Theory of the firm

Theory of the firm

Overview
The theory of the firm consists of a number of economic theories
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 that describe the nature of the firm, company
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...

, or corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

, including its existence, behavior, structure, and relationship to the market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

.

In simplified terms, the theory of the firm aims to answer these questions:
  1. Existence – why do firms emerge, why are not all transactions in the economy mediated over the market?
  2. Boundaries – why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market?
  3. Organization – why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?
  4. Heterogeneity of firm actions/performances – what drives different actions and performances of firms?


Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment.
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Unanswered Questions
Encyclopedia
The theory of the firm consists of a number of economic theories
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 that describe the nature of the firm, company
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...

, or corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

, including its existence, behavior, structure, and relationship to the market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

.

Overview


In simplified terms, the theory of the firm aims to answer these questions:
  1. Existence – why do firms emerge, why are not all transactions in the economy mediated over the market?
  2. Boundaries – why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market?
  3. Organization – why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?
  4. Heterogeneity of firm actions/performances – what drives different actions and performances of firms?


Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a labor
Labour economics
Labor economics seeks to understand the functioning and dynamics of the market for labor. Labor markets function through the interaction of workers and employers...

 market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

, it might be very difficult or costly for firms
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...

 or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for better alternatives. Thus, firms engage in a long-term contract with their employees to minimize the cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...

.

Background


The First World War period saw a change of emphasis in economic theory away from industry-level analysis which mainly included analyzing market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

s to analysis at the level of the firm, as it became increasingly clear that perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

 was no longer an adequate model of how firms behaved. Economic theory until then had focused on trying to understand markets alone and there had been little study on understanding why firms or organisations exist. Market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...

s are mainly guided by prices as illustrated by vegetable markets where a buyer is free to switch sellers in an exchange.

The need for a revised theory of the firm was emphasized by empirical
Empirical
The word empirical denotes information gained by means of observation or experimentation. Empirical data are data produced by an experiment or observation....

 studies by Berle and Means, who made it clear that ownership of a typical American
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 corporation is spread over a wide number of shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....

s, leaving control in the hands of managers who own very little equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...

 themselves. Hall and Hitch found that executives made decisions by rule of thumb
Rule of thumb
A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination...

 rather than in the marginalist
Marginalism
Marginalism refers to the use of marginal concepts in economic theory. Marginalism is associated with arguments concerning changes in the quantity used of a good or service, as opposed to some notion of the over-all significance of that class of good or service, or of some total quantity...

 way.

Transaction cost theory


According to Ronald Coase
Ronald Coase
Ronald Harry Coase is a British-born, American-based economist and the Clifton R. Musser Professor Emeritus of Economics at the University of Chicago Law School. After studying with the University of London External Programme in 1927–29, Coase entered the London School of Economics, where he took...

, people begin to organise their production in firms when the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

 of coordinating production through the market exchange, given imperfect information, is greater than within the firm.

Ronald Coase
Ronald Coase
Ronald Harry Coase is a British-born, American-based economist and the Clifton R. Musser Professor Emeritus of Economics at the University of Chicago Law School. After studying with the University of London External Programme in 1927–29, Coase entered the London School of Economics, where he took...

 set out his transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

 theory of the firm in 1937, making it one of the first (neo-classical
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

) attempts to define the firm theoretically in relation to the market. One aspect of its 'neoclassicism' lies in presenting an explanation of the firm consistent with constant returns to scale, rather than relying on increasing returns to scale. Another is in defining a firm in a manner which is both realistic and compatible with the idea of substitution at the margin, so instruments of conventional economic analysis apply. He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur
Entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...

 … who directs production.” He asks why alternative methods of production (such as the price mechanism
Bid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...

 and economic planning
Economic interventionism
Economic interventionism is an action taken by a government in a market economy or market-oriented mixed economy, beyond the basic regulation of fraud and enforcement of contracts, in an effort to affect its own economy...

), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.

Coase begins from the standpoint that markets could in theory carry out all production, and that what needs to be explained is the existence of the firm, with its "distinguishing mark … [of] the supersession of the price mechanism." Coase identifies some reasons why firms might arise, and dismisses each as unimportant:
  1. if some people prefer to work under direction and are prepared to pay for the privilege (but this is unlikely);
  2. if some people prefer to direct others and are prepared to pay for this (but generally people are paid more to direct others);
  3. if purchasers prefer goods produced by firms.


