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September 18, 2004

The Nature of the Firm

Professor Bainbridge of professorbainbridge.com was here yesterday to present a scholarly paper. I won't comment here on his paper, partly because it was stimulating enough that I spent a lot of time not listening to him but thinking about one of the big, classic, issues it raised: what is a firm? (I would actually pay closer attention to a boring talk, because a boring talk leaves the listener's mind completely blank, unable to do anything but keep listening in the hope that the speaker will eventually say something to make a few neurons fire off.)

... One answer might be that a firm is a collection of long-term contracts. One or more people provide capital in some long-term contract with each other, and then hire workers using long-term contracts and materials using short-term contracts.

The problem with that is that something we think of as a firm can exist for centuries without any long-term contracts at all. Consider a partnership which hires employees at will. The partners pool their capital, but are free to break up the partnership at any time. The employees are hired with the expectation that they will serve for life, and in fact they do serve for life, but they are free to quit at any time without penalty, and the firm can fire them without cause at any time. The inputs into production-- capital and labor-- don't break away, though, precisely because break-up is so easy: everybody recognizes that they had better behave or the other side of the transaction will pull out.

Rather, a firm seems to be a collection of inputs that mostly keep working together as time passes. It is like a human body-- a collection of cells that mostly keep working together, even though individuals come and go.

It is, of course, no accident that the inputs keep working together.

They might have signed a contract, of course, e.g., the capitalist agrees to pay the worker $30,000 in exchange for 8 hours per day of labor for one entire year. Note, however, that the contract is not the main thing. If both the worker and the capitalist agree, they can void the contract. If the worker gets an outside offer of $50,000, he will leave, because the worker will want the higher wage and he will pay enough to the capitalist that the capitalist will be happy to release him.

But the reason they signed the contract in the first place was that they expected it to be efficient for them to work together for a year, and the contract puts enough glue on the status quo to allow for better planning, avoid hold-up, avoid bargaining and squabbling, and make very clear the intent of each side. (It is often forgotten how useful written agreements are as simple clarifications of intent, regardless of whether they can be enforced.)

If they didn't have a contract, they might still work together for a year. They would still be a firm. The only difference is that a smaller outside offer will be able to lure away the worker. If they had a contract, an outside offer of $30,500 might be too small for it to be worth the worker's while to spend time haggling with the capitalist over his release fee. If they do not have a contract, the worker might decide to leave. But even then, the worker might stay, because an extra $500 in wages might not be worth the transition costs to him.

Coase's famous 1937 article, "The Nature of the Firm", talks about how within a firm Authority is used, whereas between firms, Prices are used to transfer resources and commands. Prof. Bainbridge noted that some people (e.g. William Klein, also of UCLA) object to this because often there is no long-term contract, and hence no legal Authority. If employment is at will, then whenever the employee dislikes an order, he can quit. I was just reading Thomas Sowell's excellent memoirs, and he gave an example: employed by Western Union as a messenger in his youth, he was told at the end of one workday to accept an overtime assignment or be fired. He had another job he needed to leave for, so he quit Western Union on the spot.

But legal authority is not the only kind of authority. Consider my firm with no contracts, just customary employment. The custom is for the worker to accept the capitalist's orders at a steady wage. Some orders are more unpleasant, and if it was a one-shot job the worker would bargain for a higher wage. But since he knows the relationship will continue, he doesn't bother. Other days the orders will be pleasant, and he will be overpaid at that same flat wage, so it all evens out. If it looks like it won't, that is when bargaining will reappear. In the meantime, though, Authority is in place, not Prices/Bargaining.

This approach does change the interpretation of Coase. Authority vs. Prices becomes Long-Term Fixed Relations vs. Short-Term Fluid Relations, rather than Legal Authority vs. Arms-Length Sales. The "law" part of it shrinks.

Posted by erasmuse at September 18, 2004 10:14 PM

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