Given the arguments of this book, I find it interesting to revisit the economics literature on the nature of the corporation. I’ve found that over time my views on exactly what a corporation is and what it does have evolved away from the economics mainstream. I’m more likely to think of a corporation as a carrier of reputation and a kind of metaphorical personhood, and less likely to think of a corporation as a means of minimizing transactions costs, as many mainstream economists have suggested.
In a famous 1937 article, “The Nature of the Firm,” the economist and Nobel laureate Ronald Coase defined the nature of economic thought about the corporation for many decades to come. In that piece, he described the corporation as essentially a means of reducing transactions costs. It’s not always easy to hire the worker you want just by going out into spot labor markets, not to mention get that worker to do your bidding. Or you may extend the size of the firm to ensure the quality of an asset you need for your production plans. In these cases, a company will hire and bring those assets “inside the firm,” in the hope that they will be easier to manage and control. That is what Coase meant by lowering transactions costs.
More than three decades later, another Nobel laureate, Oliver Williamson, wrote a series of articles fleshing out similar ideas. Building upon Coase’s work, Williamson argued that firm managers, by bypassing spot markets and getting things done within the hierarchical structure of the corporation, would limit problems of opportunism and hold-up behavior. Sometimes it is easier and more effective to give an employee orders rather than trying to write just the right contract with a temporary spot laborer, who may not have the same incentives to keep a good, ongoing, long-term relationship. This research has laid the groundwork for the most fundamental ideas about corporations in economic thought, but while it contains numerous grains of truth, it doesn’t describe my own perspective very well.
I agree that sometimes corporations reduce transactions costs, but they don’t always, and I am not sure they do on average. Ask yourself a simple question. Let’s say you want to buy a work computer for your desk. Which method involves lower transactions costs: going online with Amazon (or driving to Best Buy) or trying to get an order for a new computer through your company’s purchasing department? Of course, it depends on the company in question, but most of us already know the likely answer. A lot of markets today involve very, very low transactions costs. The purchasing department may get you a better price if they buy in bulk, but dealing with them probably is more of a pain. Their priorities are not your priorities, paperwork and approval may be required, and your company is probably somewhat or maybe even deeply bureaucratic, especially if it has more than fifty or a hundred employees. Opinions differ on how big a company has to become before deep bureaucratization sets in, but every corporate leader and employee is aware of this phenomenon.
Given this, I don’t view lower transactions costs as the essence of the corporation, even though companies do solve many transaction costs problems. (For instance, my assistant prints out many PDF manuscripts for me, and it would be much tougher to use an Uber-like service to have someone come over each time I need such a service performed.)
Furthermore, I am not sure exactly how to define the scope of the firm in economic (rather than strictly legal) terms. I observe innovative, transactions-cost-reducing contracts being used within firms and also with external partners, and I am not sure where to draw the line between firm and market in terms of the parameters specified by Coase’s and Williamson’s theories. Drawing the line between firm and market legally in terms of liability and the like is much easier, but that reliance on a legal distinction should give us some clues about the best way to think about the nature of the firm—namely, as a carrier of social reputation and legal responsibility.
So in lieu of the Coase and Williamson transactions-costs approach, I typically view a corporation in terms of the following properties:
1. It is a collection of assets, assembled at favorable purchase prices (or at least the prices were favorable for the case of successful corporations).
2. It is a nexus of external and internal reputation and norms.
3. It is a carrier of contractual and legal responsibility.
On top of that, I would add the following as another feature of firms, but not the essential feature:
4. It is a complex bundle of transactionally efficient and sometimes highly transactionally inefficient relationships.
Of course there are selection pressures, so if the inefficiencies are too large, the company will cease to exist. That creates some balance in favor of net efficiency, going back to the core idea of competitive pressures. In this regard, transactions costs are a significant binding constraint on which firms are possible. Thus the Coase and Williamson approaches reflect some truths at the margin, even if they overrate the role of transactions cost reduction in explaining what a firm is.1
For much of this book, I have focused on the second feature: the corporation as a carrier of external and internal reputation and norms. People have opinions about companies. Prospective workers have such opinions, as do prospective CEOs, financial journalists, government officials, voters, commentators on social media, and just about everyone else. But you also can pick up on some significant hints of the fourth feature of how I view corporations, especially in chapter 3, on CEO pay, and in the chapter on finance.2
Still, I wish to push back against the focus on transactions costs in explaining modern business activity. If firms were mainly about lowering transactions costs, they would be loved much more than is the case. Firms do have low enough transactions costs to get the job done, at least compared with the other feasible alternatives. That said, firms do not have especially low or favorable transactions costs, and so we are frustrated with them often, including in our roles as employees. Unless we are working in a very small enterprise, we so often hate the bureaucracies in the companies we work in (even if we enforce comparable bureaucratic strictures when on the other side of the relationship). And we are (partially) right to dislike this bureaucracy so much. Very often those bureaucracies stifle merit, make simple operations complex (for example, by requiring multiple permissions), and fail to reward us when we have done something good (or unjustly elevate those whom we resent). They make it harder for us to rise to the top at the pace we feel we deserve. At the same time, those bureaucracies keep some of the employees from “going off the reservation,” or make it harder for the boss to play favorites or for shareholders to use the company for personal purposes. So corporate bureaucracy is necessary. Still, because of bureaucracy, corporate life can be tough and also deeply unfair at times. And that too is “the nature of the firm,” to refer back to Ronald Coase’s title.