Instead, for Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about division of surplus, particularly if there is asymmetric information and asset specificity
Asset specificity
Asset specificity is a term related to the inter-party relationships of a transaction. It is usually defined as the extent to which the investments made to support a particular transaction have a higher value to that transaction than they would have if they were redeployed for any other purpose...

, may be considerable.

If a firm operated internally under the market system, many contracts would be required (for instance, even for procuring a pen or delivering a presentation). In contrast, a real firm has very few (though much more complex) contracts, such as defining a manager's power of direction over employees, in exchange for which the employee is paid. These kinds of contracts are drawn up in situations of uncertainty, in particular for relationships which last long periods of time. Such a situation runs counter to neo-classical economic theory. The neo-classical market is instantaneous, forbidding the development of extended agent-principal (employee-manager) relationships, of planning, and of trust. Coase concludes that “a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory,” and that “it seems improbable that a firm would emerge without the existence of uncertainty.”

He notes that government measures relating to the market (sales taxes, rationing, price controls) tend to increase the size of firms, since firms internally would not be subject to such transaction costs. Thus, Coase defines the firm as "the system of relationships which comes into existence when the direction of resources is dependent on the entrepreneur." We can therefore think of a firm as getting larger or smaller based on whether the entrepreneur organises more or fewer transactions.

The question then arises of what determines the size of the firm; why does the entrepreneur organise the transactions he does, why no more or less? Since the reason for the firm's being is to have lower costs than the market, the upper limit on the firm's size is set by costs rising to the point where internalising an additional transaction equals the cost of making that transaction in the market. (At the lower limit, the firm’s costs exceed the market’s costs, and it does not come into existence.) In practice, diminishing returns to management contribute most to raising the costs of organising a large firm, particularly in large firms with many different plants and differing internal transactions (such as a conglomerate
Conglomerate (company)
A conglomerate is a combination of two or more corporations engaged in entirely different businesses that fall under one corporate structure , usually involving a parent company and several subsidiaries. Often, a conglomerate is a multi-industry company...

), or if the relevant prices change frequently.

Coase concludes by saying that the size of the firm is dependent on the costs of using the price mechanism, and on the costs of organisation of other entrepreneurs. These two factors together determine how many products a firm produces and how much of each.

Reconsiderations of transaction cost theory


According to Putterman, most economists accept distinction between intra-firm and interfirm transaction but also that the two shade into each other; the extent of a firm is not simply defined by its capital stock. Richardson for example, notes that a rigid distinction fails because of the existence of intermediate forms between firm and market such as inter-firm co-operation.

Klein (1983) asserts that “Economists now recognise that such a sharp distinction does not exist and that it is useful to consider also transactions occurring within the firm as representing market (contractual) relationships.” The costs involved in such transactions that are within a firm or even between the firms are the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

s.

Ultimately, whether the firm constitutes a domain of bureaucratic direction that is shielded from market forces or simply “a legal fiction”, “a nexus for a set of contracting relationships among individuals” (as Jensen
Michael Jensen
Michael Cole "Mike" Jensen is an American economist working in the area of financial economics. He is currently the managing director in charge of organizational strategy at Monitor Group, a strategy consulting firm, and the Jesse Isidor Straus Professor of Business Administration, Emeritus at...

 and Meckling put it) is “a function of the completeness of markets and the ability of market forces to penetrate intra-firm relationships”.

Managerial and behavioural theories


It was only in the 1960s that the neo-classical theory of the firm was seriously challenged by alternatives such as managerial and behavioral theories. Managerial theories of the firm, as developed by William Baumol
William Baumol
William Jack Baumol is an American economist. He is a professor of economics at New York University and is also affiliated with Princeton University. Baumol has written extensively about labor market and other economic factors that affect the economy. He also made valuable contributions to the...

 (1959 and 1962), Robin Marris (1964) and Oliver E. Williamson
Oliver E. Williamson
Oliver Eaton Williamson is an American economist, professor at the University of California, Berkeley and recipient of the Nobel Memorial Prize in Economic Sciences....

 (1966), suggest that managers would seek to maximise their own utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 and consider the implications of this for firm behavior in contrast to the profit-maximising case. (Baumol suggested that managers’ interests are best served by maximising sales after achieving a minimum level of profit which satisfies shareholders.) More recently this has developed into ‘principal–agent’ analysis (e.g. Spence and Zeckhauser and Ross (1973) on problems of contracting with asymmetric information) which models a widely applicable case where a principal (a shareholder or firm for example) cannot costlessly infer how an agent (a manager or supplier, say) is behaving. This may arise either because the agent has greater expertise or knowledge than the principal, or because the principal cannot directly observe the agent’s actions; it is asymmetric information which leads to a problem of moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

. This means that to an extent managers can pursue their own interests. Traditional managerial models typically assume that managers, instead of maximising profit, maximise a simple objective utility function (this may include salary, perks
Employee benefit
Employee benefits and benefits in kind are various non-wage compensations provided to employees in addition to their normal wages or salaries...

