Entrepreneurship and the Economic Theory of the Firm

Beginning with chapter six of Organizing Entrepreneurial Judgment, Nicolai Foss and Peter Klein focus on actually making the connection between the theory of the entrepreneur and the theory of the firm. Specifically in chapter six, Foss and Klein dive into existing theories of the firm and the role for the entrepreneur within those theories. While Foss and Klein critique the form of theories of the firm for crowding out the entrepreneur, they also focus on insights that can be pulled from these theories and how to build upon them for a greater understanding of entrepreneurship within the firm.

Established Theories of the Firm

Neoclassical Theory

In earlier chapters of their book (touched on in my earlier posts), Foss and Klein argue that neoclassical economic theory leaves much to be desired in understanding the firm. Within the neoclassical school, FK argue “The firm is a set of cost curves, and the ‘theory of the firm’ is a calculus problem. There is nothing for an entrepreneur to do.” The firm becomes a “black box” in which input factors of production are transformed into an output of finished goods to be sold on the market. FK note that this treatment of the firm is unable to account for many real-world business practices (e.g. vertical and lateral integration, mergers, franchising, research joint ventures, etc…)

Coase’s Theory of the Firm

Economist Ronald Coase saw that the neoclassical theory of the firm did not satisfactorily explain why firms come into existence. He emphasized that a firm comes into existence to reduce the transaction costs involved in production processes. Coase saw that there was a cost to discovering relevant prices for goods and secondly a cost for executing separate contracts for all the transactions necessary in coordinating production processes. The example of producing a house I used in my previous post demonstrates how complex production can be and the immense amount of contracts which need to be made. Coase argued that inside the firm, the entrepreneur is able to reduce transaction costs by coordinating activities himself. He claimed that the main tasks in establishing a theory of the firm is to study the existence of the firm, the boundaries of the firm and the internal organization of the firm.

Coase’s view of the entrepreneur contrasts with Frank Knight’s view. To Coase, the primary role for the entrepreneur is to compare the costs of “organizing specified transactions in given governance structures.” The main focus for Coase is whether the entrepreneur will contract with independent suppliers and distributors or hire employees to work under him. This is how he studies the boundaries of the firm. In contrast, Knight focuses on the quality and quantity of the assets owned by the entrepreneur. Knight is concerned with ownership boundaries (ownership of assets in total) more so than solely employment boundaries. One could imagine an entrepreneur in Coase’s theory who does not own assets. Ownership is a must in Knight’s conception.

Modern Organizational Economics

Foss and Klein argue that there are four main strands in modern economics which contribute to a theory of the firm. They are transaction cost economics, the nexus of contracts view, agency theory and team

theory. A common theme within these strands is a belief that economics must move beyond analysis done while assuming perfectly competitive markets to better understand the firm. FK also note that within all these theories, “relevant units of analysis can be matched to particular alternatives to satisfy some efficiency criterion.”

Foss and Klein give a simple example of game theory to demonstrate the framework in which the firm is analyzed in modern economics. I should clarify that I do not have much knowledge of game theory myself. I will draw heavily upon their quotes in order to not misrepresent their analysis of the theory. In essence, game theory is a way to demonstrate that humans will not pick the utility maximizing (most efficient, first best) arrangement when making contracts with one another. In explaining game theory, FK state “agents who anticipate opportunism on the part of their contractual partner will refrain from taking efficient actions or making efficient investments.” Essentially there are incentive conflicts which prevent the “most efficient” contracts from being made when two individuals are bargaining with one another. Much of this stems from fear within each individual that the other individual will not honor the agreement. In regards to how this relates to the firm, FK write “transferring a transaction or activity from a market to an organization context means that the agreement will be honored.”

The Modern Theory of the Firm and Entrepreneurship

Foss and Klein critique the modern theory of the firm for making some unrealistic assumptions which crowd out the role for the entrepreneur. One of them being that these theories make very strong assumptions about the cognitive powers of agents. The theories assume that cognitive homogeneity, correctness and constancy are characteristic of all agents. Agents all have common knowledge about the structure of the theoretical “game” as well as payoffs and strategies within the game. This treats individuals as if they have an “identical model of the world”.

A second critique is that everything is given in the model. All decision alternatives are given. There is no need for experimentation; no learning takes place; and there is no place for entrepreneurs to come up with new, innovative contractual or organizational forms. FK explain, “Players have identical, shared beliefs about other players’ strategies and these beliefs are consistent with some equilibrium in the game.”

These modern theories also leave little role for individual motivation. Behavior is almost entirely modeled as a response to some external force. Experience has proven that intrinsic motivation from within is particularly important for being a successful entrepreneur. These theories unfortunately neglect such motivation. These theories also neglect heterogeneity and unrealistically assume that firms possess the same capabilities.

Foss and Klein also argue that behavior within and among firms should be analyzed as a process over time rather than by a moment-by-moment maximization problem. They write, “If firms are composed of heterogeneous, but complementary capital assets, with entrepreneurial judgment required to determine the best combinations, then firms are formed and reformed as processes of experimentation and learning, not moment-by-moment optimization.” Foss and Klein also note that these theories engage in “suppressing margins” which they define as “prohibiting the agent from knowing or doing

certain things within a given interaction structure (typically, by choosing extreme values for some variables).” For example, many of these theories assume that agents have either full knowledge of something or no knowledge at all on the subject. This kind of modeling uses an extreme “on-off” approach in which reality is not modeled very well. FK point out that under such constraints “agents are not allowed to exercise entrepreneurship to somehow circumvent the interaction problems caused by the suppression of margins.”

Existing Links between the Entrepreneur and the Firm

Having given the critiques above, it ought to be clarified that Foss and Klein are mainly critiquing the form of modern theories of the firm. This does not keep them from finding much constructive insight in these theories towards building a theory of the firm. While this chapter focuses on analyzing the form taken by modern theories, they close the chapter by noting some key insights provided by these theories. One is that an entrepreneur needs to transact with other individuals to exercise his judgment as embodied in a business plan. Additionally “an entrepreneur must decide on contractual safeguards to protect entrepreneurial returns in designing the business model.” They also note that these theories rightly deduce that the governance of a transaction may change over time.

The tone of FK’s writing clearly conveys that they aim to work together with all economists in these fields to incorporate insights and build a sound theory of the firm which incorporates the reality of entrepreneurship. They see particular potential for incorporating the entrepreneur in the contractual approach to the firm. This is the focus of their next chapter.

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One Response to Entrepreneurship and the Economic Theory of the Firm

  1. Stephen Davies November 28, 2014 at 11:13 pm #

    Wow! Great summary of the Chapter and really useful. Thanks for doing this!

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