Why Do Different Theories of the Firm Exist - Essay Example

Why do different theories of the firm exist ------------------------------ ------------------------- ------------------. Why do different theories of the firm exist Introduction Firm has been long considered to be the basic building unit of the modern day business. From the times of Alfred marshal to the present day economic theorists the mechanics of the micro economics have been built around the firm as a focused unit of economic decision making. In modern day, the economic theory making has got interspersed with the management perspective on business and various dimensions such as resources of the firm, knowledge quest of the firm and the transactions of the firm have assumed an important place in the present day firm theory. This paper examines a couple of firm theories with the objective of examining their fine and major points and in an attempt to discover what factors have prompted existence and development of multiple theories of the firm. This is achieved through a literature review that incorporates a wide ranging discussion on the main issues as outlined above. In addition, this paper extends the literature review in an attempt to find empirical basis for the existence of the multiple theories of the firm. In order to do this, the paper examines the literature studies that examine such secondary data evidence either cross sectional or case study based. Literature Review There is a wide body of research that deals with the issue of firms and theories of firms both in the realms of economics and management. Sagi & Pataki (2006) give out the classical economic firm theory in following words, "Classical firm theories in modeling offer strategies start from profit maximization as a target function of the enterprise that realizes in the conditions of market competitiveness in the form of equation as P=MR=MC, i.e. the equation of price, marginal revenue and marginal costs. Price is an external factor dictated by the market. In all the model of imperfect competition (monopoly, oligopoly markets, monopoly competition), firms form prices starting from the equation MR=MC, but in all the models the rule is still in effect that price is bigger than marginal revenue, i.e. P>MR=MC".However, these authors discredit the relevance and universal applicability of this model and went on to explain the further developments in the firm models that increasingly took into account more variables ,essentially focusing on firm behaviours as an economic decision maker. However, this paper has emphasis on examination of firm theories that lean more towards more elaborate and comprehensive models that are more management oriented in the sense of having a strategic management bias. The advantage of doing this is evident in that such models reveal more of the strategic management processes that reveal the cross section of today's large sized, globalized and information technology assisted business organizations, one such model is the Resource based model of the firm behaviour. Citing appropriate literature resources Kotelnikov (2007) explains the concept of the resource based model of firm behaviour in following words, "The currently dominant view of business strategy - resource-based theory or resource-based view (RBV) of firms - is based on the concept of economic rent and the view of the company as a collection of capabilities. This view of strategy has a coherence and integrative role that places it well ahead of other mechanisms of strategic decision making. (Kay John)". Using more literature resources Kotelnikov further explains the model as follows, "Each organization is a collection of unique resources and capabilities that provides the basis for its strategy and the primary source of its returns. In the 21st-century hyper-competitive landscape, a firm is a collection of evolving capabilities that is managed dynamically in pursuit of above-average returns (Markides C.C). Thus, differences in firm's performances across time are driven primarily by their unique resources and capabilities rather than by an industry's structural characteristics". (Kotelnikov, 2007) It is critical to examine in finer details the concepts of the resources of an organization and the competencies that are targeted out of these resources. Kotelnikov, 2007) explains the concept of resources, using appropriate literature support, in following words, "Resources are inputs into a firm's production process, such as capital, equipment, the skills of individual employees, patents, finance, and talented managers. Resources are either tangible or intangible in nature. With increasing effectiveness, the set of resources available to the firm tends to become larger. (Total War) Individual resources may not yield to a competitive advantage. It is through the synergistic combination and integration of sets of resources that competitive advantages are formed". In respect of the concept of the capability Kotelnikov has the following to say as he also cites support from the literature, "A capability is the capacity for a set of resources to integratively perform a stretch task or an activity. Through