, security, power, prestige) subject to an arbitrarily given profit constraint (profit satisficing
Satisficing
Satisficing, a portmanteau "combining satisfy with suffice", is a decision-making strategy that attempts to meet criteria for adequacy, rather than to identify an optimal solution...

).

Behavioural approach



The behavioural approach, as developed in particular by Richard Cyert
Richard Cyert
Richard Michael Cyert was an American economist and statistician who served as the sixth President of Carnegie Mellon University in Pittsburgh, Pennsylvania, United States.-Early life:...

 and James G. March
James G. March
James Gardner March is Jack Steele Parker professor emeritus at Stanford University and the Stanford University School of Education, best known for his research on organizations and organizational decision making.- Biography :...

 of the Carnegie School
Carnegie School
The "Carnegie School" was a so-called "Freshwater" economics intellectual movement in the 1950s and 1960s based at Carnegie Mellon University and led by Herbert Simon, James March, and Richard Cyert....

 places emphasis on explaining how decisions are taken within the firm, and goes well beyond neo-classical economics. Much of this depended on Herbert Simon
Herbert Simon
Herbert Alexander Simon was an American political scientist, economist, sociologist, and psychologist, and professor—most notably at Carnegie Mellon University—whose research ranged across the fields of cognitive psychology, cognitive science, computer science, public administration, economics,...

’s work in the 1950s concerning behaviour in situations of uncertainty, which argued that “people possess limited cognitive ability and so can exercise only ‘bounded rationality’ when making decisions in complex, uncertain situations.” Thus individuals and groups tend to ‘satisfice’—that is, to attempt to attain realistic goals, rather than maximize a utility or profit function. Cyert and March argued that the firm cannot be regarded as a monolith, because different individuals and groups within it have their own aspirations and conflicting interests, and that firm behaviour is the weighted outcome of these conflicts. Organisational mechanisms (such as ‘satisficing’ and sequential decision-taking) exist to maintain conflict at levels that are not unacceptably detrimental. Compared to ideal state of productive efficiency, there is organisational slack (Leibenstein’s X-inefficiency
X-inefficiency
X-inefficiency is the difference between efficient behavior of firms assumed or implied by economic theory and their observed behavior in practice. It occurs when technical-efficiency is not being achieved due to a lack of competitive pressure...

).

Team production


Armen Alchian
Armen Alchian
Armen Albert Alchian is an American economist and an emeritus professor of economics at the University of California, Los Angeles....

 and Harold Demsetz's analysis of team production is an extension and clarification of earlier work by Coase. Thus according to them the firm emerges because extra output is provided by team production, but that the success of this depends on being able to manage the team so that metering problems (it is costly to measure the marginal outputs of the co-operating inputs for reward purposes) and attendant shirking (the moral hazard problem) can be overcome, by estimating marginal productivity by observing or specifying input behaviour. Such monitoring as is therefore necessary, however, can only be encouraged effectively if the monitor is the recipient of the activity’s residual income (otherwise the monitor herself would have to be monitored, ad infinitum). For Alchian and Demsetz, the firm therefore is an entity which brings together a team which is more productive working together than at arm’s length through the market, because of informational problems associated with monitoring of effort. In effect, therefore, this is a ‘principal-agent’ theory, since it is asymmetric information within the firm which Alchian and Demsetz emphasise must be overcome. In Barzel (1982)’s theory of the firm, drawing on Jensen and Meckling (1976), the firm emerges as a means of centralising monitoring and thereby avoiding costly redundancy in that function (since in a firm the responsibility for monitoring can be centralised in a way that it cannot if production is organised as a group of workers each acting as a firm).

The weakness in Alchian and Demsetz’s argument, according to Williamson, is that their concept of team production has quite a narrow range of application, as it assumes outputs cannot be related to individual inputs. In practice this may have limited applicability (small work group activities, the largest perhaps a symphony orchestra), since most outputs within a firm (such as manufacturing and secretarial work) are separable, so that individual inputs can be rewarded on the basis of outputs. Hence team production cannot offer the explanation of why firms (in particular, large multi-plant and multi-product firms) exist.

