 106) concludes [w]hether this merger [resulting in
the reference point theory] will be successful remains to be seen.

The theory of privatisation

An often neglected topic in the theory of the firm is that of state owned
firms130 and their sale.131 But as Hart (2003: C69) makes clear there are
129
Given the importance of fundamental transformation to the analysis of economic organisation Williamson (1985: 63) asks why this notion was ignored for so long. In footnote 23 he gives three reasons: One explanation is that such transformations do not
occur in the context of comprehensive, once-for-all contractwhich is a convenient and
sometimes productive contracting fiction but imposes inordinate demands on limited rationality. A second reason is that the transformation will not arise in the absence of
opportunismwhich is a condition that economists have been loath to concede. Third,
even if bounded rationality and opportunism are conceded, the fundamental transformation appears only in conjunction with an asset specificity condition, which is a contracting
feature that has only recently been explicated.
130
On the economics of public enterprise see Aharoni (1986), Volgelsang (1990), Lawson
(1994) and Horn (1995: chapter 6). For an short overview from a law and economics
perspective see Ogus (1994: Chapter 13). For the development of a modern Marxist
economic theory of public ownership see Roemer (1989, 1994: Essay 13).
131
Hart (1995: 11-2), for example, has a short section entitled An omitted topic: public
ownership. Hart writes [a] very important topic not considered concerns the optimal
balance between public and private ownership. [ . . . ] This issue has always been a central
one in the economic and political debate, but it has attracted new attention in the last
few years as major industries have been privatized in the West and the socialist regimes
in Eastern Europe and the former Soviet Union have dissolved.

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close parallels between the theories of the firm and of privatisation.

Let me begin by discussing the very close parallel between the
theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms, A and B.
A might be a car manufacturer and B might supply car-body
parts. Suppose that there is some reason for A and B to have
a long-term relationship (e.g., A or B must make a relationshipspecific investment). Then there are two principal ways in which
this relationship can be conducted. A and B can have an armslength contract, but remain as independent firms; or A and B
can merge and carry out the transaction within a single firm.
The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents
a firm supplying the government or society with some service.
B could be an electricity company (supplying consumers) or a
prison (incarcerating criminals). Then again, there are two principal ways in which this relationship can be conducted. A and B
can have a contract, with B remaining as a private firm, or the
government can buy (nationalise) B.
and
[ . . . ] the issues of vertical integration and privatisation have
much more in common than not. Both are concerned with
whether it is better to regulate a relationship via an arms-length
contract or via a transfer of ownership (Hart 2003: C70).
Thus we can think about the nationalisation/privatisation decision of the
government in a similar way to the integration/spinoff decision of the private
firm, conceptually both decisions are about determining the boundaries of
a organisation.
Background
Privatisation132 as an important economic and political issue is a relatively
recent phenomenon. Even the word is of recent origin, dating back to only
132

Privatisation can be, and has been, defined in many ways. Jackson and Price (1994:
5) list the following activities as those which could make up a definition of privatisation:
1. the sale of public assets
2. contracting out
3. deregulation
4. opening up state monopolies to greater competition
5. the private provision of public services
6. joint capital projects using public and private finance

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around 1959.133 Before the Thatcher government came to power in the

7. reducing subsidies and increasing or introducing user charges
Parker (2004: 2) cautions against such a wide ranging definition of privatisation, [t]he
term privatisation has been used variously to describe state asset sales, the contracting out of government services, public-private partnerships, and certain other reforms
involving the reduction in direct state provision of goods and services. However, arguably
it is very misleading to refer to changes, such as contracting out and public-private partnerships, as privatisation because the state remains primarily responsible for deciding the
outputs and sometimes the inputs, instead of the market.
Former British Chancellor of the Exchequer Nigel Lawson (Lawson 1993: 198) defines
privatisation as [ . . . ] almost the same thing as denationalization. Almost because
industries such as the telephone service, which had always been in the State sector, and
thus never been through a process of nationalisation in the first place, were transferred to
the private sector.
Newbery (2006: 4) gives a British definition of privatisation: [t]he British definition
of privatisation is the transfer of ownership and control by the state (central or local
government) to private owners. In practical terms that means selling at least 50% of
the voting shares, in most cases with the objective of selling 100%, bearing in mind the
financial advantages of selling in stages at successively higher prices.
L
opez-de-Silanes, Shleifer and Vishny (1997: 447) give an American definition: [i]n
the United States, privatization mainly refers to the contracting out by the government
of local public services to private provides. A city or county government may contract with
a private company to pick up garbage, to keep city parks clean, to manage its hospitals,
to provide ambulance services, to run schools and airports, or to even provide police and
fire protection.
The theoretical literature has tended to concentrate on items (1) and (2) in the list of
seven possible definitions given above, and one of these two definitions is used in each of
the papers discussed below.
133
The second edition of the Oxford English Dictionary gives an etymology of the word
dating back to 1959:
1959 News Chron. 28 July 2/6 Erhard selected the rich Preussag mining concern for
his first experiment in privatization. 1960 Ibid. 22 Apr. 11/5 Complete privatization
was opposed by the Socialists . . because they feared . . the little man selling out his
shares to the big capitalists. 1970 Observer 25 Jan. 1/6 He foresaw privatization of
many sectors of industry now in public ownership. 1970 J. Cotler in I. L. Horowitz
Masses in Lat. Amer. xii. 440 If rural marginality allows for the . . privatization of
State power, the political sphere demands . . a new line of social integration. 1976
National Observer (U.S.) 1 May B6/3 The contrast between then and now measures the
tendency towards privatization and withdrawal of our commitments from the open, public
arena that has occurred during the Twentieth Century. 1976 Globe & Mail (Toronto) 12
Dec. 5/7 Privatization in the handing over of elements of the public service to the private
sector is threatening the livelihoods of thousands of public servants. 1977 Ibid. 20 Jan.
6/1 The Government published a working paper . . which set out some possibilities . .
including this: The possibility of the private sector providing goods or services that are
now provided through government enterprise and programs. The government, it seemed
was toying with the idea of privatization. 1979 New Statesman 6 July 14/3 This political
formula of controlled privatization depends on not too many people finding the stringent
limits on expression spiritually intolerable.
According to Yergin and Stanislaw (1998: 114) the word privatisation is due to Peter
Drucker, and the expression reprivatization does appear in Drucker (1969: 218). But
the concept of reprivatization has a wider meaning than that commonly associated with
the term privatisation, reprivatization need not mean return to private ownership.

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United Kingdom in 1979 and started implementing the first, widely known,
privatisation programme during the 1980s, very few people anywhere around
the world had heard of privatisation or knew what it meant. While there
were attempts at reform involving denationalisation134 before the mid-tolate 1970s, such sales were sporadic and limited, and there were no systematic, on going, asset sales programmes until 1974 when the first wave
of genuine privatisation started in Chile135 , a few years before the United
Kingdoms privatisation programme got underway.
A number of commentators have argued that the early privatisation programmes werent so much the result of the deliberate implementation of
a preplanned strategy founded on a well developed theoretical base, but
rather were ad hoc policies developed in practice, evolving over time, with
the theory catching up later. This argument is commonly made with respect to the Thatcher governments privatisation programme in the United
Kingdom. Bortolotti and Siniscalco (2004: 5) state that, [c]uriously, the
United Kingdom embarked on the first large-scale privatization programme
in the late 1970s largely on faith, as the main privatization theories were not
yet developed. Pirie (1988: 9-10) notes, [i]t is highly significant that the
election manifesto which the Conservatives put forward under Mrs Thatcher
in 1979 referred to the sale of only the shipbuilding and aerospace industries
and the National Freight Corporation. The fact that dozens of pieces of
privatization have been successfully implemented indicates that the British
government developed the techniques in practice. Privatization in Britain
was not the end-result of an ideological victory in the world of ideas; it
was something which was so successful in practice that the government did
more of it. Arguing in a similar vein Veljanovski (1989: vii) writes, [t]he
remarkable thing about the whole [privatisation] process is that it was unpredictable, and it followed no coherent over-arching strategy. Privatisation
evolved, each sale was self-contained and each pattern of disposing of assets,
from the legal requirements to the terms of sale, was ad hoc. In a review
of the Thatcher governments economic policies Samuel Brittan (Brittan
1989: 6) goes so far as to argue that privatisation became an important
policy plank for the Conservative government simply because it was easier
(Drucker 1969: 220). For Drucker whats important is that institutions should not be
run by government but should be autonomous. These institutions could still be owned by
governments, however.
An early use of the term privatisation in the United Kingdom was in Howell (1970:
footnote 1, p.8). This is a pamphlet by, the then Conservative MP, David Howell about
the problems of reform which would face an incoming Conservative government, published
more than ten years before Margaret Thatcher made privatisation a household word. Howell thought the word unusually ugly and hideously clumsy and added, [s]omething
better must be invented. Clearly nothing was.
134
See Megginson(2005: 14-15).
135
On the Chilean privatisation programme see Bitran and S
aez (1994), Hachette and
Luders (1993) and Luders (1991).

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to carry out than other policies: [ . . . ] privatization was hardly mentioned

in the 1979 Conservative manifesto, except for shipbuilding, aerospace and
National Freight. But it became a major thread when it was found easier
to carry out than many other Conservative aspirations.
In addition, Kay and Thompson (1986) lay the charge that privatisation in the United Kingdom lacked any clear rationale. They summed up
their view in the title of their paper Privatisation: A Policy in Search of a
Rationale. They argue that [ . . . ] the reality behind the apparent multiplicity of objectives [of privatisation in the United Kingdom] is not that the
policy has a rather sophisticated rationale, but rather that it is lacking any
clear analysis of purpose or effects; and hence any objective which seems
achievable is seized as justification. (Kay and Thompson 1986: 19).136
Following the increased importance of privatisation in practice came a,
belated, increase in interest from economists. By the early 1980s the role
of the state in the economy were being increasingly questioned and it was
at this time that the first formal theoretical and empirical investigations
of privatisation began to appear. There were, of course, discussions of the
proper role of the state before this time137 with consideration of the economic
consequences of privatisation going back at least as far as Adam Smith. On
the sale of crown lands Smith (1776: Book V Chapter II Part II p.824)
famously wrote:
[i]n every great monarchy of Europe the sale of the crown lands
would produce a very large sum of money, which, if applied to
the payment of the public debts, would deliver from mortgage
a much greater revenue than any which those lands have ever
afforded to the crown. [ . . . ] The crown might immediately enjoy
the revenue which this great price would redeem from mortgage.
In the course of a few years it would probably enjoy another
revenue. When the crown lands had become private property,
136

The view that privatisation was not part of the Thatcher governments original objectives but was more a piece of political opportunism has been challenged by former British
Chancellor of Exchequer Nigel Lawson. Lawson (1993: 199) has written, [t]he limited and
low-key reference to denationalization in the 1979 manifesto has led many commentators [
. . . ] to suppose that privatization was not part of our original programme and emerged as
an unexpected development into which we stumbled by happy accident. They could not
be more mistaken. The exiguous references in the 1979 Conservative manifesto reflected
partly the fact that little detailed work had been done on the subject in Opposition; partly
that the enthusiasts for privatization were Keith Joseph, Geoffrey Howe, John Nott, David
Howell and me, rather than Margaret [Thatcher] herself; and, perhaps chiefly Margarets
understandable fear of not frightening the floating voter. But privatization was a central
plank of our policy right from the start.
137
For discussions of the role of the state including state ownership of firms see, for
example, Mill ([1848] 1909: Book 5), Boon (1873), Harper (1886), Adams (1887), Bemis
and Outerbridge (1891), Ely (1894), Marshall (1907), Keynes (1926), Pigou (1937), Hayek
(1944), Jewkes (1948, 1953, 1965), Meade (1948), Lewis (1949), Davies (1952), Friedman
(1962), Olson (1974: 327-31) and White (2012).

