Firms as the Basic Units of Economic Activity - Essay Example

Introduction The comment provided above by G. B. Richardson delineates his views on economic activity and how it is organised in the marketplace.Richardson believes that firms are the basic units of economic activity and that firms are actually well planned in most of their behaviour. Moreover, he contends that firms tend to interact with each other in a planned fashion such that they tend to act as independent entities that are devoid of each other’s existence. However, if this were the case then theoretically all activities carried out by firms would never result in disputes since they would be well planned and thus well executed. This is not the case in real interactions between firms. In order to dissect the concept further it would be pertinent to explore different points of views on the firm and its unique position in the market. The views of Coase, Penrose and finally Richardson will be explored in this paper in order to see how firms interact to form market structures and how these structures require the assistance of the law. 2. Defining The Firm Within the perspective of business, a firm can simply be seen as an organisation that is involved in the provision of goods and services or a combination of both to consumers1. Here it must be kept in mind that the work of such an organisation is determined by market consumption otherwise this definition would fit other organisations as well such as military organisations and the like. Therefore, the actions of a firm can be seen as being driven through competition in the market that requires the efforts of a team. Another major consideration to look into over here is the basic unit that composes the domain of economic activities. Firms are conglomerations of people who are geared to a common purpose namely the creation of economic value. In themselves, firms are actually composed of individuals and so individuals must be the basic unit of economic activity. This would tend to make a lot of sense in the theoretical realm. However, the more practical perspectives will reveal that one man acting alone in the form of an entrepreneur will not be able to amount much. This lends credence to the belief that an entrepreneur will tend to recruit the services of other individuals in order to perform larger and more complex economic functions. This idea has been espoused by Coase who adds another dimension to hiring the services of other individuals. 2.1. Coase’s Ideas on The Nature of the Firm The earliest ideas as to why firms exist in an economy were presented by Coase2 in his article The Nature of the Firm (1937). It was recognised well before Coase’s ideas that firms existed but there had been little investigation into their need for existence. There was a visible change in emphasis of the dominant economic theory after the First World War. Analysis tended to shift from the level of industry (which relied in large part on market analysis) to the level of individual firms. This move can be attributed to a change in thinking over perfect competition. Previously perfect competition was seen as an effective model to delineate how firms behaved. Up till this point in time the emphasis of the economic theory had been to study the markets in order to understand their behaviour. There had been little work on understanding reasons as to why firms existed. In themselves, markets are guided Coase holds that in a perfect market, that is efficient, it would make sense to contract out services rather than hiring people. In Coase’s time the traditional theory of economics provided that entities that were best at providing goods or services were already providing these goods and services because the market was efficient. This would then have the implication that any entrepreneur looking for goods and services would tend to contract out goods and services to the best providers3. However, the actual market practice was just the opposite – entrepreneurs looked to hire people instead of contracting out services. It is only in recent years that outsourcing has gained popularity as a viable means of providing products and services. In the thirties or the forties there was hardly any concept of outsourcing as it exists today so Coase’s questions held great value. Coase tried to investigate the circumstances which made sense for an entrepreneur to hire people rather than outsource these functions. Through his investigation, Coase came to the conclusion that dealing with the market had its own transactional costs that were additional to the cost of goods and services being procured. The ideas of Coase can be understood better in the context of a relevant market example. Let’s suppose that an entrepreneur handles construction contracts and tends to procure management services for every contract rather than hiring permanent management. In order to procure the services of a manager for a construction site, the entrepreneur would need to initiate a complete hiring process. This hiring process would require its own unique costs such as advertising, holding interviews for candidates, screening measures and the like. When the total cost of procuring a manager is considered, it becomes clear that they are split into two portions. The primary costs result from the wages paid to the manager while the secondary and tertiary costs result from latent market transaction costs such as those mentioned above. In addition to the costs outlined above, Coase suggested a number of other transactional costs. The major market transaction costs identified by Coase included costs for search and information, keeping trade