Williamson's approach


For Oliver E. Williamson
Oliver E. Williamson
Oliver Eaton Williamson is an American economist, professor at the University of California, Berkeley and recipient of the Nobel Memorial Prize in Economic Sciences....

, the existence of firms derives from ‘asset specificity’ in production, where assets are specific to each other such that their value is much less in a second-best use. This causes problems if the assets are owned by different firms (such as purchaser and supplier), because it will lead to protracted bargaining
Bargaining
Bargaining or haggling is a type of negotiation in which the buyer and seller of a good or service dispute the price which will be paid and the exact nature of the transaction that will take place, and eventually come to an agreement. Bargaining is an alternative pricing strategy to fixed prices...

 concerning the gains from trade
Gains from trade
Gains from trade in economics refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade...

, because both agents are likely to become locked into a position where they are no longer competing with a (possibly large) number of agents in the entire market, and the incentives are no longer there to represent their positions honestly: large-numbers bargaining is transformed into small-number bargaining.

If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing the transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

s. Moreover there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the hold-up problem
Hold-up problem
In economics, the hold-up problem is a situation where two parties may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits...

, which occurs when either party asymmetrically incurs substantial costs or benefits before being paid for or paying for them). In this kind of a situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one of them from the equation by takeover
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...

 or merger. Asset specificity can also apply to some extent to both physical and human capital, so that the hold-up problem can also occur with labour (e.g. labour can threaten a strike, because of the lack of good alternative human capital
Human capital
Human capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...

; but equally the firm can threaten to fire).

Probably the best constraint on such opportunism is reputation
Reputation
Reputation of a social entity is an opinion about that entity, typically a result of social evaluation on a set of criteria...

 (rather than the law
Law
Law is a system of rules and guidelines which are enforced through social institutions to govern behavior, wherever possible. It shapes politics, economics and society in numerous ways and serves as a social mediator of relations between people. Contract law regulates everything from buying a bus...

, because of the difficulty of negotiating, writing and enforcement of contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...

s). If a reputation for opportunism significantly damages an agent’s dealings in the future, this alters the incentive
Incentive
In economics and sociology, an incentive is any factor that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way...

s to be opportunistic.

Williamson sees the limit on the size of the firm as being given partly by costs of delegation
Delegation
Delegation is the assignment of authority and responsibility to another person to carry out specific activities. However the person who delegated the work remains accountable for the outcome of the delegated work. Delegation empowers a subordinate to make decisions, i.e...

 (as a firm’s size increase its hierarchical bureaucracy
Bureaucracy
A bureaucracy is an organization of non-elected officials of a governmental or organization who implement the rules, laws, and functions of their institution, and are occasionally characterized by officialism and red tape.-Weberian bureaucracy:...

 does too), and the large firm’s increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is in the nature of a large firm that its existence is more secure and less dependent on the actions of any one individual (increasing the incentives to shirk), and because intervention rights from the centre characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the lesser responsibility, thereby diluting incentives. Milgrom and Roberts (1990) explain the increased cost of management as due to the incentives of employees to provide false information beneficial to themselves, resulting in costs to managers of filtering information, and often the making of decisions without full information. This grows worse with firm size and more layers in the hierarchy. Empirical analyses of transaction costs have rarely attempted to measure and operationalize transaction costs. Research that attempts to measure transaction costs is the most critical limit to efforts to potential falsification and validation of transaction cost economics.

Firm economies


The theory of the firm considers what bounds the size and output variety of firms. This includes how firms may be able to combine labour and capital so as to lower the average cost
Average cost
In economics, average cost or unit cost is equal to total cost divided by the number of goods produced . It is also equal to the sum of average variable costs plus average fixed costs...

 of output, either from increasing, decreasing, or constant returns to scale
Returns to scale
In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...

 for one product line or from economies of scope
Economies of scope
Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in...

 for more than one product line.