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they would, in the course of a few years, become well improved

and well cultivated. The increase of their produce would increase
the population of the country by augmenting the revenue and
consumption of the people. But the revenue which the crown
derives from the duties of customs and excise would necessarily
increase with the revenue and consumption of the people.
In the period, roughly, between the Second World War and the 1980s
there was some, if not vigorous, debate as to the correct economic role of
government, including state ownership of firms, but there was little or no
formal modelling of either privatisation138 or nationalisation139 despite the
prevalence of state ownership at this time. As late as 1989 George Yarrow
(Yarrow 1989: 52) could write:
[u]nfortunately, at the theoretical level, economic analysis has
not accorded a high priority to the question of the likely effects
of ownership on industrial performance. Despite a number of
distinguished contributions from property rights theorists, the
literature is much less well developed than in other areas of
the subject. Thus, as an examination of economics textbooks
will show, it is hard to find convincing positive theories of public enterprise behaviour. This may be because of factors such
as the complexities arising from international differences in the
frameworks of accountability and control for state industries but,
whatever the cause, the point is simply that, on this issue, the
cupboard is remarkably bare.
During this period many governments and economists favoured,140 for
138
Heldman (1951) does consider the economic problems of denationalisation, concluding
that [. . .] denationalization would not be an easy policy to carry out, because of the variety
and complexity of the issues that would require attention.
139
Lewis (1949: Chapter 8), for example, discusses nationalisation but stops short of
formally modelling it.
140
Shleifer (1998: 135n1 and 138) argues that economists pre war and pre depression were
more skeptical about state ownership; Alfred Marshall is one example:[t]he same may be
said of the undertakings of Governments imperial and local: they also may have a great
future before them, but up to the present time the tax-payer who undertakes the ultimate
risks has not generally succeeded in exercising an efficient control over the businesses,
and in securing officers who will do their work with as much energy and enterprise as is
shown in private establishments (Marshall 1920b: 253-4). Starting from the fact that
the growth of the national dividend depends on the continued progress of invention and
the accumulation of expensive appliances for production; we are bound to reflect that
up to the present time nearly all of the innumerable inventions that have given us our
command over nature have been made by independent workers; and that the contribution
from Government officials all the world over have been relatively small (Marshall 1920b:
593). A Government could print a good edition of Shakespears works, but it could not
get them written. When municipalities boast of their electric lighting and power, they
remind me of the man who boasted of the genius of my Hamlet when he has but printed

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various reasons, at least some degree of state ownership of firms. Megginson

and Netter (2001: 323) note that:
[t]he Depression, World War II, and the final breakup of colonial empires pushed government into a more active role, including ownership of production and provision of all types of
goods and services, in much of the world. In Western Europe,
governments debated how deeply involved the national government should be in regulating the national economy and which
industrial sectors should be reserved exclusively for state ownership. Until Margaret Thatchers conservative government came
to power in Great Britain 1979, the answer to this debate in the
United Kingdom and elsewhere was that the government should
at least own the telecommunications and postal services, electric
and gas utilities, and most forms of non-road transportation (especially airlines and railroads). Many politicians also believed
the state should control certain strategic manufacturing industries, such as steel and defense production.
Scitovsky (1952: 374) argues that concerns over the power of private
a new edition of it. The carcase of municipal electric works belongs to the officials; the
genius belongs to free enterprise (Marshall 1907: 22). Carlson (1994: 83) portrays Eli
Heckschers view of state ownership, in 1918, as Heckscher also considered the time ripe
for new reflections on state enterprises. If his reasoning prior to the war had laid stress
on proposals for improvements to enable state enterprises to live up to the more stringent
requirements now being imposed on them, he was now (SvT 1918, p. 520) clear that it is
a contraction and not an expansion of state business activity, even such as existed before
the war, that we need. The criterion which Heckscher (1918, pp. 6-7, 21-23) propounded
for the choice between state and private enterprise was now: who will best serve the
interests of the consumer? And the answer (just as with Cassel) was that private firms
in a competitive environment always have a sword of Damocles hanging over them which
keeps efficiency alive and weeds out incompetent companies by natural selection - survival
of the fittest. In the case of publicly-owned corporations, however, their survival or
death really has no connection at all with their capacity for managing their affairs but is
decided on political grounds or [by] prejudices concerning the expediency or otherwise of
state production. Because state-owned corporations do not live under the sword, what
they supply is not automatically adapted to market demand, and they are not compelled
to develop new techniques and products. For state monopolies the watchword, more or
less inevitably, is the well-known phrase Quieta non movere - dont ruffle the prevailing
calm. And on the occasions when they do experiment, it is often popular fancies and not
the prospect of profit that are the guiding star. White (2012: 22-5) argues differently.
In his view many economists of the time, including Alfred Marshall, desired an increase
in the scope of government intervention in the economy. Marshalls own view was that
various influences, among which he listed the increasing professionalism of government
bureaus and the socialist ideas of the noble if weird Robert Owen, have co-operated
with technical progress to enlarge the scope for the beneficial intervention of Government
since Mills death even more than during his long life. (White 2012: 23). For Marshall
such interventions included municipal ownership of public utilities (Marshall 1907: 22). In
the U.S. Richard T. Ely supported the nationalisation of telegraph, telephones, railways,
forests, arable lands and large manufacturing plants (Ely 1899: 10).

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monopolies explains the creation of state-owned monopolies in telephone,

telegraph and public utilities in most European countries during this period.
But monopoly was not the only reason for public ownership. As Vickers and
Yarrow (1988: 125) point out, when dealing with the case of the U.K., there
were a number of other motivations for state control:
British Petroleum (BP), in which a controlling interest was acquired by the Government before the First World War with the
object of securing fuel oil products for the Navy; the British
Sugar Corporation, created by the Government in 1936 to promote domestic production of beet sugar for reasons of national
security; Cable and Wireless, acquired in two stages (1938 and
1946) with a view to extending state ownership in telecommunications activities; Short Brothers and Harland (aircraft and
aircraft components), acquired during the Second World War
because the company was not being operated efficiently and the
Government was not prepared to see it collapse; Rolls-Royce and
British Leyland (now the Rover Group), both taken into public
ownership in the 1970s to mitigate the consequences of impending bankruptcy.
As far as the U.K. nationalisations of the 1940s are concerned Jewkes (1948:
145) is sceptical of there being any economic basis for them, [b]ut the
experience of the British Labour Government in the first years of office
suggests that, in fact, no objective economic principles were being applied
in choosing industries for nationalisation. Millward (1997: 215), on the
other hand, put forward the hypothesis that these nationalisations can be
explained by
(a) The infrastructure industries of electricity, gas, water, transport, and
communications display the classic problems of natural monopoly and
externalities on a substantial scale and this explains why in many
western countries, and in Britain specifically form the middle of the
nineteenth century, they were subject to increasing government control.
(b) The failure of arms length regulation of the infrastructure industries
in the interwar period explains why in the 1940s public control took
the form of public ownership and why this has support over a wide
political spectrum.
(c) Manufacturing, commerce, and agriculture did not have problems of
natural monopoly and externalities on anything like the same scale
and were left largely in private hands.
(d) The fundamental class division between wage earners and owners of
capital to be found in the neo-marxist characterisations of capitalist

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society played a limited role in the 1940s drive to public ownership
and had a clear manifestation only in that large industry whose working conditions and economic fortunes in the nineteenth and twentieth centuries appeared to suffer most from the cold winds of market
forcesthe coal industry.

(e) The election of a Labour government in 1945, and its commitment

to economic planning together with the specific historical context of
reconstruction following the Second World War go along way to explaining the particular institutional arrangements which emerged in
the public sector, specifically the nationwide dimension of public ownership, the legal form of the public corporation, the means of achieving
coordination within the fuel and transport sectors, and the nationalization of the Bank of England.
Writing in 1953 Jewkes notes that, [i]t is only recently that the claim has
been made that nationalization is a more efficient way of organizing an
industry than is possible whilst it remains in private hands (Jewkes 1953:
616).141
Carlson (1994: 77) makes the case for defence policy as the motivation behind the first (partial) nationalisation of an incorporated company
in Sweden:
[t]he states first major involvement in the incorporated company form was initiated in 1907, under Lindmans Conservative
government, when the state become half-owner of the mining
company LKAB. This action of the Conservatives was dictated
largely by considerations of defence policy.
In the U.S. context, Troesken and Geddes (2003) argue that for the case
of the municipal acquisition of waterworks in the period 18971915 the
data supports the explanation that municipalities were unable to credibly
precommit to not expropriating value from the private water companies once
investments were made, resulting in a rational reduction in investment in
water provision by private companies. This rational underinvestment was
141
Jewkes adds that [t]he claim that nationalization represents a more efficient manner
of running industry and of translating decisions regarding prices and investment into
actions can best be examined in terms of the fundamental changes introduced in any
industry subjected to nationalization. They are:
1. The nationalized industry is a larger operating unit than those it replaced. From
this arises the claim for the economies of scale.
2. The nationalized industry is monopolistic. Out of this arises the claim that it can
adopt more complete integration and coordination of related functions.
3. The nationalized industry is not operated for private profit. From this it is asserted
that price and investment policy can be made more rational and that the collaboration
between different classes of workers in the industry can be made more willing, smoother
and, thereby, fruitful (Jewkes 1953: 617).

