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The Foundation of Firm Existence

January 2012 Corporate

After reading Tim Smith’s November 2011 Wiglaf Journal Article, Occupy Movement and the Existential Purpose of a Firm [i], I wanted to offer another theoretical approach to discovering key reasons for firms to exist.  Appreciating Adam Smith’s “Invisible Hand” contributions to market coordination based on supply, demand, and price, and understanding his argument of allowing markets to allocate goods and resources based on individual incentives, I pose the question, “How much value is created by managerial competency and organized business entities?”  In other words, why do firms exist?

 As a follower of Armen Alchian’s academic works in graduate school, I always find myself referring back to his incentive driven theory on behavior bounded by rationality.  Pulling from his work on economic organizations, business firms are created when the sum of production from individuals working as a team exceeds the sum of production from individuals working alone.[ii]  For example, 5 individuals working in a gristmill produce 5 pounds of flour each day working alone (Total: 25 pounds of flour).  If the same 5 individuals work as a team where specialization is respected, they can produce 40 pounds of flour per day.  If maximizing production is the foremost objective, team production would be favored over individual production.  In this scenario, a group of individuals working together would provide a greater economic benefit, therefore validating the need for a firm.

Of course, team production brings about consequences such as shirking by team members and monitoring of such actions.  Electing managers to supervise workers and mitigate shirking, and offer residual claimants increases the opportunity cost for team members performing at a less than optimal production capacity.  Establishing a hierarchy of management within the firm creates a production environment bounded by sharing the largest potential benefits possible among team members.

In addition to Alchian and Demsetz’s contributions to economic organizations, Ronald Coase provides evidence supporting the existence of the firm, worthy enough to win the 1991 Nobel Prize in Economics.  His main proposition rests on the minimization of transaction costs incurred by firms interacting in the market to provide goods or services to customers.  Coase states in his academic article, The Nature of the Firm[iii], “the main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.”

For example, in order to produce a single pencil, 10 different processes must occur.  To successfully provide a pencil to a consumer if a firm was not in existence, 10 separate contracts would be have to be fulfilled.  A contract between a wood worker and individual to mill the pencil would be necessary and another with a lead installer and the same individual would be needed as well. To enforce each contract would require significant effort and be quite expensive.  The creation of a firm would be the remedy to cut the cost of enforcing each contractual agreement.  Instead of allowing outside entities to be involved in the production process, individuals combine efforts and establish firms.

Firms exist not only to provide a customer’s needs profitably, but also to maximize firm production through teamwork when it is the most efficient means and minimize transaction costs.  Although profitability may be the end result of every business, better profit margins are realized due to monitored team production and low transaction costs.

 

References

[i] Tim J. Smith, Occupy Movement and the Existential Purpose of a Firm, Wiglaf Journal, November 2011

[ii] Armen Alchian and Harold Demsetz, Production, Information Costs, and Economics Organization, American Economic Review 62, December 1972, pp. 777-795.

[iii] Ronald Coase, The Nature of the Firm, Economica, November 1937.



About the author

Curry W. Hilton is a senior pricing analyst at Wiglaf Pricing and economics lecturer at Elon University. His primary research interest focuses on price segmentation, negotiations, and firm strategy.

Curry W. Hilton
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