Other models


Efficiency wage
Efficiency wages
In labor economics, the efficiency wage hypothesis argues that wages, at least in some markets, are determined by more than simply supply and demand. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage in order to increase their...

 models like that of Shapiro and Stiglitz (1984) suggest wage rents as an addition to monitoring, since this gives employees an incentive not to shirk, given a certain probability of detection and the consequence of being fired. Williamson, Wachter and Harris (1975) suggest promotion incentives within the firm as an alternative to morale-damaging monitoring, where promotion is based on objectively measurable performance. (The difference between these two approaches may be that the former is applicable to a blue-collar
Blue-collar worker
A blue-collar worker is a member of the working class who performs manual labor. Blue-collar work may involve skilled or unskilled, manufacturing, mining, construction, mechanical, maintenance, technical installation and many other types of physical work...

 environment, the latter to a white-collar
White-collar worker
The term white-collar worker refers to a person who performs professional, managerial, or administrative work, in contrast with a blue-collar worker, whose job requires manual labor...

 one). Leibenstein (1966) sees a firm’s norms or conventions, dependent on its history of management initiatives, labour relations and other factors, as determining the firm’s ‘culture’ of effort, thus affecting the firm’s productivity and hence size.

George Akerlof
George Akerlof
George Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics George Arthur Akerlof (born June 17, 1940) is an American economist and Koshland Professor of Economics at the University of...

 (1982) develops a gift exchange model of reciprocity
Reciprocity (cultural anthropology)
In cultural anthropology and sociology, reciprocity is a way of defining people's informal exchange of goods and labour; that is, people's informal economic systems. It is the basis of most non-market economies. Since virtually all humans live in some kind of society and have at least a few...

, in which employers offer wages unrelated to variations in output and above the market level, and workers have developed a concern for each other’s welfare, such that all put in effort above the minimum required, but the more able workers are not rewarded for their extra productivity; again, size here depends not on rationality or efficiency but on social factors. In sum, the limit to the firm’s size is given where costs rise to the point where the market can undertake some transactions more efficiently than the firm.

Recently, Yochai Benkler
Yochai Benkler
Yochai Benkler is an Israeli-American professor of Law and author. Since 2007, he has been the Berkman Professor of Entrepreneurial Legal Studies at Harvard Law School. He is also a faculty co-director of the Berkman Center for Internet & Society at Harvard University.- Biography :In 1984, Benkler...

 further questioned the rigid distinction between firms and markets based on the increasing salience of “commons-based peer production” systems such as open source software (e.g. Linux
Linux
Linux is a Unix-like computer operating system assembled under the model of free and open source software development and distribution. The defining component of any Linux system is the Linux kernel, an operating system kernel first released October 5, 1991 by Linus Torvalds...

), Wikipedia
Wikipedia
Wikipedia is a free, web-based, collaborative, multilingual encyclopedia project supported by the non-profit Wikimedia Foundation. Its 20 million articles have been written collaboratively by volunteers around the world. Almost all of its articles can be edited by anyone with access to the site,...

, Creative Commons
Creative Commons
Creative Commons is a non-profit organization headquartered in Mountain View, California, United States devoted to expanding the range of creative works available for others to build upon legally and to share. The organization has released several copyright-licenses known as Creative Commons...

, etc. He put forth this argument in The Wealth of Networks: How Social Production Transforms Markets and Freedom
The Wealth of Networks
The Wealth of Networks: How Social Production Transforms Markets and Freedom is a book by law professor Yochai Benkler published by Yale University Press on April 3, 2006....

, which was released in 2006 under a Creative Commons share-alike
Share-alike
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 license.

See also

  • Knowledge-based theory of the firm
    Knowledge-based theory of the firm
    The knowledge-based theory of the firm considers knowledge as the most strategically significant resource of a firm. Its proponents argue that because knowledge-based resources are usually difficult to imitate and socially complex, heterogeneous knowledge bases and capabilities among firms are the...

  • Organizational capital
    Organizational capital
    Organizational capital is the ability of an organization to mobilize and sustain the process of change required to execute strategy. Working practices such as Just In Time, accounts payable processes and Total Quality Management contribute to organizational capital...

  • Organizational effectiveness
    Organizational effectiveness
    Organizational effectiveness is the concept of how effective an organization is in achieving the outcomes the organization intends to produce. The idea of organizational effectiveness is especially important for non-profit organizations as most people who donate money to non-profit organizations...

  • Transaction cost
    Transaction cost
    In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

  • Dynamic capabilities
    Dynamic capabilities
    Dynamic capability is defined as “the firm’s ability to integrate, build, and reconfigure internal and external competences to address rapidly changing environments”...

  • Industrial organization
    Industrial organization
    Industrial organization is the field of economics that builds on the theory of the firm in examining the structure of, and boundaries between, firms and markets....

  • Williamson's Model of Managerial Discretion
    Williamson's model of managerial discretion
    Oliver E. Williamson hypothesised that profit maximization would not be the objective of the managers of a joint stock organisation.This theory, like other managerial theories of the firm, assumes that utility maximisation is a manager’s sole objective....