|A business firm is a needs-satisfying machine; it is an entity invented and employed by
society to better satisfy the society's interests. A society is better off when properly
regulated business firms are allowed to carry the bulk of economic activity than when
they are not allowed to exist or are severely regulated by the state. And, as history has
documented, societies fare better when they are dependent on such business firms than
when they are dependent on central planning.
The business firm generates consumer satisfaction in return for income that gets
distributed to its owners, employees, suppliers and public goods recipients. Any firm of
any size is in existence because:
This book describes four theories about the firm that have emerged since Adam Smith's
An Inquiry into the Nature and Causes of the Wealth of Nations. These theories are:
The Neoclassical Theory, The Transactions Cost Theory, The Principal-Agent Theory,
and The Evolutionary Theory.
The Neoclassical Theory of the Firm, in its basic form, views the firm as a black box
rational entity. The theory is built on imaginary but plausible production and demand
functions and it establishes the principal of profit maximisation according to which profit
is maximised when marginal revenue is equal to marginal cost. The theory may be used
to, among many other things, describe various market structures, regulation issues,
strategic pricing, barriers to entry, economies of scale and scope and even optimum
portfolio selection of risky assets. The main weakness of the theory is that it assumes
complete information and, as a result, there is no agency problem or concern for
transaction costs due to conflict between owners and suppliers of inputs (even specific to
whatever the firm produces) in the market system. Another weakness of the theory is that
it does not allow for firm evolution.
The Transactions Cost Theory of the Firm focuses on problems of asymmetric
information involved in transactions. The firm, according to this theory, comes into
existence because it successfully minimises ‘make' inputs costs (through vertical
integration) and ‘buy' inputs costs (using available markets). The more specific the inputs
that the firm needs are, the more likely it is that it would produce them internally and/or
acquires them through joint ventures and alliances. The weakness of this theory is that it
does not take into consideration agency costs or firm evolution neither it explains how
vertical integration should take place in the face of investments in human assets, with
unobservable value, that cannot be transferred.
The Principal-Agent Theory of the Firm extends the neoclassical theory by adding
agents to the firm. The theory is concerned with friction due to asymmetric information between owners of firms and their stakeholders or managers and employees; the friction
between agent and principal, requires precise measurement of agent performance and the
engineering of incentive mechanisms. The weaknesses of the theory are many: it is
difficult to engineer incentive mechanisms, it relies on complicated incomplete contracts
(borderline unenforceable), it ignores transaction costs (both external and internal), and it
does not allow for firm evolution.
The Evolutionary Theory of the Firm places emphasis on production capabilities and
process as well as product innovation. The firm according to this theory possesses unique
resources, tied semi-permanently to the firm, and capabilities; the firm’s recourses can be
classified into four categories: financial, physical, human and organisational. The theory
sees the firm as a reactor to change and a creator of change for competitive advantage.
The firm, as a creator of change, may cause creative destruction, which in turn may give
birth to new industries and enable sectors of, or entire, economies to grow. Although
many countries have established architectures to support entrepreneurial endeavours, a
weakness of the theory remains: process and product innovation (especially the latter) are
mostly due to serendipity and as a result ‘entrepreneurship’ is a very expensive factor of
production; in the pursuit of profit and general well-being, it cannot be easily
programmed within a firm or a nation.
The book consists of nine chapters followed by an epilogue:
- it identifies a consumer need and develops/invents a recipe on how to satisfy that
- it makes the right decisions with respect to making or buying inputs so that it
delivers its recipe at the lowest possible cost
- it provides the best incentives to its stakeholders and because
- it constantly and deliberately evolves through the relentless pursuit of competitive,
organisation and strategic advantage.
- Chapters 1 and 2 describe the external environment of the firm and the firm’s
decision-making process with emphasis on strengths and weaknesses of the
following models: rational, satisficing, probabilistic (inclusive of Bayesian),
cost/benefit and behavioural.
- Chapters 3–6 are devoted to the Neoclassical Theory of the Firm and some of its
applications ranging from market structures to managing a portfolio of risky assets
and from free pricing to regulation.
- Chapter 7 describes the Transactions Cost Theory of the Firm and its variants as well
as hybrids (structures between the extremes of markets and hierarchies).
- Chapter 8 focuses on the Principal-Agent Theory of the Firm, the central problem of
which is how to induce the agent to act in the best interests of the principal when the
agent has an informational advantage over, and different interests from, the principal.
- Chapter 9 deals with the Evolutionary Theory of the Firm built around the concepts
of creative destruction, competitive advantage, entrepreneurial styles and habitat,
strategy and firm structure as well as entrepreneurial architecture.