Saturday, October 02, 2010

Why do corporations (firms) exist?

Economists used to wonder, from a theoretical perspective, why "firms" including companies, and especially large corporations, exist (aka theory of the firm). In 1937 Coase thought that while corporations didn't allocate labor and capitol as well as the market, this was offset by lower transaction costs.

Of course transactions costs in the net era are far less than in Coase's time, so this doesn't explain why corporations remain so entrenched.

This still seems like a valid question. Does knowledge work, in particular, scale all that well? Movies seem to be put together by loose coalitions of small to medium sized companies, why aren't more things done like that?

I suspect most people familiar with large corporations would agree that often the company seems much less than the sum of its parts. In particular, the absence of internal markets can make intra-company collaboration less efficient than market based collaboration. Corporations, on the inside, operate like the command economies of the Soviet Empire (or, for that matter, like today's China -- which is doing well for the moment).

I'm trying to put together a list of things that large corporations can do uniquely well. I wasn't at all impressed with the conventional "theory of the firm" list. Here's mine ...

  1. Act without the restraints of antitrust law. A large corporation can do many things that would require collusion to be done by smaller entities.
  2. Change laws, particularly accounting standards and tax laws, to favor large corporations and lower their cost of capitol. This creates a positive feedback loop where tax laws and accounting rules favor large corporations, which in turn influence laws and rules that favor large corporations and so on.
  3. Corporations can buy senators and lesser politicians, again without collusion.
  4. Corporations can engage in financial warfare, cutting off suppliers to smaller competitors, blocking access to capitol, and so on.
  5. Corporations can capture regulators.
  6. Corporations may be able to create and institute processes that allow them to do knowledge work with "average" knowledge workers instead of temperamental and expensive "stars". (I don't think this actually works, but a lot of effort is spent on this.)
  7. Corporations can buy A and above ratings from (corrupt) rating agencies.
  8. Once a corporation exists, it has an unusual ability to sustain itself even when its mission ends (like the inquisition)

Taking these items as a whole, it's apparent that once corporations are established, they are large and powerful enough to change their ecosystem to suit them. Rather like some primates.

I'll update my list as I get more ideas. Any suggestions?

See also:

My stuff

Other people's

Update 2/25/11: In a Krugman article I learn that Williamson won the Nobel in 2009 for work in the 70s on the theory of the firm. So Williamson extended Coase ...

Williamson argues that the firm is best regarded as a "governance structure," a means of organizing a set of contractual relations among individual agents. The firm, then, consists of an entrepreneur-owner, the tangible assets he owns, and a set of employment relationships ...

Personally I wasn't that impressed with the descriptions I read of Williamson's work, but Krugman likes it (emphases mine)...

Oliver Williamson shared the 2009 Nobel mainly because of his work on a question that may seem obvious, but is much less so once you think about it: why are there so many big companies? Why not just rely on markets to coordinate activity among individuals or small firms? Why, in effect, do we have a lot of fairly large command-and-control economies embedded in our market system?

Williamson answered this in terms of the difficulties of writing complete contracts; when the tasks that need to be done are complex, so that you can’t fully specify what people should do in advance, there can be a lot of slippage and strategic behavior if you rely on market incentives; in such cases it can be better to do these things in-house, so that you can simply tell people to do something a particular way or to change their behavior.

... there are times when it’s better to rely on central planning than to leave things up to the market...

Krugman's "Central planning" comment sent the usual suspects frothing mad. They've obviously never lived in a large corporation. I have. Krugman is spot on.



Anonymous said...

Large corporations can have global resource sharing. This is true for advertising and marketing (opening a new McDonalds is more likely to succeed than Joe's Hamburger Hut), but also in terms of financial and physical resources. It is ok if the new branch takes a few years to become profitable because the rest of the company is making money and 'opening X new branches' looks good on the annual report.

This actually comes down to hedging as well I think. Walmart has branches everywhere in the U.S. so to some degree they are better able to weather local downturns in Mississippi or Michigan. There is no way a purely local business can hedge like that.

Some of these advantages are also conferred by franchising, but not all.

Of course, the reverse holds true as well. It may be that my local Circuit City was profitable, but it still went out of business when the whole company toppled.

This whole topic is interesting, and I also think you should look at it from a labor market point of view. Corporations seem to be able to compete exceptionally well in the labor market, not just in goods or services markets.

Augustine Hope said...

I would ad:

8. Grow their business (including IP) by buying smaller competitors.