continued use, capabilities become stronger and more difficult for competitors to understand and imitate. As a source of competitive advantage, a capability "should be neither so simple that it is highly imitable, nor so complex that it defies internal steering and control. (Schoemaker & Amit) It is evident that this model provides a very neat system to organize and inventory firm resources and convert them into capabilities that are aimed at attaining firm objectives. However this is only focused on resources of the firm. Another firm theory is based on the transactions of the firm. Transactions cost model or the property rights model examines from the strategic point of view, the firm as a nexus point of various explicit and implicit contracts (or transactions). The transactions based model of the firm behavior is contrasted and explained for its finer points by Kim& Mahoney (2006), using rich literature support, in following words, "Moreover, Foss and Foss (2005) go further and make an important theoretical point that the source of the economic value is not inherent in the resource itself, but rather that economic value creation is an outcome of the process of economizing on transaction costs incurred in the transaction involving such a resource. This claim is consistent with the so-called Coase Theorem (Coase, 1960, 1988), which maintains that where the economic cost of transacting is nil, resources are utilized in ways that maximise economic value. However, there is a subtle (but key) difference. Whereas Coase (1960) makes the argument in terms of a Pareto-optimal equilibrium, Foss and Foss' (2005) view is closer to an 'Austrian' perspective, in the tradition of Mises (1949), Hayek (1948) and Kirzner (1973)". Explaining the role of implicit contracts and transactions and their contribution to firm specific economic value with the help of several literature discussions, Mahoney et al (2004) state as follows, "We argue that the modern property rights perspective of incomplete contracting and implicit contracting provides a solid economic foundation for the revitalization of a stakeholder theory of the firm in strategic management. In order to make progress in strategic management an improved (conceptual and empirical) understanding of implicit contracting is needed. Currently, a firm's assets are certainly understated by the economic value of the implicit contracts with a firm's employees, when valuable firm specific human capital is excluded from the balance sheet (DeAngelo, 1982). The same can be said for the economic value that other stakeholders bring, or the loss in economic value these stakeholders suffer when decisions are made strictly on the basis of shareholder value. For example, financial distress can create a tendency for the firm to take actions that are harmful to debt-holders and other non-financial stakeholders (Baden-Fuller, 1989; Cornell and Shapiro, 1987; Jog, Kotlyar and Tate, 1993; Opler and Titman, 1994). If the goal is to maximize total economic value, and this value is to be allocated among those contributing to/gaining from this economic value then one needs a property rights stakeholder theory, which recognizes the role each of these groups plays in the creation and distribution of that economic value". Klein(2007) produces clear evidence that the empirical work in testing the resource based firm hypothesis has not yielded much outcome in the sense that most such tests report inconclusive outcomes. Using the help of the literature Klein states that, "Surprisingly, while the RBV is central to much recent empirical work in strategy and organization, its empirical track record has not been scrutinized systematically as has TCE's. Strategic Organization published a paper last year, "Tests of the Resource-Based View: Do the Empirics Have Any Clothes" by Richard Arend, that begins to fill this gap. Arend reviews 60 empirical RBV papers and finds the overall picture disappointing: In this essay, I outline four explicit tenets of the RBV, translate them into a set of criteria that a test of the RBV would need to meet and then assess the extent to which the most cited recent empirical support of the RBV meets these criteria". (Klein,2007) Klein continues to quote Arend in following words, " My conclusion is that there are no satisfactory empirical tests of the RBV. No paper or collection of related papers measures the benefits specified by RBV theory; adjusts for the costs of the resources; provides evidence that resources meet the RBV criteria; and controls for the influence of higher-level resources. Moreover, the adequacy of testing has not improved over the last 10 years. If empirical testing does not alter its approach, the RBV will be in increasing jeopardy".