Peter Radford on corporations

Most theories of the firm within economics pick up the narrative with the existence of the corporation as a given. They then bend over backwards to retro-fit this highly centralized pseudo economy into the larger free market narrative preferred in all major textbooks. In so doing they blithely ignore Alfred Chandler’s famous explanation for the rise of modern business organization, which he argued became possible “only when the hand of management proved be more efficient than the invisible hand of market forces”.

Chandler, being a historian rather than an economist, was more interested in reality than in hypotheticals. He understood and tried to explain the actual landscape of large-scale business. I have always wondered what would have happened to economics had it absorbed the true gist of the challenge issued by Coase in 1937. The impudence of that challenge has never been fully understood. Coase asked simply: “why do firms exist?”. After all if market forces are as supreme as the textbooks tell us, there is no room for business organization at all. We ought be able to accomplish all our transacting through a web of contracts in the open marketplace.

Indeed the most common response of economists to the challenge represented by business organization is to argue that a business organization is simply such a web of contracts. In this view we can continue to ignore any oddities of business organization since it is indistinguishable from the market. In this view the firm exists at a “nexus of contracts” and has no special attributes that cannot be negotiated and contracted for in the marketplace.

Except this is not true....

The key to understanding corporations is to separate the economics from everything else. We need to do this because the economics, as expressed in various theories of the firm, are usually entirely idealized and bear no resemblance to reality. Economists, as usual, love to theorize about things that don’t exist but which they wished did exist....

Corporations, far from being products of the free market, are actually franchises of the state. They are sub-contracted jurisdictions.

To be a corporation is to possess a charter from the state. That charter brings privileges not available to non-corporations. The most notable privilege is that the corporation is recognized as a distinct legal entity separate from any “natural” person who may be associated with it. And because the corporation is brought into existence prior to it being populated or animated by any natural person, it is not owned by any of them. It is unowned. In this sense it is akin to a nation state, the church, most universities, and, at least here in the US, most towns, It would be odd to describe any of those bodies as being owned by the people who animate them. Yet we routinely talk of firms being owned by stockholders. It is this misattribution of ownership that leads most economists astray in their theorizing...

Peter Radford explain why this is important and what problems misunderstanding engenders.

The Radford Free Press
Who “Owns” a Corporation?
Corporations Cont’dPeter Radford

Diane Coyle — Management as a productive resource

The economic theory of "the firm" (representative firm) assumes homogeneity that may not be there, which widely differing results in output and productivity suggests in the case.

I’ve been browsing through Edith Penrose’s Theory of the Growth of the Firm, having read the biography by Angela Penrose, No Ordinary Woman. Published in 1959, it is an interesting narrative approach to the dynamics of individual firms, with plentiful examples from case studies. One can see that it was heading in a very different direction methodologically from mainstream economics, and hence why Penrose was taken up by business schools instead.… 

All of this reminded me very much of the recent World Management Survey work by Nick Bloom, John Van Reenen and colleagues looking at the importance of management quality for firm productivity. They write: “Economists have long puzzled over the astounding differences in productivity between firms and countries. In this paper, we present evidence on a possible explanation for persistent differences in productivity at the firm and the national level — namely, that such differences largely reflect variations in management practices.” Maybe Penrose was less puzzled than many.

The Enlightened Economist
Management as a productive resource
Diane Coyle | freelance economist and a former advisor to the UK Treasury. She is a member of the UK Competition Commission and is acting Chairman of the BBC Trust, the governing body of the British Broadcasting Corporation

David F. Ruccio — Theory of the firm

The problems surrounding the central institution of capitalism—the corporation—are so widespread and enormous they’ve even provoked concern in sympathetic quarters, such as the Harvard Business School.

This past November, Harvard hosted a conference during which participants attempted to grapple with the tensions between Milton Friedman’s theory of the firm—according to which firms can and should only benefit society by focusing on maximizing shareholder value—and the growing political influence of corporations after Citizens United—when it has become increasingly easy for firms to tweak the rules of the game in their favor.…

Occasional Links & Commentary

Theory of the firm

David F. Ruccio | Professor of Economics, University of Notre Dame

ProMarket — Is There a Crisis in the Economic Theory of the Firm? Participants at Harvard Business School Conference Agree: Firms Try to Change the Rules of the Game

A novel conference at Harvard Business School brought together top scholars in order to answer the question: Is Milton Friedman’s dictum that firms that maximize shareholder value maximize social value as well still relevant in a post-Citizens United world?

With "experts" like these, we are in trouble. Sounds like a theology conference to me.

ProMarket
Is There a Crisis in the Economic Theory of the Firm? Participants at Harvard Business School Conference Agree: Firms Try to Change the Rules of the Game

ht Mark Thoma at Economist's View

Lord Keynes — Keynesians, Austrians, Demand, and Production

Austrians emphasize price signaling, while Keynesians emphasize quantity signaling.