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then used by local governments as an pretext for municipalising the private

water companies. Similar results were found for the municipalising of gas
companies in the U.S. Troesken (1997) argues that the data are consistent with commitment and small market theories of public ownership. The
commitment hypothesis, again, refers to the inability of municipalities to
be able to credibly precommit to not expropriating value from the private
companies once investments were made, while the small market hypothesis
argues that in small towns inadequate consumer demand prevents suppliers from exploiting scale economies and from recouping their large capital
investments.
Towards the more radical end of the spectrum of views of economists,
Joseph A. Schumpeter (Schumpeter 1950: 228-31) argued that, in England
at least, an extensive programme of nationalisation could accomplish a big
step forward towards socialism. His list of industries ready for nationalisation included the Bank of England; insurance; inland transport, in particular
railroads and trucking; mining, in particular coal mining; the production,
transmission and distribution of electricity; iron and steel and the building
and building material industries142 . He added to this list a number of other
industries - the armaments or key industries, movies, shipbuilding, trade in
foodstuffs - that could also, for special, mostly non-economic reasons, be
nationalised. In addition he noted that as an economist he had no objection
to make to land nationalisation.
Shleifer (1998: 133) sums up the prevailing thinking among the majority
of more mainstream economists as [ . . . ] economists were quick to favor
government ownership of firms as soon as any market inequities or imperfections, such as monopoly power or externalities, were even suspected.
The instigator of the standard tax/subsidy approach to correcting negative/positive externalities, Arthur Cecil Pigou, favoured the nationalisation
of some industries including [ . . . ] certainly the manufacture of armaments,
probably the coal industry, and possibly the railways in addition to the
Bank of England (Pigou 1937: 138). On the basis of fears about monopoly
power Sir W. Arthur Lewis (Lewis 1949: 101) argued for the nationalisation
of land, mineral deposits, the generation of electricity, telephone service,
insurance and the motor car industry. Similar concerns led James Meade
(Meade 1948: 68) to suggest that the iron and steel and chemical industries,
to take just two examples, should not long escape socialization. On the
other side of the English Channel Maurice Allais (Allais 1947: 66) went as
far as to recommend the trial nationalisation of a small number of the most
important firms in each industry to make possible the comparison of public
142
Its interesting to note that much of what Schumpeter recommended came to pass
within a short period after the publication of the first edition of his book. The first
edition appeared in 1942 and the Bank of England was nationalised in 1946, road and
rail transport in 1948, the coal industry in 1947, electricity in 1948 and the iron and steel
industry in 1951 (and again in 1967).

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and private ownership. But Allais was not alone in making this suggestion,
back on the English side of the channel, Arthur Lewis (Lewis 1949: 102)
argued in a similar vein:
[t]here is a case for having some private firms in industries
mainly nationalised, to act as a check on the efficiency of the
public firms, and to provide an outlet for ideas which the public
firms might suppress (this is particularly important in a country
dependent on foreign trade). And equally there is a good case
for public firms in many industries that are largely in private
hands, to serve similarly as a yardstick and as an opportunity
for experiments.
There was, however, also a minority view which was sceptical about state
ownership. Jewkes (1965: 13-14) agues that state owned industries could
not help but be politicised:143
[t]hus it is claimed that a government may take responsibility
for some new public service but take the whole operation out of
politics and thereby escape any increase in its own administrative burdens. [ . . . ] Experience in the past twenty years suggests
that that view is nave. Nationalization has not taken industries
out of the political area. It has pushed them more firmly into
it.
By the late 1970s-early 1980s the sceptical minority was becoming larger,
the mood was turning against government ownership among both politicians
and economists.144 In the eighties the opinions of many public economists
began intensively to deviate from the Musgravian view which has long been
prevalent. The allocation of resources became the field of central interest.
[ . . . ] Theories of public enterprises similarly began to concentrate on the
question of how a regulating government could give the best incentives for
efficient production in the firm. Internal subsidization was increasingly considered undesirable, as was any form of pricing with redistributive features.
Furthermore, stabilization by public enterprises fell into disapproval. [ . . . ]
This view on allocation, distribution, and stabilization dismissed many of
143

The problem of politicisation of public firms had been noted before. Baker (1899),
for example, pointed out, with respect to waterworks in cities around the United States,
that [t]he absence of political considerations, generally speaking, from the management
of private works, is undoubtedly a great advantage (Baker 1899: 41) and [p]rivate
companies . . . certainly will not be accursed of lowering rates unduly for political effect,
as cities sometimes do (Baker 1899: 42).
144
One reason for the move by politicians at different times and in different countries
towards a more pro-privatisation position is simply the bad experiences many governments
have had with state-owned firms, world-wide. See Appendix 4, page 162 for a brief discussion of some of the more extreme examples of poor performance of SOEs around the
world at different times.

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those arguments in favor of public enterprises [ . . . ] in particular the desirability of distributional and stabilization politics of public firms (Bos
1994: 21).
One factor driving the changes in economists point of view as the slow
accumulation of empirical evidence145 that was beginning to suggest that
private firms were, by and large, more efficient than public firms. The
theoretical question this raised was, Why?
The post-1980 theory of privatisation
During the first ten years, 1980-1990, efforts to explain the empirical results
consisted of either informal, somewhat ad-hoc, models146 of the advantages
of bringing market pressure and institutions to bear on state-owned firms,
or formal models which, in the main, utilised a principal-agent framework
to analyse the differences between public and private firms147 . The major
145

For surveys of the results of empirical studies of privatisation see Bortolotti and Siniscalco (2004), Kikeri and Nellis (2004), Megginson (2005), Megginson and Netter (2001),
Sheshinski and L
opez-Calva (2003), Shirley and Walsh (2000)and Yarrow (1986). See also
the Forum on Privatisation in CESifo (2005). Gupta, Schiller, Ma and Tiongson (2001)
is a survey of the literature on the effects of privatisation on job loses and wages. A survey
on privatisation in transition countries is Havrylyshyn and MacGettigan (1999). Claessens
and Djankov (2002) look at privatisation in Eastern Europe. The Latin American experience is covered in Chong and L
opez-de-Silanes (2003), Chong and L
opez-de-Silanes (2005)
and Nellis (2003b). Privatisation in Sub-Saharan Africa is discussed in Nellis (2003a). A
survey on privatisation in the developing world, in general, is Parker and Kirkpatrick
(2003). For studies of the European experience with privatisation see Parker (1999) and
K
othenb
urger, Sin and Whalley (2006) which contains chapters on Austria, Denmark,
Finland, France, Germany, Italy, Ireland, The Netherlands, Spain and the United Kingdom. For other views on the British privatisation experience see Pollitt (1999), Part 2
of Vickers and Yarrow (1988) and Yarrow (1993). On the French experience see Dumez
and Jeunemaitre (1994) and Schmidt (1999). On the politics of privatisation in Britain
and France see Suleiman (1990). G
okg
ur(2006) looks at the case of Turkey. La Porta
and L
opez-de-Silanes (1999) analyse the Mexican privatisation program. For a discussion
of privatisation in Malaysia see Sun and Tong (2002). For differing viewpoints on the
privatisation experience in Russia see Boycho, Shleifer and Vishny (1995), Kokh (1998),
Nellis (1999), Radygin (2003) and Brown, Earle and Gelbach (2013). The performance of
newly privatised firms in China is studied in Wei, Varela, DSouza and Hassan (2003). See
Hodge (2003), King and Pitchford (1998) and Mead and Withers (2002) for discussions
of privatisation in Australia and Duncan and Bollard (1992), Duncan (1996) and Barry
(2002) for discussions of the New Zealand case. In addition see Table 1.3, pages 22-24, in
Megginson (2005) for a more comprehensive listing of country studies describing national
privatisation programs.
146
For overviews of this literature see B
os (1989a), Domberger and Piggott (1986), Rees
(1994), Yarrow (1986) and Yeaple and Moskowitz (1995).
147
For examples see B
os and Peters (1991a, 1991b). For summaries of this literature see
B
os (1991) and Vickers and Yarrow (1988). See B
os (1986, 1987) and B
os and Peters
(1988) for examples of papers which develop models of privatisation within the Boiteux
tradition of public enterprises. Haskel and Szymanski (1992) develop a firms/workers
bargaining theory of privatisation. B
os (1989b, 2000) model privatisation as a cooperative

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problem with these formal frameworks is that they assume that contracts are
complete/comprehensive and so cannot credibly address the issue of ownership and thus cannot satisfactorily explain why privatisation/nationalisation
should make any difference to the operations of a firm.
It turns out that incomplete contracts are in fact a necessary condition
to explain the differences between the two forms of ownership. In a world of
complete or comprehensive contracts there is no difference between private
and state owned firms. In both cases the government can write a contract
with the firm that will anticipate all future contingencies - it will detail
the managers compensation, the pricing policy of the firm, how changes in
technology will the change the firms products etc - and thus the outcome
under both forms of ownership will be the same. As Hart (2003: C70)
explains,
[a]pplying this insight to the privatisation context yields the
conclusion that in a complete contracting world the government
does not need to own a firm to control its behaviour: any goals
- economic or otherwise - can be achieved via a detailed initial
contract. However, if contracts are incomplete, as they are in
practice, there is a case for the government to own an electricity
company or prison since ownership gives the government special
powers in the form of residual control rights.
This intuition has been formalised into a series of Neutrality Theorems.
These theorems establish the conditions under which private or public ownership of productive assets is irrelevant for the final allocation of resources.
Consider first the fundamental privatisation theorem due to Sappington
and Stiglitz (1987).148 Assume the governments aim is to simultaneously
achieve three objectives: (i) economic efficiency; (ii) equity; (iii) rent extraction. What Sappington and Stiglitz show is that the government can design
an auction scheme that will result in these three objectives being achieved
and where both public and private production give the same outcome. The
government has a social valuation of the level of output. This valuation
embodies the governments concerns with regard to equity issue such as the
consumption levels of the good among different classes of citizens. It is assumed that the costs of production are such that production by a single firm
is optimal but there are at least two risk-neutral firms, who have symmetric beliefs about the least-cost production technology, willing to bid to be
the supplier. The government auctions off right to the supplier of the good
with the understanding that the supplier receives a payment which equals
the social evaluation. The most efficient firm will win the contract with
game between the government, a trade union and the private shareholders.
148
Martimort (2006) discusses this theorem in detail and gives conditions for it to hold
under complete contracts.

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the highest bid, which will equal the firms (expected) profits, and will set
the production level most preferred by the government. Rent extraction is
achieved since the wining bit equals the firms profits and economic efficiency
is achieved since the most efficient firm is selected as the producer and the
firm produces the governments preferred (social welfare maximising) level
of output.
A simple example of this mechanism is given by Bos (1991: 20). Let the
payment received by the firm equal the governments social valuation which
equals the sum of consumer surplus plus revenue.149 This induces a profit
maximising firm to maximise the sum of consumer and producer surplus.
This implies technological and allocative efficiency. Since the highest offer
in the competitive auction is identical to the expected profit of the firm, the
expected monopoly profit goes to the government.
Shapiro and Willig (1990) obtain a similar result for a setting in which a
public-spirited social planner or framer decides on the nationalisation/privatisation outcome and sets up the governance structure for the enterprise
chosen. The framers decision is driven by the informational differences
between private and public ownership. The important pieces of information
are: (i) information about external social benefits generated by the firm;
(ii) information concerning the difference between the public interest and
the private agenda of the regulator; (iii) information about the firms profit
level (cost and demand information).
First consider the case where the firm is state owned. Here the firm is
run by a public official that Shapiro and Willig refer to as a Minister. By
virtue of his role in managing the enterprise, the minister receives the private
information about the profitability of the enterprise. By virtue of his position
in the public sector, the minister also observes information that bears on the
external social benefits generated by the enterprises operations. Given this
information the minister makes decision as to the level of investment in the
firm and the level of output for firm. The overall social welfare function that
the framer seeks to maximise is the sum of external benefits plus enterprise
profits where there is a magnification factor added to the profit term which
equals the unit cost of raising public funds, including any distortions caused
by the taxes required to finance public sector operations. The ministers
objective function is that of the framer plus a term related to the private
agenda of the minister where there is a weighting parameter attached to
private agenda term which measures how easily the minister can extract
these benefits. This parameter can be interpreted as being a proxy for how
well the political system works. The better the system the greater the limits
on what the minister can extract.
If the firm is a private company then it is managed by a professional
manager and is overseen by a regulator. The manager observes the profit149

This is the total area under the demand curve for a given quantity.