(Klein,2007) Klein(2007)summarizes the major empirical evidence based observations of Arend on resource based firm model in following words, "Some of Arend's complaints: (1) resources that meet the VRIO criteria are usually identified only ex post, making the explanation circular; (2) many of the papers use RBV as a framing device without testing any specific implications of the theory; (3) the link between resources and performance is not carefully examined; (4) key resources are hard to measure; and (5) the gains from superior resources may not be captured at the firm level, in which case firm performance cannot be the dependent variable". Conclusion Discussing the entrepreneurship model of the firm behavior Klein &Foss (2004) explain the reasons that lie behind having multiple perspectives behind the theory of the firm. They essentially state that the theory of firm has been evolving in the sense that it is gradually picking for examinations various factors that affect firm activities and affect firm objectives and that there is a gradual realization that mathematical modeling may limit the conclusions severely, and, therefore, there is an emphasis on qualitative assessment of the empirical evidence and theorizing. Klein& Foss state this in following words with the help of support from appropriate literature, "Will these insights be incorporated into the economic theory of the firm We are optimistic, but guardedly so. Because these concepts lie fundamentally outside the standard constrained optimization framework, they are inherently difficult to model mathematically. Modern economists have difficulty appreciating ideas that are not ex-pressed in this familiar language. Indeed, most recent theoretical advances in the economic theory of the firm have been developed within the more formal framework associated with Grossman, Hart, and Moore, not the more "open" framework associated with Williamson.22 Relaxing this constraint may lead to considerable advances in economists' understanding of the firm. Thus, it is abundantly clear that a firm's existence in perpetuity with a common seal is not a simplistic existence as was assumed in the classical firm models. In today's highly integrated globalized market places that have the benefits of the information technology and the internet; the firm level decision making has turned more complex and time sensitive. These decisions are to be taken in the real time and space and with a view to match competitor's and thus a model that puts in place a strategic structure which takes into account the multiple factors which affect such decisions, is ideal. But a single such system has not been devised and is still in the realms of strategic management drawing boards. The various firms' models represent layers or portions of such a holistic system and there is a good need to prune and integrate all these concepts. References agi Andra & Eva Pataki.(2006). Contemporary Theories of Firm Behavior. SISY 2006 - 4th Serbian-Hungarian Joint Symposium on Intelligent Systems Kotelnikov Vadim. (2007). Resource-Based View (RBV) of Firms. Retrieved on November 12 ,2007 from www.1000ventures.com. Kay John. Strategy and the Delusion of Grand Designs. Markides C.C. A Dynamic View of Strategy. Total War and Managers from Mars. Schoemaker P.J.H. and Amit R. Investment in Strategic Assets: Industry and Firm-Level Perspectives. Kim Jongwook & Mahoney Joseph T. (2006). How property rights economics furthers the resource-based view: resources, transaction costs and entrepreneurial discovery. Int. J. Strategic Change Management, Vol. 1, Nos. . Foss, K. and Foss, N.J. (2005).Resources and transaction costs: how property rights economics furthers the resource-based view. Strategic Management Journal, Vol. 26, pp.541-555. Coase, R.H. (1960).The problem of social cost. Journal of Law and Economics, Vol. 3, pp.1-44. Coase, R.H. (1988). The Firm, the Market, and the Law, The University of Chicago Press, Chicago, IL. Mises, L.v. (1949).Human Action: A Treatise on Economics, Reprinted in 1996, Fox & Wilkes,San Francisco, CA. Hayek, F.A. (1948).Individualism and Economic Order. The University of Chicago Press,Chicago and London. Kirzner, I.M. (1973).Competition and Entrepreneurship. The University of Chicago Press, Chicago and London. Mahoney Joseph ,Mahoney James & Cheryl Carleton Asher.(2004). Towards a Property Rights Foundation for a Stakeholder Theory of the Firm. Retrieved on November 12, 2007 from http://www.business.uiuc.edu/Working_Papers/papers/040116.pdf. DeAngelo, L. E. (1982). Unrecorded human assets and the "hold-up" problem. Journal of Accounting Research, 20: 272-274. Baden-Fuller, C. W. F. (1989). Exit from declining industries and the case of steel castings. Economic Journal, 99 (December): 949-961. Cornell, B. and A. C. Shapiro (1987). Corporate stakeholders and corporate finance. Financial Management (Spring): 5-14. Jog, V. M., I. Kotlyar and D. G. Tate (1993). Stakeholder losses in corporate restructuring: Evidence from four cases in the North American steel industry. Financial Management, (Autumn): 185-201. Opler, T. C. and S. Titman (1994). Financial distress and corporate performance. Journal of Finance, 49 (3): 1015-1040. Klein Peter.(2007). Empirical Research in theRBV. Retrieved on November 12 ,2007 from WordPress.com. Klein Peter G &Foss Nicolai J. (2004). Entrepreneurship and the Economic Theory of the Firm: Any Gains from Trade Prepared for Rajshree Agarwal, Sharon A. Alvarez, and Olav Sorenson, eds., Handbook of Entrepreneurship: Disciplinary Perspectives (Kluwer) Read More