secrets, bargaining, policing as well as enforcement costs. Coase suggested that when a business can provide these services internally (such as through already hired managers), it would make sense for individuals to come together to create a firm. However, Coase has also noticed that not all products and services can be procured internally so certain functions have to be handled by outside entities. He has also suggested that as the size of a firm increases beyond a certain threshold, there are “decreasing returns to the entrepreneur”. This would occur as overhead costs would swell up making managers more susceptible to errors during resource allocation. Resultantly, these mistakes would cost the firm negatively. Using these perspectives, Coarse argues that the size of a firm is a function of the firm’s internal and external contractual relationships. The optimal balance between the internal and external contractual relationships of a firm will determine its size. Initially increasing the size of a firm would be advantageous but beyond a certain threshold negative costs would set in. This would make firm expansion uneconomical and hence impossible4. It must be related here that the contractual relationships of a firm may pose significant costs. This could result from improperly construed contracts that tend to expose the firm to unwanted liability or other such risk exposure. In these terms, the legal transactional costs of a firm can be seen as having a significant bearing on the firm and its functions in the market. The legal frameworks that surround a firm also tend to define it both in its form and its interaction with the market that the firm operates in. The primary function of the lawyer associated with firms is to minimise the risk exposure of the firm in order to reduce the cost of legal transactions. Again the size of the legal functionaries and their method of attending the firm’s legal needs (employed or outsourced) would depend on the firm’s affordability of such functions. Legal attachments may be employed in the firm as legal advisors or legal functions may be outsourced to outside legal practitioners. The latter approach is usually preferred for small and medium enterprises as well as for some large enterprises. However, it is standard practice to employ a legal team in large enterprises. In addition to this, Coase also provides another reason for sizing a firm that depends on external market competition. He contends that the size of a firm is also determined by the costs of organisations borne by other entrepreneurs. This would indicate that a firm would continue to grow as long as its transactional costs were lower than that of the competition. At any point in time that these transactional costs became equal to those of the competition, the growth of the firm would stagnate. Alternatively, if the transactional costs of one entrepreneur were to increase beyond the transactional costs of the competition then the subject firm’s size would tend to decrease5. This could come about due to external as well as internal factors such as tax measures, foreign competition, internal problems of the firm etc. The ideas presented by Coase can be seen as the earliest neo-classical attempts at defining the firm in relation to the market it operates in6. The explanation provided by Coase provided grounds for further debate on the issue of firms and their relationship to the wider economy. It has to be realised that when Coase formulated his ideas, international trade was not this common. Moreover, the economies that Coase tends to delineate have also evolved over time to assume new forms. Additionally new means of thinking over this issue have also emerged. Coase’s manner of defining the firm and its relationship to the market is based on the transaction cost theory7. 2.2. Penrose’s Ideas on the Firm The research of Dr. Penrose at John Hopkins University concluded that the contemporary theory of firms was unable to explain the growth of firms8. Penrose provided the idea that firms defined in theory are not comparable to the “flesh and blood” firms that entrepreneurs are used to interacting with. In a sense Penrose’s model of the firm can be called as the biological model of firm growth9. The firm has been likened to a biological organism that requires time and resources in order to come to the optimal level of production. The firm has been theorised by Penrose as being analogous to an organism that requires active input in order to grow. Being an organism means that the firm has been envisaged as an independent entity though no limits have been placed on its interaction with other entities in the market. The expansion of the firm has been linked to human resources because these are required in order to deal with management of change. The particular human resources that are required by a firm to expand must come internally and since such resources are internal so they are scarce. The scarcity of such resources would indicate that more human resources need to be procured from the market. However, the recruitment of new resources is not an end by itself but rather a means to the end. By hiring more human resources the firm is actually procuring greater resources to manage the change that stems from expansion. A typical problem associated with procuring new resources is the fact that new recruits cannot be expected to function effectively overnight. This limitation means that these resources can only be utilised fully once they are functional and that in term requires time as well as other inputs. Penrose holds that the growth process of firms is effectively dynamically constrained. This has