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ability of the firm while the regulator learns the nature of the externality
variable and the private agenda variable. The regulator designs a regulatory scheme that offers the expectation of a competitive rate of return on the
private firms sunk capital. The firm then maximises profit subject to the
regulatory scheme while the regulator has the same objective function as
the minister under state ownership. The framers objective is to maximise
the sum of the external benefits plus profits net of the cost of rasing any
public funds needed to make the transfers to the private company required
under the regulatory scheme.
The important difference between the two ownership forms is who receives the information about cost and demand conditions. The manager is
the informed party under private ownership while under public ownership
the minister is informed. This means that an informational barrier is created
between the firm and the government by privatisation. The advantage of
this barrier is that it reduces the discretion the minister has to interfere with
the working of the firm. The disadvantage is that it makes it more difficult
for the regulator to motivate the firm to purse social welfare objectives.
When considering neutrality results first consider the operation of an
enterprise in an environment in which there is no private information whatsoever. Suppose all information about the external benefits of the enterprise
and all information about its profitability is contractible. In such circumstances, the regulator could put in place a set of taxes or subsidies, contingent on what will become commonly known realisations of the public costs
and benefits of the enterprises operations. These taxes and subsidies could
be designed to induce the owners to operate the enterprise to serve precisely
the regulators objectives in every contingency.
Perhaps it is not surprising that one can obtain a neutrality result in the
complete absence of noncontractible private information, for in such a case
there is no truly active role for the managers of the enterprise. They need
only carry out the detailed instructions left by the minister or the regulator,
and the manager cannot claim that there will ever be any new information or
extenuating circumstances that can justify departures from that mechanical
mandate.
The more interesting neutrality results arise in situations where there
is private information. First assume that the private information about
the firms profitability is known only after the investment is made but the
private information concerning public impacts and private agenda is known
to the regulator when he must commit himself to the regulatory mechanism,
before the time of the investment decision. Under these conditions, the
regulator can exert sufficient indirect control over the private firm to obtain
the same outcome and payoff as under public ownership, so the framer is
indifferent between public and private enterprise. The regulators control
is secured by paying the firm according a the schedule which takes into
account the sum of external benefits generated plus the private agenda of

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the regulator plus the smallest possible payment that will induce the firm
to invest. With this schedule, the regulator induces the same actions and
achieves the same payoffs as does the minister under public enterprise. The
mechanism operates by forcing the firm to internalise the objectives of the
regulator.
The second distinct case occurs when private information concerning
both costs and public impacts is revealed only after the investment commitment must be made. Only the prior probability distributions of the private
information of the regulator and the profitability of the firm are known at
the time the investment decision must be effected. After the investment has
been made, but before the activity level must be chosen, the priate information of the regulator will become know to him and the nature of the firms
profitability will be revealed to the manager of the enterprise. Again, the
regulators optimal payment scheme results in the same choices of activity
levels and the same expected drain on the treasury that would be the result
of public enterprise. The logic behind this result is a straightforward extension of the analysis of the first case. Here the regulator commits himself to
the menu of payment schedules, with the understanding that he will choose a
particular schedule from this menu after investment is made and his private
information is revealed to him, but still before the activity level must be
chosen by the firm. The firm is indifferent, ex ante, about which particular schedule will be chosen from the menu by the regulator, because each
of them offers the same zero level of expected profits, that is just enough
to induce the firm to make the investment. Once the regulator learns his
private information, he will be motivated to select the payment schedule
corresponding to that information because that schedule is optimal for his
objective function. Given this payment schedule, the firm will be motivated
to choose the same activity level as in the first case above, and here too that
is the optimum from the perspective of either the regulator or the public
minister.
In the third case of neutrality the private firm has private information
about its costs before the investment decision must be made. It is assumed
that there are no costs to raising public funds and thus any transfers from
the treasury are not a matter for concern to the framer, the regulator or the
public minister. Because the firm knows information about its profitability
and the regulator is aware of that fact but does not know this information
himself, the regulator, to assure that investment will be made, must commit
to a payment schedule or to a menu of schedules that provides non-negative
profit for all demand/cost cases. Here, because of the stipulation that public
funds can be raised at zero cost, this requirement poses no problem for
the regulator: he is perfectly willing to add enough funds to any payment
schedule to assure its profitability in the light of his indifference to transfers
from the treasury. Consequently, it is optimal for the regulator to offer
the firm internalisation schedules, each with different levels of investment

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funds, such that these funds are sufficiently large to guarantee the firm
non-negative profit even if its profitability level is the worst possible. In
the end, the regulated firm chooses the same activity levels that the public
enterprise would choose, but the drain on the treasury caused by regulation
is greater than that caused by public enterprise. Since, in this case, however,
that drain is not a matter of concern, the framer would find no difference
between the performance of public and private forms of organisation.
The third neutrality result is that of Shleifer and Vishny (1994). Their
starting point is the idea that politicians control SOEs in order to achieve
political objectives, such as excess employment and/or high wages. In this
model the politician derives benefits from this inefficient allocation of resources, as they create political support for him. If the firm is privatised
then the politician must bargain with the manger of the firm to get the
outcome he wants. Clearly the manager, who aims to maximise profits, and
the politician, who wants political support, have conflicting objectives. The
firm will not want to expand employment above the profit maximising level
as the politician wishes to do. The politician must make a transfer, from the
treasury, to the firm to induce the takeing on of the extra workers. This is
a problem to the politician since the transfer is costly to him as taxes need
to be raised to finance the subsidy.
The Shleifer and Vishny model allows for a complete separation of income
rights and control rights. There is no clear-cut dichotomy between stateowned and private firms in the model as it allows for four corparate forms:
(i) a SOE, the Treasury has income rights and the politician has control
rights;
(ii) a regulated firm, the private owners have income rights, but the politician has control rights and can interfere in the operating activity of
the firm;
(iii) a corporatised firm, when the government has income rights, but the
control rights are in the hand of the firms management;
(iv) a purely private firm, when the manager/owner has both income and
control rights.
As the model has the two parties bargaining, disagreement points have to
be identified. These point are were the politician and the manager control
the firm. When the politician controls the firm he has control over the
manager and is able to the firm down to zero profits. He can use the firms
cash flow to hire extra labour up to the point where the marginal benefits
of the excess employment equals the marginal cost of raising public funds.
Under control by the manager, the manager has power over the politician,
and the firm produces at the efficient level (with zero excess labour) but
does not receive any transfer from the Treasury.

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As far as the manager and the politician are concerned, the efficient point
is reached when the level of excess employment reaches the point where the
marginal political benefits equals the wage, which is the marginal cost of
labour. At this point the amount of excess labour employed is lower than
that under politician control and the subsidy paid to the firm is higher than
under private control.
The neutrality result that Shleifer and Vishny present is basically an
application of the Coase Theorem to privatisation. As side payments are
allowed - or more correctly in this case, when the manager and politician
can freely bribe each other - then the manager and the politician will reach
the jointly efficient solution no matter what the initial allocation of income
and control rights.
The importance of the above theorems is that they outline the conditions
under which ownership of the firm does not matter. Of all the assumptions
on which the irrelevance results hinge the most important requirement is
that complete contingent long-term contracts can be written and enforced.
But writing complete contracts is only possible in a world of zero transaction
costs. In a positive transaction costs world only incomplete contracts can be
written but contractual incompleteness creates a role for ownership - making
decisions under conditions not covered in the contract. It is only within such
an environment that we can explain why privatisation matters, that is, why
the behaviour of state owned and private companies differ. This reliance
on incomplete contracts means that the theory of privatisation can be seen
as forming a part of the incomplete contracts framework explained in the
subsection directly above.
These results also shows why the previous theoretical privatisation literature was largely unsuccessful. As noted above that literature took a
complete/comprehensive contracting perspective, in which any imperfections present in contracts arose solely because of moral hazard or asymmetric
information. But as Hart (2003: C70) notes
[ . . . ] if the only imperfections in are those arising from moral
hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner
has no special power or rights since everything is specified in
an initial contract (at least among the things that can ever be
specified). In contrast, ownership does matter when contracts
are incomplete: the owner of an asset or firm can then make all
decisions concerning the asset or firm that are not included in
an initial contract (the owner has residual control rights).
Thus ownership, and therefore privatisation, only matters in an incomplete contracts world. In such an environment the allocation of residual
control rights can differ and so the behaviour of publicly owned firms will
differ from that of privately owned firms.

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Schmidt (1996a)150 considers a monopolistic firm that producers a public good in a world of incomplete contracts. His model is multiple period
with the privatisation decision being made in the initial period. That is,
the government must decide whether to sell the SOE to a private ownermanager or keep it in state hands and hire a professional manager to run
it. Importantly knowledge concerning the firms cost is private information
known only by the firms owner. Given this, privatisation amounts to a
transfer of private information from the government to the private owner.
In the next period the manager selects his effort level and the state of the
world is then revealed. The importance of the managers effort level is that
it affects the probability of the state of the world. A high level of effort from
the manager results in productive efficiency being enhanced and costs being
lowered for any level of output. In the last period, the government selects
the transfer scheme and payoffs are revealed.
When the firm is an SOE the government observes the firms realised
cost function and thus can implement the first-best allocation by choosing
the ex post efficient level of production. But the managers wage will be
fixed, since contingent contracts can not be written, and thus independent
of level of output. Given this the manager has no incentive to exert effort
and the government knowing this will therefore offer him only his reservation
wage.
On the other hand when the firm is in private hands the government does
no know the exact cost structure of the firm. In an effort to get the private
owner to produce the efficient level of output the government must provide
an incentive via the payment of an informational rent.But if transfer are
costly it will be impossible to implement the optimal allocation and therefore
the cost to private ownership is an inefficiently low level of production.
However given the rent payment provides an incentive to increase effort,
productive efficiency is greater.
Schmidts main conclusion is therefore that when the monopolistic firm
produces a good or service which provides a social benefit, there is a tradeoff between allocative and productive efficiency that needs to be considered
when deciding if a firm is to be privatised. The equilibrium production level
is socially suboptimal but the incentives for better management results in
cost savings. Considered overall the welfare effect of privatisation should be
positive for cases where the social benefits are small, but social welfare will
be greater under public ownership for those cases where production exhibits
large social benefits.
An important implication of this is that a case can be made for privatisation even when the government is a fully benevolent dictator who wishes
150
Schmidt (1996a) is variant of Schmidt (1996b). 1996b considers the case of privatisation to an employee manager while 1996a applies to the case of privatisation to an
owner-manager. While this second case is less realistic it is simpler and does not require
the assumption that the manager is an empire builder that is utilised in 1996b.

