In the final chapters of Organizing Entrepreneurial Judgment, Nicolai Foss and Peter Klein set out to theoretically account for the existence, boundaries and internal organization of the firm. They continue to focus on the central role of the entrepreneur in explaining the firm. Chapter seven is the point at which Foss and Klein really begin to connect and forge the theory of the firm with the theory of entrepreneurship.
The Emergence of the Firm
In explaining the existence of the firm, Foss and Klein focus on the prominent roles played by transaction costs, heterogeneity of assets, and experimentation. Foss and Klein argue, while drawing support from other scholars, that it is particularly difficult for entrepreneurs to communicate their judgment and therefore the value of their service to other market participants. They write, “Firms may emerge because those whose services are most difficult to measure become entrepreneurs, employing and supervising others, and committing their own capital to the venture.” The extraordinarily high transaction costs make it necessary for an entrepreneur to be part of a firm to exercise his judgment. Here, Foss and Klein establish that the firm as a minimum consists of the entrepreneur and the assets he owns.
Within the firm, as has been touched on already, heterogeneous assets are combined in the production process. Foss and Klein argue that experimentation with these assets is a central function of the firm. They define “experiments” to mean a range of things including assembly lines, implementing organizational architecture, inventing new products, etc… The entrepreneur arranges these experiments according to his judgment. The various attributes of assets are created and discovered through this entrepreneurial experimentation within the firm.
Through this process of experimentation, the firm alleviates coordination problems that arise in an economy. Foss and Klein state that coordination problems, “arise when those who deliver parts or carry out activities are not aware of the need for mutual adjustment, or do not have the incentive to make their activities mesh with those of others.” If all individuals are completely self-directed in exchange, these coordination problems would be more severe. When individuals come together and work in a firm, combining their knowledge and abilities to combine assets owned by the firm, these problems are alleviated.
The authors argue that submission to the authority of the entrepreneur by the employees of the firm may be the least costly way of organizing experiments with assets. By authority, FK mean “the entrepreneur has the right to redefine and reallocate decision rights among team members and to sanction team members who do not use their decision rights efficiently.”
The Boundaries of the Firm
Foss and Klein argue that an understanding of ownership rights is essential to understanding the boundaries of the firm. Here, Foss and Klein cite the literature coming from new property rights theory which argues that ownership rights over assets strengthen a person’s bargaining position when making contracts. Such ownership rights will also heavily influence one’s decision to either invest or not invest in developing a business idea.
Foss and Klein define ownership in terms of “having the residual control rights over a resource, especially the right to exclude others from a resource.” In essence, ownership rights are necessary for an entrepreneur to reap the rewards from his judgment and carrying out his ideas. For the entrepreneur to secure the proceeds from his venture, he must acquire the ownership rights of the resources he will use in his production venture. The boundaries of the firm are determined by the amount of resources the entrepreneur owns. An increase in resources leads to an expansion of firm boundaries while a decrease in resources leads to a contraction of boundaries.
Foss and Klein also make mention of and support the work done by Giovanni Gavetti and Daniel Levinthal on cognitive representations held by entrepreneurs. In summary, Gavetti and Levinthal emphasize that different individuals have different ideas of how to best combine assets to bring the best products to the market place. They call these ideas and speculations about production in the mind of entrepreneurs “mental models”. Foss and Klein argue that accounting for the heterogeneity of these mental models gives a solid framework for understanding firm boundaries. These mental models change over time causing firm boundaries to change as well. This helps avoid the misleading conclusions often drawn by those analyzing the economy from an equilibrium standpoint.
In equilibrium, any reversals in firm behavior represent errors and market inefficiencies. But reality is not equilibrium. Reality is that we live in a changing, dynamic world. What FK call a “process oriented perspective” is more fitting to analyze the world we live in. Foss and Klein write that from this perspective, “A divestiture of previously acquired assets may mean simply that profit-seeking entrepreneurs have updated their forecasts of future conditions or otherwise learned from experience. They are adjusting the structure of heterogeneous capital assets specific to their firms.”
Foss and Klein close their chapter by drawing upon economists Ludwig von Mises and Murray Rothbard to explain the limits of firm boundaries. In short, Foss and Klein conclude from the literature that no firm can become so large that it is both the unique producer and user of an intermediate product. Firms would be unable to calculate profit and loss within different divisions of the firm and therefore unable to efficiently allocate resources between these divisions. This is because there would be no market for the “intermediate product” in question to determine its price.
Mises convincingly argues that private ownership of factors of production is necessary to have markets for asset prices. If no exchange exists for a given asset (if it is entirely produced and used by one firm) then it cannot have a meaningful price. If it does not have a meaningful price, then there is no way to determine if the cost of producing the good is profitable or not. This is the basis for Mises argument that a socialist economy could not survive. In a purely socialist economy, all resources would be under the ownership of a single entity. There would be no private ownership of assets, therefore no exchange and thus no meaningful asset prices.
To conclude the blog on chapter 7, I will simply cite the summary of the chapter given by Foss and Klein. They write:
“Firms exist as manifestations of entrepreneurial judgment-to realize their visions, entrepreneurs must take possession of resources, and, in a world of heterogeneous assets and knightian uncertainty, they are continually combining and recombining these resources. Doing so as a network of independent contractors, each possessing residual income and control rights over his own resources, would be prohibitively costly. Hence it makes sense for entrepreneurs to own complementary resources.”