been likened by other researchers to a biological model of growth for the firm10. Penrose creates the conception of “productive opportunities” that can be utilised by a firm in order to grow. The model presented by Penrose for the firm mandates that productive opportunities be identified and worked towards using typically human resources. While Penrose declares that productive opportunities are both enabled and constrained but at the same time she declares that these productive opportunities can be used by entrepreneurs to enhance business through networking11 12. In such circumstances the networking between firms is undeniable and tends to raise questions as to the very nature of the firm again. Another issue of importance in more recent times has been the interaction between these productive opportunities that have created unique conglomerations that were not identified before. One typical example of such a unique and novel conglomeration are supply chain networks. A supply chain network in itself is not a firm (being evaluated as a separate entity) but rather a causation of their interactions. However, if a supply chain network or any other such unique and novel conglomeration is seen closely it can be observed that these conglomerations depend on the gathering and application of knowledge and skills. Thus another strong contribution of the Penrose model to the firm theory is that firms require and in large part depend on knowledge and skills. The required knowledge and skills are typically classed in the form of networks that can be seen as resulting from the interaction of firms. Again it can be seen that the existence of firms is both dynamic and yet constrained in itself. Another notable aspect is the fact that the knowledge and skills that make up firms and the networks of their interaction are comprised of legal issues amongst other forms of knowledge and skills. Legal knowledge and skills are essential to the function of any organisation since legal technicalities are used to govern the networks that are formed by firms. Thus a firm tends to create economic value since it is composed of knowledge and skills that in turn help it to create competitive advantage and business linkages. Also legal knowledge and skills are essential to moderating and regulating these business linkages. Therefore in order for a firm to create economic value, legal knowledge and skills are both necessary and important. The primary duty of a lawyer in this scenario is to regulate the various business linkages and to ensure the health of the formed networks. As previously mentioned, these networks may be conventional or unconventional but they will still be provided coverage through the use of legal knowledge and skills. This also indicates that legal knowledge and skills are equally applicable to all forms of business linkages and hence to firms. While this discussion presents one method of looking at firms and their linkages, the views of G. B. Richardson are a little differentiated. 2.3. G. B. Richardson’s Views on the Firm The text presented at the start of this paper highlights the paradigm shift that Richardson has taken over the years regarding the firm and its relationship to the overall market. Richardson contended previously that firms in themselves were “islands” signifying that he saw them as separate entities capable of being identified as such. These islands according to Richardson underwent “planned coordination in a sea of market relations”13. When compared to previous theorists such as Coase and Penrose it is noticeable that Richardson believes in the importance of relations in the market between firms. However, where Richardson and other theorists fall apart is how firms are defined. While Richardson tends to define firms as separately identifiable entities, Coase shows no such tendencies. However, the biological organism model presented by Penrose can be seen as somewhat related to a separate identity in that biological organisms are well differentiated from each other. On another note, as far as the relationships between firms are considered, Coase delineates the relationships as being construed only when they can bring in positive fiscal benefit to the involved parties. In a somewhat similar manner Penrose holds that firms will create relationships amongst themselves in order to expand or to grow. From Penrose’s point of view the creation of economic value can be replaced with growth of the firm. However, Richardson tends to differ from both in that he introduces “planned coordination” as being critical to the relationship between firms. Richardson’s previous views provide that all activities within the “island” firms and their neighbours are carried out in a systematic and planned manner. This view has since been rejected by Richardson himself to pursue an approach that tends to add the element of spontaneity in the relationships between organisations. The theoretical concept previously provided by Richardson sought to delineate how economic activity was being coordinated. The key pillar of this conception was planning within the realms of the firm and within the domains of its relations with other firms. Another major pillar was the price regulation mechanism that provided for the relationship between firms as well as firms and customers14. The theory of the firm also tended to favour the planning view at the time but a closer examination reveals otherwise. Richardson argues in other pieces of work that the division of labour is critical in determining the state of relationships between firms. He presents the example of manufacturing a pin using different techniques including a