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to maximise social welfare. Even if all the deficiencies of the political system
could be remedied it is still possible for privatisation to be superior to state
ownership.
In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firms
manager. In the case of a public firm this investment can be diverted by
the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow
ex post access to the general population. Such an action may be socially
optimal but would expropriate part of the firms investment. A rational
expectation of such an expropriation would reduce the incentives of a public
firms manager to make the required investment. For a private firm, the
managers incentives to invest are better given that both the firms owners
and the manager are interested in profit maximisation. The cost of private
ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government
purses economic efficiency. Both groups have incomplete knowledge about
the firms cost structure and have to offer incentive schemes to induce the
manager to act in accordance with their interests. Obviously the game here
is a multi-principal game which dilutes the incentives and yields low-powered
managerial incentive schemes and low managerial rents.151 Each principal
fails internalise the effects of contracting on the other principal and provides
socially too few incentives to the firms management. The added incentive
for the managers of a private firm to invest is countered by the low powered
managerial incentive schemes that the private firms managers face. The
net effect of these two insights is ambiguous with regard to the relative cost
efficiency of the public and private firms. Laffont and Tirole can not identify
conditions under which privatisation is better than state ownership.
In the Shapiro and Willig paper discussed above privatisation is considered in a context where the regulator pursues a different agenda from the
framer. Assume that either information about profitability is known before
investment is decided upon or that there are costs to rasing public funds.
In these cases the neutrality results of Shapiro and Willig dont hold. The
equilibrium behaviour of the minister who is in charge of the firm is virtually
unconstrained and he will set the activity levels of the firm as to maximise
his utility. The regulator of the private firm has a more complex problem to
deal with. This involves the designing of regulatory scheme which ensures
non-negative profits for the firm. Given this is a case of optimal regulation
under asymmetric information we would expect to see the firm enjoying informational rent, which are proportional to the activity chosen. As public
funds are costly to raise these transfers are costly to the state.
151

Technically the multi-principal distortion is similar to the double marginalisation on

two complementary goods sold by noncooperative monopolists.

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The trade-off in this model is driven by how easily the public official can
interfere with the operations of the firm. If the public officials objectives
are the same as the (welfare maximising) framer, i.e. the public official has
not private agenda, then public ownership is optimal. In this case private
ownership reduces performance since the firm extracts a positive information
rent. But when there is a private agenda then a reduction in discretion may
increase welfare. Politicians find it easier to distort the operations of a
firm in their favour when that firm is an SOE and under the direct control
of the minister. The regulated private firms does earn a positive rent but
is less subject to the control of the regulator. This means that regulated
private firms are likely to out perform SOEs in poorly functioning political
systems,which are open to abuse by the minister, and where the private
information about the profitability of the firm is less significant. This makes
it easier for the regulator to get the firm to maximise social welfare.
In Boycko, Shleifer and Vishny (1996) information problems do not explain the difference between public and private firms. Here it is differences
in the costs to a politician of interfering in the activities of the different types
of firms that explains the effects of privatisation. The starting point of the
paper is the observation that public firms are inefficient because they address objectives of politicians rather than maximise efficiency. One common
objective for a politician is employment. Maintaining employment helps
the politician maintain his power base. In their model Boycko, Shleifer and
Vishny assume a spending politician, who controls a public firm, forces it to
spend too much on employment. The politician does not fully internalise the
cost of the profits foregone by the Treasury and by the private shareholders
that the firm might have.
Boycko, Shleifer and Vishny argue privatisation can be a strategy to
reduce this inefficiency in state-owned enterprises. By privatisation they
mean the reallocation of control rights over employment from politicians to a
firms managers and the reallocation of income rights to the firms managers
and private owners. The spending politician will still want to maintain
employment and can use government subsidies to buy excess employment
at the private firm. In this model the advantage of privatisation is that it
increases the political costs to maintaining excess employment. It is less
costly for the politician to spend the profits of the state-owned firm on
labour without remitting them to the Treasury than it is to generate new
subsidies for a privatised firm. Given that voters will be unaware of the
potential profits that a state firm is wasting on hiring excess labour they are
less likely to object than they are to the use of taxes, which they know they
are paying, to subsidise a private firm not to restructure. This difference
between the political costs of foregone profits of state firms and of subsidies
to private firms is the channel through which privatisation works in this
paper.
Shleifer and Vishny (1994) is a continuation of research stated in Boycko,

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Shleifer and Vishny (1996). As with the 1996 paper Shleifer and Vishny
assume that there is a relationship between politicians and firm mangers that
is governed by incomplete contracts and thus ownership becomes critical in
determining resource allocation. As noted above the Shleifer and Vishny
model is a game between the public, the politicians and the firm managers.
The model derives the implications of bargaining between politicians and
managers over what the firms will do. A particular focus is on the role of
transfers between the private and state sectors including subsidies to firms
and bribes to politicians.
To consider the determinants of privatisation and nationalisation Shleifer and Vishny utilise what they term a decency constraint which says that
the government cannot openly subsidise a profitable firm. To do so would
be seen as politicians enriching their friends. The first, obvious, point made
is that politicians are always better off when they have control rights. Control brings political benefits, via excess employment, and bribes, to allow
a reduction in the excess employment. Both the Treasury and the politicians prefer nationalisation152 to subsidising a money-losing private firm.
Control brings bribes and even without bribes politicians get a higher level
of employment and lower subsidies when they have control. The Treasury
likes the smaller subsidies that come with nationalisation. When it comes
to profitable firms politicians like control or Treasury ownership because
these firms have a strong incentive to restructure since the profits go to the
private owners and they lose little in terms of subsides due to the decency
constraint. To ensure the firms achieve political objectives politicians need
control. Given the decency constraint politicians dont want managers who
have control rights to also have large income rights since the decency constraint means smaller subsidies are lost if employment is cut and income
rights mean the managers gain from restructuring and maximising profits.
Politicians who have control prefer higher private and lower Treasury ownership since higher private ownership implies higher bribes. Without bribes
the private surplus is extracted via higher levels of employment.
Given that politicians like control, Why would they ever privatise a firm?
To explain privatisation the interests of taxpayers must become more prominent. Given this the decision to privatise then becomes the outcome of
competition between politicians who benefit from government spending (and
bribes) and politicians who benefit from low taxes and support from taxpayers. We would expect privatisation to take place when political benefits
of public control are low, and the desire of the Treasury to limit subsidies
is high. This is most likely to occur when the political costs of rasining
taxes to pay subsides is high and when the political benefits from excess
employment are low.
Next we consider Hoppe and Schmitz (2010). Here the government signs
152

As a SOE the Treasury has income rights and the politician has control rights.

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a contract with a manager which stipulates that he will produce and deliver a particular good. The contract specifies the characteristics of a basic
version of the good. After the contract has been signed it is possible to
make an investment that increases both the quality of the good and the
costs of production. It is also possible to make an investment which lowers
the managers costs and the goods quality. These, ex ante non-contractible,
innovations result in modifications to the basic version of good meaning the
actual good provided can differ from that stipulated in the contract. To be
able to make these modifications access to essential assets is required. The
difference between public and private ownership is that under state ownership the government controls these assets and thus government approval is
needed to be able to make any modifications. Under private ownership the
decision as to what changes, if any, are made to the basic good are in the
hands of the manager. In addition two kinds of public-private partnerships
are considered: 1) either both parties can veto the implementation of innovations - i.e., there is joint ownership, or 2) neither party has veto power i.e., the government has the right to implement quality innovations and the
manager has the right to implement cost innovations.
With regard to which investment decision should be allocated to whom,
Hoppe and Schmitz show that under private ownership the manager should
have control over the cost innovation decision while the relative bargaining
strengths of parties should determine the quality investment decision. For
public ownership the government should undertake the investment in quality decision with responsibility for cost innovation depending on the parties
bargaining powers. Under a partnership deal neither party should have veto
power and cost investment should be assigned to the manager with the government being assigned the quality investment decision. Different ownership
allocations also result in different levels of investment. Under private ownership the first best level of investment in cost reduction is achieved while
there is underinvestment in quality innovations. There is a similar result for
public ownership but in this case it is the investment in quality innovations
that is first best while there is underinvestment in cost reduction. In the
case of a partnership with neither party having veto rights, both kind of
innovation occur.
As to which governance structure is best, this depends on the importance
of the cost reductions, their effect on quality reductions, the importance of
quality reductions, their effect on cost increases and the bargaining strength
of the parties. Hoppe and Schmitz (2010: 260) explain,
[r]oughly speaking, if one party has a sufficiently large bargaining power, then the extent of the underinvestment in one task
(which is the only disadvantage of ownership by a single party)
becomes arbitrarily small, so that a partnership cannot be optimal. In contrast, if the parties bargaining powers are almost

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equal, then the underinvestment problem under single ownership will turn out to be most severe, which makes ownership by
a single party less attractive. Whether private or public ownership will be preferred depends on the relative strengths of the
side effects caused by the innovations. If the side effect of the
cost (quality) innovation becomes very large, so that inducing
cost (quality) investment is relatively unimportant, then public
(private) ownership is optimal (because then the first-best investment in the important innovation is induced). In contrast,
if the side effects of both innovations almost disappear, then a
partnership with no veto power must be optimal, because overinvestment (which is the partnerships drawback compared to
single ownership) is no longer a problem.
There are two points worth noting about the Hoppe and Schmitz framework. The first is that unlike a number of the other papers considered here
their model does not rely on informational asymmetries and second the paper is rare in that it allows for the ex ante allocation of investment tasks in
addition to ownership rights.
The final paper to be considered is Hart, Shleifer and Vishny (1997).
Again in this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private,
can invest his time in improving the quality of the service or reducing the
cost of the service. The important assumption is that investments in cost
reduction have negative effects on quality. Investments are non-contractible
ex ante. For the case where the provider is a government employee he must
obtain approval from the government to implement any innovation he has
created. Given that the government has residual rights the employee will
gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e.
the service has been contracted out, then he will have stronger incentives to
both cut costs and improve quality. This is because he keeps the returns to
his investment. The downside to private provision is that the incentives to
cut costs are strong and the provider does not fully internalise the negative
effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation
and quality improvements. Costs are always lower under private ownership
but quality may be higher or lower under a private owner. Hart, Shleifer and
Vishny argue that the case for public provision is generally stronger when
(i) non-contractible cost reductions have large deleterious effects on quality;
(ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests
that the case for privatisation is stronger when (i) quality-reducing cost
reductions can be controlled through contract or competition; (ii) quality

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innovations are important; (iii) patronage and powerful unions are a severe
problem inside the government.
Summary
The theoretical literature on privatisation has only been able to explain why
ownership matters for firms since around 1990. Before then the privatisation
literature, such as it was, relied on a complete or comprehensive contracts
framework which is, as the Neutrality Theorems make clear, unable to differentiate between the two forms of ownership. It was only in the post-1990
period that the property rights approach to the theory of the firm was applied to privatisation and a literature began to emerge that could explain
performance differences between SOEs and private firms.
As these post-1990 privatisation theories utilise a framework based upon
the incomplete contracts approach to the theory of the firm, many of the
criticisms of latter group of theories carry over to the former group. To note
just three examples: the Maskin and Tirole (1999) critique of incomplete
contracts applies just as well to the theory of privatisation as to the theory
of the firm. In addition questions can be raised as to whether the firm in
the theory of privatisation is an organisation or an individual. Also the
contradiction between bounded rationality and incomplete contracts is as
problematic for the theory of privatisation as it is for the theory of the firm.

