Munger on Theory of the Firm

Michael Munger | Firms, Markets and transaction costs

Michael Munger, Bosses Don’t Wear Bunny Slippers: If Markets are so Great, Why are there Firms?
Michael Munger is Chair of Political Science at Duke University.

Prices are the central force directing resources and shaping consumption in a market economy. But most economic activity seems (at first glance) to take place without any influence from prices at all.

• Most people work for a firm, a company, a large organization, and they have a boss. The Boss guesses their productivity.
• coordinating all those contract employees, and making all those different transactions work together in time and space, is a really hard job.

The Theory of the Firm

• If prices and competition do such a terrific job of directing resources (and they do!), then why are there firms? Why are there hierarchical organizations that are internally directed by command and control, rather than the price system? Why not outsource everything?

• The pin factory showed the power of the market, through division of labor. The factory divides pin-making into a number of smaller, more specialized, tasks. Increased dexterity, improved tools, and economies of scale raise productivity so much that just a few workers could make thousands more pins than they could themselves use.

• Each step, each break in the production process from one artisan to another, would require negotiations, a transaction, payment, and transportation of the product to the next step.

The task of the economist, then, is to explain two phenomena with just one theory. First, why are firms more efficient than markets at organizing some transactions? Second, if firms are so efficient, why are there any market transactions at all? What determines the margin where the firm stops organizing additional transactions internally, and buys goods or services instead through the market?

Ronald H. Coase (pioneers of the transactions costs approach): his remarkable 1937 paper in Economica contained two key insights.

• First, firms are contractual means of reducing transactions costs. Division of labor requires groups, sometimes large groups, of workers. But it would be too expensive and time-consuming to negotiate sales of labor, services, and products at every stage of production. So, an entity called “the firm” is created, which specializes in directing these activities. Firms compete with each other, but within the firm, activities are directed by command and control.
• Second, Coase argues that the optimal size of firms responds directly, though in undirected ways, to market forces. This is true both for vertical integration (owning suppliers, and retail outlets) and market share (the number of units sold, total). So the market is at work after all, since the expansion or contraction of the firm is directed by prices and the actions of consumers and suppliers. Firms that guess wrong, and expand (or contract) too much will lose profits, and may even be “selected” for extinction by bankruptcy.

Outsourcing, either across town or across a huge ocean, is a form of transforming a transaction from one organized within a firm to one organized through a market. All firms use some combination in-house work and outsourcing (no computer company makes its own furniture, grows the wheat for bread in the employee cafeteria, or makes waste paper baskets). Where is the line? How does the company decide what to buy, and what to produce?

• The answer is: profits. The company has to decide which approach, at every stage, costs less, improves quality, or in some other way increases profits. Price is an important consideration, of course, for managers. But the day-to-day activities of most employees, in most firms, are not directed by prices the way that price directs the choices of farmers. Workers are for the most part paid salaries, or by the hour.
• Where do prices come in? Workers work, and change jobs, for wages. Sure, and the Brazilian farmers could change jobs, too. They could go from being farmers to woodcutters, or factory workers. My point is that the farmer looks to prices to say “What will I plant today?” The worker in a firm doesn’t look to price, but rather asks his boss, “What will I do in the plant today?”
• Most importantly, bosses can’t contract out all the activities of the firm, in most situations. The coordination and monitoring function, as some of the authors in the “further reading” section below argue, may be the real reason that firms exist. The problems of transactions costs, and management, are complex and hard to solve. If you want to run your own firm, you are going to be doing a lot of walking around and giving instructions to people who don’t have prices to direct them.

Further Reading

• Alchian, Armen A., and Demsetz Harold, “Production, Information Costs, and Economic Organization”, American Economic Review, Vol. 62, No. 5., pp. 777-795, 1972.
• Chandler, Alfred. The Visible Hand: The Managerial Revolution in American Business. New York: Belknap, 1993. (2nd edition).
• Coase, Ronald H., “The Nature of the Firm”, Economica 4, pp 386-405, 1937.
• Benjamin Klein, Crawford, and Armen Alchian. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics. 1978.
• Williamson, Oliver E., Markets and Hierarchies: Analysis and Antitrust Implications, NY: The Free Press, 1975.