The Nature of the Firm is Organic

Too much central planning and too few market signals are the pesticides.

Roderick Long at AotP explains the basics behind the Austrian theory of the firm, how the socialist calculation debate has ramifications for determining the optimal size of private corporations, an idea also explored by Ronald Coase in his seminal 1937 article, "The Nature of the Firm."

In 1920, Ludwig von Mises published an argument against the workability of “socialism” (by which he meant state ownership of the means of production), an argument subsequently elaborated by himself and his student Friedrich Hayek. [...]

The Mises-Hayek account of the limits of state centralisation was subsequently extended, by Mises’s student Murray Rothbard, to cover the limits of private cartelisation as well. [...]

Everyone knows about economies of scale; after all, that’s why we have firms in the first place. What Rothbard’s analysis shows is that there are also diseconomies of scale, and that these grow more severe as vertical integration increases.

What happens when a firm grows so large, its internal operations so insulated from the price system, that the diseconomies of scale begin to outweigh the economies? Well, that depends on the institutional context. In a free market, if the firm doesn’t catch wise and start scaling back, it will grow increasingly inefficient and so will lose customers to competitors; markets thus serve as an automatic check on the size of the firm.

But what if friendly politicians rig the game so that favoured companies can reap the benefits associated with economies of scale while socialising the costs associated with diseconomies of scale? Then we might just possibly end up with an economy dominated by those bloated, bureaucratic, hierarchical corporate behemoths we all know and love.

The final takeaway?

So long as the confusion between free markets and plutocracy persist – so long as libertarians allow their laudable attraction to free markets to fool them into defending plutocracy, and so long as those on the left allow their laudable opposition to plutocracy to fool them into opposing free markets – neither libertarians nor the left will achieve their goals, and the state-corporate partnership will continue to dominate the political scene.

I look forward to reading Long's next post, which will be an application of Austrian price theory to the current financial crisis.

Share this



This is the same conclusion I reached in an earlier external post: you can't have most efficience of capitalism within a structure where principal-agent issues, moral hazard and SNAFU principle trounce it at every level.

When you take a funny look at today's corporations, the resemblance with the soviet model of production organisation is unmistakable. Elected Councils of shareholders at the top, appointed "corporate fat" of middle management ripe with collusion and self-interest internal wars, complete with elected councils of representatives of employees at the bottom.

I'd say a mechanism for easily dividing the capital of a single corporation into multiple ones would help.

Do you mean a spin off ?

Do you mean a spin off ? It's quite common.

I mean it as a way for

I mean it as a way for shareholders to invest or divert their valuation of the enterprise into a specific activity inside a given corporation.

Ronald Coase pointed out that the corporation exists as a way for employee X to trade the time it would take him to find a buyer for his specific kind of work every day, over and over, in exchange for a part of the profits on this sale and the possibility to change buyer.

So a mechanism for breaking down these fixed arrangements is needed when transaction costs decrease with market (and technology) development. A free market where you can change freely your providers and find new buyers as opportunities come and go is ideal in this sense, but I don't see an obvious way to apply it to this problem, short of banning corporations as "fictitious persons" and having all capital registered under a single existing individual.

How the market evolves

If there is a too-large company that would be more profitable were it divided into smaller pieces, then competitors can come along which are already divided, and take over the marketplace. A possible real-world example is Apple versus Microsoft and PC makers. The too-large company doesn't have to evolve itself. It can simply be driven out of business.

If the company would be more

If the company would be more profitable were it divided in smaller piece, shareholders can make money by doing a spin off, the opposite of a merge. Investment banker will not fail to advertise this to them.

OK, but the process is

OK, but the process is certainly not as simple and easy as changing providers, is it ? Also, I'm not talking about breaking down a company into similar entities, but really tearing a function out of it and having it offer its services to other companies, including competitors of the original enterprise. In many cases only a part of the breakup results is really increasing profits, and not the other parts. In fact in many cases the profits would come in deduction to the rest of the company, so shareholders never really have an incentive to do it: the collectivization of capital and collectivization of the profits across the whole company prevents this... That's why I mention the possibility to invest in a specific "shard" of the enterprise and not the whole.