Conclusion
A useful classification of the post-1970 mainstream literature is based on
seeing the theories forming this literature as being derived from the breaking of either of two assumptions in the standard neoclassical general equilibrium model. One group of theories corresponds to the breaking of the
assumption that there are no asymmetries in the information available to
contracting parties and thus no principal-agent type problems. The second
group of theories violates the assumption that agents can costlessly write
contracts. Both these groupings take a Coaseian approach to explaining
aspects of the firm insofar as they both set out to answer questions about
the existence, boundaries and/or internal organisation of the firm. These
were the questions asked, for the first time, in Coase (1937). Famously, part
of Coases answer to these questions was to point out that firms can only
exist in a world of positive transaction costs.153 This assumption of positive
153

The importance of positive transactions costs is the theme that links Coases two most
famous papers. As Demsetz (1996: 565) notes, The Problem of Social Cost (Coase,
1960) is R. H. Coases most cited and most influential work. It is noted for, among other
things, demonstrating the importance of incorporating transaction cost into the analysis
of externalities and into the analysis of markets more generally. This theme, that markets
are not free, is also found in the classic The Nature of the Firm (Coase, 1937), so that,

The present

143

transaction costs separates the current incomplete contracting theories of

the firm, including the theory of privatisation, from the neoclassical model
of the firm which was developed, implicitly, within a zero transaction cost
framework. The principal-agent theories can be differentiated from the neoclassical theory by their emphasis on monitoring and incentives issues, which
do not arise in the symmetric information neoclassical framework.

taking the perspective offered by both works, transaction cost turns out to be important
whether one is analyzing allocation through the price system or through the firm.

Partial versus general equilibrium

A final point about the models of the firm discussed in this essay is that
they highlight a general issue to do with post-1970 microeconomics, namely,
the retreat from the use of general equilibrium (GE) models.154
As early as 1955 Milton Friedman was suggesting that to deal with
substantive hypotheses about economic phenomena a move away from
Walrasian towards Marshallian analysis was required. When reviewing Walrass contribution to GE, as developed in his Elements of Pure Economics,
Friedman argued,
[e]conomics not only requires a framework for organizing our
ideas [which Walras provides], it requires also ideas to be organ154

When discussing the influence of Gerard Debreu on economics D

uppe (2010: 2-3)
nicely sums up the fate of GE as well.From the point of view of today Debreus influence
on the body of economics could be called zero, in that general equilibrium theory (GET) is
the economics of yesterday. While GET had mirrored most analytic advances in economic
theory before Debreu, after Debreu most theoretical innovations came as alternatives to
GET (from game theory to complexity theory). Historian of economic thought Roger
Backhouse writes that [i]n the 1940s and 1950s general-equilibrium theory [ . . . ] became
seen as the central theoretical framework around which economics was based (Backhouse
2002: 254) and that by the [ . . . ] early 1960s, confidence in general-equilibrium theory,
and with it economics as a whole, as at its height, with Debreus Theory of Value being
widely seen as providing a rigorous, axiomatic framework at the centre of the discipline
(Backhouse 2002: 261), but [ . . . ] there were problems that could not be tackled within
the Arrow-Debreu framework. These include money (attempts were made to develop a
general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models,
often dealing only with a specific part of the economy or with a particular problem. The
search for ever more general models of general competitive equilibrium, that culminated
in Theory of Value, was over (Backhouse 2002: 262). One set of particularly problematic
results for general equilibrium are the Sonnenschein-Mantel-Debreu (SMD) theorems. In
part because of a conviction that progress could not be made in general equilibrium theory, there was a substantial redirection in economic theory. As the results in SMD theory
became well known, for example through Wayne Shafer and Hugo Sonnenscheins survey
(1982), economists began to question the centrality of general equilibrium theory and put
forward alternatives to it. Thus in the ten years following the Shafer-Sonnenschein survey,
we find a number of new directions in economic theory (Rizvi 2006: 230).

Partial versus general equilibrium

145

ized. We need the right kind of language; we also need something

to say. Substantive hypotheses about economic phenomena of
the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has
little to contribute in this direction; for this we must turn to
other economists, notably, of course, to Alfred Marshall (Friedman 1955: 908).
By the mid-1970s microeconomic theorists had largely turned away from
Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic
interaction, asymmetric information and economic institutions.
All the models considered above are partial equilibrium models, but in
this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s.155 Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation,
organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial
equilibrium framework.156 This illustrates the point made at the beginning
of the paper that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general
equilibrium, so does the theory of the firm.157
One major path of influence from the mainstream of modern economics
to the development of the theory of the firm has been via contract theory.
But contract theory is an example of the mainstreams increasing reliance
on partial equilibrium modelling. Contract theory grew out of the failures
of GE. As Salanie (2005: 2) has argued,
[t]he theory of contracts has evolved from the failures of general
155

Gale (2000: 38-9) describes partial equilibrium is the following terms, [ . . . ] partial
equilibrium analysis, that amalgam of handy short cuts that allows economists to isolate
particular phenomena and study them on the back of a virtual envelope, ignoring the
fact that an economy is a complex system in which everything affects and is affected by
everything else. It may not he pure, but it is very practical. He describes the elegant
theory of GE as a theory in which [ . . . ] the interaction of individual agents and
individual markets throughout the economy are aggregated to provide a precise account
of the equilibrium of the entire economy. It may not be practical, but it is very pure
(Gale 2000: 39).
156
This is not to say there has been no work at all on GE within these areas. For
examples of work on the GE approach to firms see Kihlstrom and Laffont (1979), Dreze
(1985) and Zame (2007). On the GE approaches to the multinational firm see Markusen
and Maskus (2001). For a discussion of the Arrow-Debreu model when faced with moral
hazard and adverse section see Guesnerie (1992). For a look at effects to provide strategic
foundations for GE see Gale (2000). On the GE approach to tax and to international trade
see, for example, Shoven and Whalley (1984), Creedy (1997), Jones (2011) and Woodland
(2011). There has also been much work on computable general equilibrium analysis, see
Boehringer, Rutherford and Wiegard (2003) and Sue Wing (2004) for overviews.
157
Arrow (1971) discusses the pre-1970 GE approach to the firm.

146

Partial versus general equilibrium

equilibrium theory. In the 1970s several economists settled on
a new way to study economic relationships. The idea was to
turn away temporarily from general equilibrium models, whose
description of the economy is consistent but not realistic enough,
and to focus on necessarily partial models that take into account
the full complexity of strategic interactions between privately
informed agents in well-defined institutional settings.

The Foss, Lando and Thomsen classification scheme utilised above illustrates clearly the movement of the current theory of the firm literature
away from GE towards partial equilibrium analysis. The scheme divides
the contemporary theory into two groups based on which of the standard
assumptions of GE theory is violated when modelling issues to do with the
firm. The theories are divided into either a principal-agent group, based
on violating the symmetric information assumption, or an incomplete contracts group, based on the violation of the complete contracts assumption.
The reference point approach extends the incomplete contracts grouping to
situations where ex post trade is only partially contractible.
The introduction of the entrepreneur, as in the models proposed by Spulber and by Foss and Klein, also challenges, albeit in a different way, the
standard GE model since, as William Baumol noted more than 40 years
ago, the entrepreneur has no place in formal neoclassical theory.
Contrast all this with the entrepreneurs place in the formal theory. Look for him in the index of some of the most noted of recent
writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they
are totally absent. The theoretical firm is entrepreneurlessthe
Prince of Denmark has been expunged from the discussion of
Hamlet (Baumol 1968: 66).
The reasons for this are not hard to find. Within the formal model the
firm is a production function or production possibilities set, it is simply a
means of creating outputs from inputs. Given input prices, technology and
demand, the firm maximises profits subject to its production plan being
technologically feasible. The firm is modelled as a single agent who faces
a set of relatively uncomplicated decisions, e.g. what level of output to
produce, how much of each input to utilise etc. Such decisions are not
decisions at all, they are simple mathematical calculations, implicit in the
given conditions. The firm can be seen as a set of cost curves and the
theory of the firm as little more than a calculus problem. In such a
world there is a role for a decision maker (manager) but no role for an
entrepreneur.
The necessity of having to violate basic assumptions of GE theory so that
we can model the firm, suggests that as it stands GE can not deal easily

Partial versus general equilibrium

147

with firms, or other important economic institutions. Bernard Salanie has

noted that,
[ . . . ] the organization of the many institutions that govern
economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are
modeled as a production set. This makes the very existence
of firms difficult to justify in the context of general equilibrium
models, since all interactions are expected to take place through
the price system in these models (Salanie 2005: 1).
This would suggest that to make GE models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with the firm developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and
the like is not so much desirable as essential.

Conclusion

Even though firms may be, in practice, as old as farming and even if not
that old, firms, of some description, are at least two to three thousand
years old attempts at the formulation of a theoretical explanation for
the existence, boundaries and organisation of firms only goes back, at the
most, to the 1920s or 1930s, while the current mainstream approach to the
theory of the firm is even more recent having been developed only since
the 1970s. During the period, roughly, from 1930 to 1970 the mainstream
theory of the firm was the neoclassical model in which the firm is seen as
a production function or production possibilities set, simply a means of
transforming inputs into outputs. Given the available technology, a vector
of input prices, and a demand schedule, the firm maximises money profits
subject to the constraint that its production plans must be technologically
feasible. For the pre-1930 neoclassical period there was no generally accepted
theory of the firm. Before that the classical economists had only a theory
of aggregate production.
When discussing the post-1930 neoclassical model of the firm Jensen and
Meckling write,
[w]hile the literature of economics is replete with references to
the theory of the firm, the material generally assumed under
that heading is not actually a theory of the firm but rather a
theory of markets in which firms are important actors (Jensen
and Meckling 1976: 306).
The move from a theory of markets with firms to a theory of the firm is
the major change that has taken place within the mainstream approach to
the theory of the firm over the theorys history.158 What we have seen since
the 1970s is a movement away from the theory of the firm being seen as
developing a component of price theory, namely the component which asks,
158

It could be argued that the mainstream theory of the firm has changed while the
orthodox (neolcassical) theory has not.