one man show where the iron ore is extracted, purified, drawn and then the pin manufactured. He contrasts this idea with the manufacturing of pins using specialized task assignments such as when one person extracts the iron ore, another purifies it, another person draws the resulting steel and yet another person manufactures the pin. Understandably the time required in the former process is far too much with far too little production volumes to be justified. The latter process enables far greater production volumes in far less time and is hence the chosen method. This brings the next issue in sight – how to decide if operations need to be outsourced or processed in house. Richardson suggests that operational outsourcing is only justified when processing in house is not economically feasible. This may occur for example if installing new equipment and training new labour is far more expensive than procuring external services. Another limitation presented by Richardson is the minimization of risk. When operations are being internalized, the carried risks are internalized as well leading to enhanced risk exposure for the firm. Consequently firms may choose to limit risk by outsourcing certain operations15. These approaches outlined by Richardson in his latter ideas also espouse the size and growth of the firm. As per Richardson, the size of a firm will continue to grow till the overhead (or typically administrative) costs can be justified in creating economic value. When more economic value cannot be created by committing new resources then there is little need for the firm to expand. Another notable issue about Richardson’s latter approach is how he has disentangled the firm from being an entity with fixed borders. In his own words16: “One may find that firm A is a joint subsidiary of firms B and C, has technical agreements with D and E, sub-contracts work to F, and is in marketing association with firm G. So complex and ramified are these arrangements that the skills of a genealogist rather than an economist might often seem appropriate for their disentanglement.” It can be seen from Richardson’s comment that firms are highly entangled with each other so much so that their structures may become liquid and the fine line of distinction between a concrete firm structure and an amorphous entanglement may disappear altogether. For most general purposes it may be assumed that firms as separate identities do not exist in the modern marketplace but instead a number of intermediate structures exist in their place. These structures may assume the form of subsidiaries, joint agreements, supply chains and other such features. The contention will stay the same – creation of economic value but the structure of the market will be defined by intermediaries rather than firms as the basic unit. Here the contribution of the economic lawyer comes into focus. All of the processes outlined by Richardson’s comment above are subject to legal arrangements. Whether one speaks of subsidiaries, technical agreements, sub-contracting or marketing association, there is a definite need to espouse the arrangement into a set of contracts that abide the prevalent law. As economic value is being created, these legal rules allow firms to transact business with each other while minimizing risk. As related before and as per Richardson’s ideas it is clear that the minimization of risk is essentially adding economic value to the firm’s operations. Hence, the lawyers employed or contracted by firms tend to add economic value in their own ways and tend to deal with the relationships between firms. Moreover, these relationships may be spontaneous (as delineated by Richardson’s latter ideas and by Penrose) and would therefore need regulation in order to make them acceptable and enforceable. The economic lawyer must essentially understand how the market operates including the existence of firms both in their concrete and liquid aspects so that they can add value by minimizing risk exposure for the firm. 3. Conclusion Since Coase’s time other thinking has made its way through including reconsiderations of the transaction cost theory, managerial theories, behavioural theories, firm economies as well as other models such as those presented by Williamson. These modes of thinking each present their novel perspectives on the nature of the firm and the market and the manner in which it is organised. However, the basic contention in all of these perspectives remains the same – creation of economic value. Coase contended that firms are created when an entrepreneur must procure services at transactional costs lower than those of the market. In this manner the firm may continue to grow until overhead costs cannot be offset by the created economic value. Penrose adds to this idea by contending that firms tend to add economic value through knowledge and skills that tend to offer it competitive advantage. Since individuals are unable to create such knowledge and skills on their own so it only makes more sense to act collectively as a firm. Moreover, the growth of firms is constrained and dynamic at the same time being limited by human resources required for management of change. In contrast, Richardson tends to replace the idea of the firm with the presence of entangled intermediary structures that add economic value. These structures are all connected using linkages that are dealt with using legal instruments. No matter how the market is organised, or how it is supposed to be organised, the economic lawyer is essential to regulation of the underlying entities and their inter-relationships. 4. 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