Social Democracy For The 21St Century: A Post Keynesian Perspective
Keynesians, Austrians, Demand, and Production
Lord Keynes

Daniel Little — Thorstein Veblen's critique of the American system of business

Thorstein Veblen was certainly a heterodox observer of modern capitalism. He was trained in the late nineteenth-century iteration of neoclassical economics, but he was more impressed by the irrationality of what he observed than the optimizing rationality that is postulated by the neoclassicals. He was also an intelligent observer and analyst of contemporary economic and sociological trends — not in theory but in the concrete forms that turn-of-the-century capitalism was taking in the United States and Europe. It is interesting, therefore, to examine his analysis of the business firm in The Theory of Business Enterprise, published in 1904. (I examined his critique of American universities in The Higher Learning in America in an earlierpost.) ...

Veblen is sometimes credited with being one of the originators of institutional economics. This is due, in large part, to his effort to discover some of the institutional dynamics created for the modern industrial system by the incentives and constraints created for the owners and managers of firms.

Understanding Society
Thorstein Veblen's critique of the American system of business
Daniel Little | Chancellor, University of Michigan at Dearborn

John Carney — Ronald Coase and the nature of shadow banking

John Carney interprets Ronald Coase's insights about transaction cost with respect to finance rather than industry and commerce.

CNBC NetNet
Ronald Coase and the nature of shadow banking

John Carney | Senior Editor

Ronald Coase: "Markets, Firms and Property Rights"

Ronald Coase: "Markets, Firms and Property Rights"
(h/t Tschäff Reisberg on FaceBook)

This address by Ronald Coase (Clifton R. Musser Professor Emeritus of Economics at the University of Chicago Law School) to the conference "Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase" was recorded November 23, 2009.

From Tschäff at FB"

Highlights: "Markets are creations, they aren't something we find... ..They are the result of people deciding to make contracts, and making all the negotiations necessary to bring it about."

"Firms are not to be analyzed in the way I did in 'The Nature of the Firm.' ..It is a very poor article although it has been much referred to. It talked about a firm like it was an entity in economic theory. I said as the firm got bigger there were decreasing returns to management. Well this is treating it like it is fertilizer being applied to land and you measure the outcome... ..Firms aren't like that, firms are entities where parts of the firm have an interchange with other parts. It's a sociological problem rather than an economic problem... ...Also I discovered there are friendships and antagonisms in firms. One part of the firms was always afraid that another part would mess up what they were doing. It operated in a very different way than it did in economic theory where you have a firm maximizing profits, knowing all the things that affect it and acting accordingly. It's very difficult to imagine firms act the way they do in the text books where they maximize profits by equating marginal costs and marginal revenue. One of the reasons one can feel doubtful about this particular way of looking at things is that firms never calculate marginal costs and so can not possibly act as they do in the textbooks. I think we should study directly how firms operate and develop our theory accordingly."

After giving a presentation advocating the allocation of radio frequencies via auction, his first response from the FCC was, "Is this all a big joke?" The FCC didn't imagine this solution, they thought their job was to chose the right people to use those frequencies. He responded, "Is it a joke to believe in the American economic system?" He got the idea from a student who got it from Abba Lerner. Abba Lerner was a fellow student of Coase at the LSE. "Abba was older than the rest of us, he was in a printing business that failed I always said it was because he put price according to marginal cost, but that's just a joke.. ..Our relations were always very good. He wrote a book called _The Economics of Control_, and a very fine book it is... ...He was a socialist who believed that socialism would be fine if only he carried out the various rules and regulations that he set in motion.

 

Peter F. Drucker — Profit is not the purpose of business and the concept of profit maximization is not only meaningless, but dangerous

I heard Peter say a lot of strange things when I was his student, but this has got to be one of the most unusual that I’d heard up to that time. I think most of my Drucker classmates agreed. Indeed, until Drucker came along most everyone believed the basic “fact” that the purpose of a business was to make money. That is, to make a profit. This belief leads to a corollary, another myth, believed by all—that is, that the goal of any business is profit maximization. Another words, whatever your business, your goal should be to make as much profit as possible. If you accept making a profit as a business’s purpose, the second part just follows naturally. This might even seem worthy to many. To quote Michael Douglas’s famous (or infamous) statement in his role as Gordon Gekko in the 1987 movieWall Street: “Greed is good.” Even today many “know” greed, or profit maximization to be the correct prescription for business success, even if it is amoral or shouldn’t be “good” from a moral perspective. Not so fast, Gordon. As Drucker so often said, whatever everyone knows is usually wrong, Hollywood films not excepted. Drucker told us first that profit is not the purpose of business and that the concept of profit maximization is not only meaningless, but dangerous.

Lessons from Peter F. Drucker
The Purpose of Business Is Not To Make A Profit
William Cohen, Ph.D. | Peter Drucker’s first executive Ph.D. graduate at what is now the Peter F. Drucker and Masatoshi Ito Graduate School of Management. His latest books are Drucker on Leadership (Jossey-Bass, 2010) and Heroic Leadership: Leading with Integrity and Honor (Jossey-Bass, 2010). Cohen is the president of The Institute of Leader Arts and a vice president of the 26 Peter F. Drucker Academies of China and Hong Kong. He is also a retired Air Force general.

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 by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory. — Wikipedia

Neoclassical economics is at odds with the foremost figure in business management has to say, and which most business people know from experience. "The business of business is business." that is, attracting and retaining customers in a marketplace that is ever-changing. Profit is a by-product of business success, which is the result of efficient and effective management. "Efficiency is doing things right, and effectiveness is doing the right things," is the message of Peter F. Drucker's The Effective Executive.