Conclusion

149

How does a firm act in its factor and product markets?, to the theory being
concerned with the firm as an important institution in its own right.
Mark Roe (1994: vii) sums up much of this change when he writes,
[e]conomic theory once treated the firm as a collection of machinery, technology, inventory, workers, and capital. Dump these
inputs into a black box, stir them up, and one got outputs of
products and profits. Today, theory sees the firm as more, as
a management structure. The firm succeeds if managers can
successfully coordinate the firms activities; it fails if managers
cannot effectively coordinate and match people and inputs to
current technologies and markets. At the very top of the firm
are the relationships among the firms shareholders, its directors,
and its senior managers. If those relationships are dysfunctional,
the firm is more likely to stumble.
The post-1970 changes to the theory of the firm have also made possible the development of a theory of privatisation. Before, roughly, 1990,
despite a number of contributions from property rights theorists, economic
analysis did not accorded a high priority to the question of the likely effects of ownership on industrial performance. It was only after 1990 that
the contemporary theory of the firm was applied to the theory of privatisation and we started to develop a greater appreciation for when and why
ownership matters for the performance of a firm. This theory highlights the
importance of incomplete contracts for understanding the boundary between
state owned and privately owned firms in addition to their importance for
explaining the boundaries between firms and between firms and markets.
Put simply, a rudimentary history of the development of the theory of the
firm from the past to the present would read: the classical economists had
a theory of aggregate production but no theory of firm level production, the
neoclassical economists had a theory of firm level production but no theory
of the firm and it has only been since the the advent of the contemporary
literature that a start has been made on developing a genuine theory of
the firms existence, boundaries and internal structure. Today we also see
attempts at integrating the theory of the entrepreneur and the development
of markets with the theory of the firm. The introduction of such elements
may seem on the surface anti-mainstream but these theories still utilise
many mainstream ideas and thus are not so much attempts to subvert the
contemporary theory as attempts to broaden the range of topics the theory
can handle. Alfred Marshalls comments at the end of the 19th century on
the development of economics in general apply with full force to the specific
case of the development of the theory of the firm today.
Some of the best work of the present generation has indeed
appeared at first sight to be antagonistic to that of earlier writers

150

Conclusion
; but when it has had time to settle down into its proper place,
and its rough edges have been worn away, it has been found
to involve no real breach of continuity in the development of
the science. The new doctrines have supplemented the older,
have extended, developed, and sometimes corrected them, and
often have given them a different tone by a new distribution
of emphasis ; but very seldom have subverted them (Marshall
1920: v).

Appendix 1: the particular expenses curve

Blaug (1996: 367-72) discusses Marshalls idea of the particular expenses

curve (PEC) and he notes that the curve is a cumulative array of the average
costs of different firms.159 Note that this means that the PEC is not a supply
curve, that is, it is not a cumulative array of the marginal costs of the firms
in the industry.
As an example consider a short-run equilibrium where the price is equal
to the marginal costs of an intra-marginal producer and the average cost of
a marginal firm. See Figure 151.1 below.
P rice/Costs

P rice/Costs
M C2

P rice/Costs

AT C2

M C1
P

AT Cq2
AT C1
b

P EC
b

AT Cq1

q1

Output

q2

Output

q1 q1 + q2
Output

Figure 151.1
Here there are two firms; one, a low cost intra-marginal firm - firm 1 - and
one the marginal firm - firm 2. The price, P , is given by the intersection
of the market supply and demand curves which occurs at the equilibrium
quantity of q1 + q2 . At P firm 2s M C2 = AT C2 (= P ) and the firm
produces an output of q2 . Firm 1 is more efficient than firm 2 and thus
P = M C1 > AT C1 . Output is q1 . The PEC includes the points (AT Cq1 , q1 )
and (AT Cq2 , q1 + q2 ). The change from using dots to represent the PEC to
159

cf. Viner (1932: 43-6)

152

Appendix 1

using a curve to do so implies the addition of many (an infinite number of)
extra firms with efficiencies between firm 1 and firm 2.
In general the PEC shows the average total costs of the firms involved in
the production of the output for a given market price-output combination
with the firms arranged in order of efficiency from left to right, with the
most efficient firm on the left and the marginal (least efficient) firm at the
right. Since this must be true for any market price-output combination,
with each firm producing a different output and incurring different average
total costs for each market price-output combination, it follows that there
is a PEC for each point on the short-period supply for the industry. The
end point of the PEC shows the marginal (and average) cost of producing
for the marginal firm. It follows that the industry supply curve is the locus
of end points of the PECs. See Figure 152.1
P rice
SRS
P4
P3
P2
P1
P ECs

q1

q2

q3

q4
Output

Figure 152.1.
While the above discussion has been in terms of the short-run, the notion
of a PEC can be equally well applied to the long-rum. In fact it was this
latter application which interested Marshall (Blaug 1996: 368-72).
Marshall (1920b: 811) argues that the difference between the PEC and a
normal supply curve is that in the former we do, and in the latter we do not,
take the general economies of production as fixed and uniform throughout.
The PEC is based on the assumption that all firms have access to the internal
and external economies which belong to the market level of production while
for the supply curve a firms internal and external economies are determined
by its level of production. For example, for the PEC in Figure 151.1 firm 1
can take advantage of the internal and external economies associated with
the market level of output q1 + q2 . For the supply curve the internal and
external economies for firm 1 are those associated with the output level q1 .

Appendix 2: Simon (1951)

Proof of Theorem 72.1:

Let Tm be this greatest value. The proof has two parts. In the first it is
shown that if T (x) = Tm for (x, w), then there is no point preferred to (x, w).

The second part deals with the situation where T (x ) < Tm and show that

there is a point (x, w), with T (x) = Tm , that is preferred to (x , w ). These

two parts complete the proof.

(1) Suppose that T (x, w) = Tm . Consider any other point (x , w ) with

T (x , w ) Tm . Given that TM T (x , w ) we know from the definition of

T that a2 S1 + a1 S2 a2 S1 + a1 S2 or, rearranging things,

a2 (S1 S1 ) a2 (S2 S2 ) 0

(153.1)

For (x , w ) to be preferred to (x, w) we must have

(S1 S1 ) 0 and (S2 S2 ) 0

(153.2)

But given that a1 > 0 and a2 > 0 both 153.1 and 153.2 can only hold if

S1 = S1 and S2 = S2 . Therefore (x , w ) can not be preferred to (x, w).

(2) Assume that

T (x)
 n, w ) < Tm . Let x be such that
o = Tm .
 T (x

1
F1 (x)S2 (x , w ) F2 (x)S1 (x , w ) .
Also let w = T (x )
Then
S1 (x, w) = F1 (x) a1 w
n

o

1
F1 (x)S2 (x , w ) F2 (x)S1 (x , w )
= F1 (x) a1
T (x )

n
1

=
F1 (x)T (x ) a1 F1 (x)S2 (x , w )

T (x )
o

+a1 F2 (x)S1 (x , w )

(T (x )=a2 S1 (x ,w )+a1 S2 (x ,w ))

154

Appendix 2


1
T (x )

n

F1 (x)a2 S1 (x , w ) + F1 (x)a1 S2 (x , w )

a1 F1 (x)S2 (x , w ) + a1 F2 (x)S1 (x , w )

(F (x)a S (x ,w ) and a F (x)S (x ,w ) cancel)

1
1 2
1 1
2
n
o
1

=
F
(x)a
S
(x
,
w
)
+
a
F
(x)S
(x
,
w
)
1
2 1
1 2
1
T (x )


1

=
{a2 F1 (x) + a1 F2 (x)} S1 (x , w )

T (x )

(T (x)=a2 F1 (x)+a1 F2 (x))

1
T (x )

T (x)S1 (x , w )

1
T (x )

Tm S1 (x , w )

> S1 (x , w )

(T (x)=Tm by assumption)

(given that

T (m)
>1)
T (x )

Similarly it can be shown that S2 (x, w) > S2 (x , w ). Hence (x, w) is pre

ferred to (x , w ).
Derivation of TX E[T (xa )]
Utilising the definitions given above (see pages 69 to 76) TX E[T (xa )] can
be written
Z
Z
(a2 F1 (xb ) + a1 )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
+
(a2 F1 (xa ) + a1 )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )
F1 (xb )= F1 (xa )=F1 (xb )
Z Z
F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb ) a1
(154.1)
a2

R R
First note that a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb ) a1
can be rewritten as
Z
Z F1 (xa )=F1 (xb )

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xb )= F1 (xa )=
Z
Z

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xb )=

F1 (xa )=F1 (xb )

F1 (xa )=F1 (xb )

F1 (xb )= F1 (xa )=
Z
Z
F1 (xb )=

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=F1 (xb )

(154.2)

Appendix 2

155

Also note that

Z

F1 (xb )=

(a2 F1 (xa ) + a1 )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=F1 (xb )

can be rewritten as
Z
Z

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xb )= F1 (xa )=F1 (xb )

Z
Z

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=F1 (xb )

F1 (xb )=

(155.1)

Adding 154.2 to 155.1 and using 154.1 we see that TX E[T (xa )] can be
expressed as
Z
Z
(a2 F1 (xb ) + a1 )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )=

F1 (xb )=F1 (xa )

F1 (xa )=F1 (xb )

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xb )= F1 (xa )=
Z
Z F1 (xa )=F1 (xb )

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb ) (155.2)

F1 (xb )=

F1 (xa )=

which can, in turn, be written as

Z
Z
a2 F1 (xb )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
+
a1 p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )=

F1 (xb )=

F1 (xb )=

F1 (xb )=F1 (xa )

F1 (xa )=F1 (xb )

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=
F1 (xa )=F1 (xb )

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb ) (155.3)

F1 (xa )=

The second and fourth line of the above equation are

Z
Z
a1 p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

F1 (xa )= F1 (xb )=F1 (xa )

Z F1 (xa )=F1 (xb )

F1 (xb )=
Z

= a1

F1 (xa )=

a1

a1 p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xa )=
Z

F1 (xb )=

p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

F1 (xb )=F1 (xa )

F1 (xa )=F1 (xb )

F1 (xa )=

p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

156

Appendix 2
Given that the integrals
Z
Z
F1 (xa )=

p()dF1 (xb )dF1 (xa )

(156.1)

p()dF1 (xa )dF1 (xb )

(156.2)

F1 (xb )=F1 (xa )

and
Z

F1 (xb )=

F1 (xa )=F1 (xb )

F1 (xa )=

integrate to give the same region (see below) it is possible to rewrite the
above equation as
Z
Z
= a1
p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
a1
p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
= a1 ( )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
=
a1 ( )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa ) (156.3)
F1 (xa )=

F1 (xb )=F1 (xa )

The third line of 155.3 is

Z
Z F1 (xa )=F1 (xb )
a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xa )dF1 (xb )

F1 (xb )=

F1 (xa )=

We know that (see below)

Z
Z
F1 (xa )=

F1 (xb )=

a2 F1 (xa )p()dF1 (xb )dF1 (xa )

F1 (xb )=F1 (xa )
F1 (xa )=F1 (xb )

a2 F1 (xa )p()dF1 (xa )dF1 (xb ) (156.4)

F1 (xa )=

which means that the third line can be rewritten as

Z
Z

a2 F1 (xa )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

F1 (xa )=

F1 (xb )=F1 (xa )

(156.5)

Appendix 2

157

Using equations 156.3 and 156.5 means we can rewrite 155.3 to get,
Z
Z
(a2 F1 (xb ) a2 F1 (xa ))p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
+
a1 ( )p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )
F1 (xa )= F1 (xb )=F1 (xa )
Z
Z
=
((a2 F1 (xb ) a2 F1 (xa )) + a1 ( ))
F1 (xa )=

F1 (xa )=

F1 (xb )=F1 (xa )

p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

(a2 (F1 (xb )

F1 (xb )=F1 (xa )

F1 (xa )) + a1 ( ))

p(F1 (xa ), F1 (xb ))dF1 (xb )dF1 (xa )

(157.1)

The figure below helps explain why

Z
Z
p()dF1 (xb )dF1 (xa ) =
F1 (xa )=

F1 (xb )=F1 (xa )

F1 (xb )=

F1 (xa )=F1 (xb )

p()dF1 (xa )dF1 (xb )

F1 (xa )=

The dashed 45 degree line is the F1 (xa ) = F1 (xb ) line. The blue region
is where F1 (xb ) > F1 (xa ).
Z

F1 (xb )=

p()dF1 (xb )
F1 (xb )=F1 (xa )

represents the probability of the light grey column and thus

Z
Z
p()dF1 (xb )dF1 (xa )
F1 (xa )=

F1 (xb )=F1 (xa )

represents the probability of being in the blue region.

R
F1 (xb )=F1 (xa ) p()dF1 (xb )
F1 (xb )
R F1 (xa )=F1 (xb )
F1 (xa )=

F1 (xa ) = F1 (xb )

p()dF1 (xa )

F1 (xb ) > F1 (xa )

F1 (xa )

158

Appendix 2

On the other hand

F1 (xa )=F1 (xb )

p()dF1 (xa )

F1 (xa )=

is represented by the dark gray area and

Z

F1 (xb )=

F1 (xa )=F1 (xb )

p()dF1 (xa )dF1 (xb )

F1 (xa )=

is also the probability of being in the blue area.

Why does equation 156.4 hold? That is, Why does
Z
Z
a2 F1 (xa )p()dF1 (xb )dF1 (xa )
F1 (xa )=

F1 (xb )=F1 (xa )

equal

F1 (xb )=

F1 (xa )=F1 (xb )

a2 F1 (xa )p()dF1 (xa )dF1 (xb )?

F1 (xa )=

\
Assume that in the bottom part of 156.4 F1 (xb ) = F\
1 (xb ) where F1 (xb )
F1 (xa ), then for each and every value of F1 (xa ), denote these values as
F\
1 (xa ) for convenance, we get a value
\ \
a2 F\
1 (xa )p(F1 (xa ), F1 (xb )).
The bottom part of is just the sum of these values for all F1 (xa ) and F1 (xb ).
We can pair this value with a corresponding value in the top line of equation
156.4. When F1 (xa ) = F\
1 (xa ) there must be value of the top part of the
equation where F1 (xb ) = F\
1 (xb ) so we get
\ \
a2 F\
1 (xa )p(F1 (xa ), F1 (xb ))
in the top line as well.
We can do this paring for all values of F1 (xa ) and F1 (xb ) and thus the
top and bottom parts of 156.4 must be the same.

Appendix 3: monotone comparative statics

The follow results are drawn from Van Zandt (2002). For a complete
discussion of the topic see, in addition to the Van Zandt notes, Milgrom and
Shannon (1994), Topkis (1998) and Vives (1999).
We start with the definition of increasing differences.
Let X R and Y R. Let u : X Y R.
Definition 1. The function u has increasing differences in (x, y)
if, for xL , xH X such that xH > xL and for y L , y H Y such
that y H > y L , we have
u(xH , y H ) u(xL , y H ) u(xH , y L ) u(xL , y L )

(159.1)

If this inequality is always strict, then u has strictly increasing

differences in (x, y).
Van Zandt makes three relevant remarks following on from the definition.
Remark 1. The interpretation of inequality 159.1 is that the
extra value of increasing x is higher when y is higher. However, this property is symmetric with respect to x and y. The
inequality
u(xH , y H ) u(xH , y L ) u(xL , y H ) u(xL , y L )

(159.2)

is just a rearrangement of inequality 159.1, but its interpretation

is that the extra value of increasing y is higher when x is higher.
One can check whichever inequality falls out more naturally in
an application.
Remark 4. Suppose that X is convex (i.e., is an interval) and
that u is continuously differentiable in x. Then u has increasing
is nondecreasing in y.
differences in (x, y) if and only if u(x,y)
x
If also this partial derivative is strictly increasing in y (except

160

Appendix 3
perhaps at isolated values of x), then u has strictly increasing
differences. (We can reverse the roles of x and y. For example,
if Y is convex and u is differentiable in y, then u has increasing
is nondecreasing in x.)
differences in (x, y) if and only if u(x,y)
y

and
Remark 5. Suppose that X and Y are both convex and that u is
twice continuously differentiable in (x, y). Then u has increasing
differences in (x, y) if and only if
2 u(x, y)
0
xy
for all x X and y Y . If inequality 1 is strict (except perhaps at isolated values of x or y), then u has strictly increasing
differences.
The above results have one decision variable and one parameter. What
happens with multiple decision variables and parameters?
Start with an expanded set-up. Let X = X1 Xm be be a set of m
choice variables, where Xi R for i = 1, . . . , m. Let Y = Y1 Yn be
a set of n parameters, where Yj R for j = 1, . . . , n. Let u : X Y R
be a utility function. Let : Y X be the solution correspondence for the
utility maximization problem. That is, for y Y ,
(y) = arg max u(x, y)
xX

The takeaway result here is given by Zandts Theorem 3.

Theorem 3. Suppose that
1. u has strictly increasing differences in (xi , yj ) for i {1, . . . ,
m} and j {1, . . . , n};
and
2. u has increasing differences in (xi , xk ) for i, k {1, ..., m}
such that i 6= k.
Then, for y L , y H Y such that y H > y L and for xL (y L )
and xH (y H ), we have xH xL .
But what about cases, like the proof of Proposition 90.2, where an increase in a parameter causes the choice variable to go down?
First note that the definition of strictly decreasing differences is the same
as Definition 1 of strictly increasing differences except that the inequality
is reversed. A function f (x, y) has strictly decreasing differences in (x, y) if
and only if f (x, y) has strictly increasing differences in (x, y).

Appendix 3

161

Thinking in terms of Remark 5 above the condition for the cross-partial

2 u(x,y)
0.
derivative becomes xy
For concreteness, consider suppose there are two decision variables and
one parameter, with the objective function u(x1 , x2 , y).
The takeaway result here is Zandts Theorem 4.
Theorem 4. Suppose that
1. u has strictly decreasing differences in (xi , y) for i {1, . . . ,
m};
and
2. u has increasing differences in (xi , xk ) for i, k {1, ..., m}
such that i 6= k.
Then, for y L , y H Y such that y H > y L and for xL (y L )
and xH (y H ), we have xH xL .
Now thinking about the proof of Proposition 90.2 in terms of Theorem
4 - note that in the proposition there are two choice variables, {z, G}, and
2S
2S
two parameters, {, } - the conditions z
< 0 and z
< 0 and the need
S
S
for and to be decreasing in G are requirement 1 and the condition
S
z is increasing in G is requirement 2.

Appendix 4: examples of poor SOE performance

One of the motivating forces for reform of state-owned enterprises was a

history of under performance by these firms worldwide. Some of the more
extreme cases of poor SOE performance that have been publicised include:
McDonald (1991) outlines the case of the Hindustan Fertiliser Corporation in Haldia, West Bengal, India. By 1991 the firm had been operating
for twelve years and employed twelve hundred workers. Yet up to that time
the enterprise had not produced a single kilogram of fertiliser for sale!
The Economist (Economist 1994) details similar experiences in Italy:
[o]ne example was a rolling mill at Bagnoli near Naples built by Italys
state-owned steel company ILVA. Designed to create jobs in a depressed
area where the Christian Democrats were strong, the plant, which took
nearly a decade to complete, was never used. In Sardinia, another area of
high unemployment, politicians made ENI, a state chemicals and energy
conglomerate, refit a coal mine, only to leave the miners idle but on the
payroll.
In France, the near-bankruptcy of then state-owned bank Credit Lyonnais is another example. In 1997 the French finance minister Dominique
Strauss-Kahn admitted that the bank had probably lost around Ffr100 billion (around US$17 billion). The bank had to be bailed out three times in
the 1990s. The total cost to the French taxpayer of the whole debacle has
been estimated at between US$20 and US$30 billion. See the Economist
(1997) for more on the affair.
With regard to the experience of the steel industry in the United Kingdom, Aylen (1988: 2) writes that in 1980/1 the [British Steel] Corporation
made a total loss of 1 billion on a turnover of just under 3 billion, earning
a place for a while in the Guinness Book of Records. [ . . . ] By 1980 British Steel was fundamentally uncompetitive, with cost per tonne almost a
third above those of West German producers, and by rights should not have
survived. About coal, Vickers and Yarrow (1988: 331) could write, [i]n
recent years, mostly as a consequence of the combination of overinvestment
in new capacity and the relatively slow rate of closure of inefficient collieries, the NCB [National Coal Board]s continued viability has depended upon

Appendix 4

163

large injections of Government finance. In 1983-1984, for example, operating

losses were covered by subsidies, known as deficit grants, amounting to 875
million.. During a House of Commons debate on nationalisation, denationalisation and renationalisation in 1991 the then Financial Secretary to the
Treasury, Francis Maude, said of the British experience with nationalised
industries: I do not wish to dwell on the record of nationalised industries
in Britain. It is a sad and depressing saga in our nations life. We all remember the British Steel Corporation, with its losses of 1 million every day
of the year. We all remember British Telecom being in the Guinness Book of
Records for the largest loss ever. We all remember the sloppy standards, the
waiting lists for telephones, the ever-rising prices, the dingy tale of failure,
the contempt for the customer, the craven management and the political
interference (Maude 1991).
The World Bank (World Bank 1995: 33-35) notes that in Turkey,
Turkiye Taskorumu Kurmu, a state-owned coal mining company, lost the
equivalent of about $6.4 billion between 1986 and 1990. Losses in 1992
worked out to about $12,000 per worker, six times the average national income. Yet health and safety condition in the mine were so poor that a
miners life expectancy was forty-six years, eleven years below the national
average. [ . . . ] In the Philippines, the performance of the National Power
Corporation steadily deteriorated from 1985 until the early 1990s. In 1990
the capital region alone lost an estimated $2.4 billion in economic output
due to power outages. By 1992-93, electricity was shut off about seven
hours a day in many parts of the country. In Bangladesh, in 1992 the state
sugar milling monopoly had twice as many office workers as it needed, or
about 8,000 extra employees. [ . . . ] Meanwhile, sugar cost twice as much on
the open market in Bangladesh as it did internationally. In Tanzania, the
state-owned Morogoro shoe factory, built in the 1970s with a World Bank
loan, never manufactured more than about 4 percent of its supposed annual
capacity.
Kikeri, Nellis and Shirley (1992: 2) state that [o]f particular concern
to governments is the burden that loss-making SOEs place on hard-pressed
public budgets. SOE losses as a percentage of gross domestic product (GDP)
reached 9 percent in Argentina and Poland in 1989; through the 1980s about
half of Tanzanias 350 SOEs persistently ran losses that has to be covered
from public funds; in Ghana from 1985 to 1989 the annual outflow from government to fourteen core SOEs averaged 2 percent of GDP; and in China
about 30 percent of SOEs were loss-making in 1991. The losses have important consequences: Mexicos minister of finance has noted that a fraction
of the $10 billion in losses incurred by the state-owned steel complex would
have been enough to bring potable water, sewerage, hospitals, and educational facilities to an entire region of the country (Aspe 1991).

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