Firm theory is an awkward field for economists. Firms are inextricably linked to markets but utterly unlike markets. Economists believe they are excellent at explaining how people react to incentives in markets. Economists are not as comfortable analyzing command structures. Firms represent an odd middle ground.
This is why firm structure is a relatively understudied field for economists. Economists can design the most complex auction system that satisfies X,Y,Z. Great, but when is the last time you participated in an auction? That is not to say auctions and auction theory is not important, but for the average person, firms are a huge part of their lives. One would think firms would be much more important to economists. Unfortunately, they are not.
For many economists, the firm is a black box. Inputs go in (duh, its in the name) and outputs come out. Markets take over from there. Anything more explicit than that is beyond the scope of economics and belongs in the realm of management or business theory. You know, that soft gushy stuff, not the hard science of economics.
This shortcoming of modern economics has peaked my interest in the field. You can understand why I was excited to hear about An Entrepreneurial Theory of the Firm by Frederic Sautet. Yes, the book is 15 years old, but hey, I’m new to this game and still catching up.
Sautet tries to answer a simple question: why do firms exist? It almost seems obvious, but economists have a habit of skirting the obvious.
The standard answer goes back to Coase; markets are sometimes expensive. It would be expensive for me to go to an auction every time I wanted anything. Firms can lower transaction costs. Robbinsian economizer will want to step in to save money this money and creates a firm.
Sautet agrees, along with almost everyone who has looked at the topic since Coase, that lowering transactions costs a role for the firm. However, Sautet is not convinced, nor I am after reading him, that this explanation is enough.
Showing this requires an abstract model of an economy without transaction costs1. If firms still form in a world without transactions costs, clearly, the firm has other purposes.
Most economists would say that in this model the firm has no role. Without transactions costs, all goods are already distributed to their most highly desired uses once in equilibrium. The firm adds no value.
Where the Entrepreneur Fits In?
Here is where Sautet provides an important addition. What if the economy is in disequilibrium? Can the firm help direct an economy towards equilibrium?
Sautet only assumed zero transactions costs in his model. He did not assume perfect information. Actors can still suffer from the Hayekian Knowledge Problem (HKP). The actors in this imaginary economy might not be aware of what they do not know and are unaware of possible equilibrating actions.
In disequilibrium, an entrepreneur discovers these profit opportunities, and thus, push the economy towards equilibrium. This is the traditional Kirznerian theory of the entrepreneur.
Sautet’s addition is to embrace the role of the firm as a tool for the entrepreneur. The firm is a way to align the interests of multiple people and thus let their entrepreneurial insights work together. Yes, but why don’t they just write contracts to align incentives? Plenty of work over the past 40 years studies how to align incentives. This typical examples are principle-agent problems.
However, usual contract theory assumes that all possible states of the world can be put in a contract, thus aligning incentives. This is not possible in a world with a HKP. Entrepreneurship cannot be planned and therefore cannot be contracted. The insights of the entrepreneur are beforehand unknown to anyone in the economy and it is impossible to contract on something that is unknown. The actors cannot even trade for this information even without transaction costs, because it literally does not exist.
The firm fills an important role. At the same time, it aligns incentives and deals with the unknown possibilities that cannot be put into a specific contract. It kills two stones with one bird.
Sautet provides new insight and perspective on the nature of the entrepreneur, discovery, disequilibrium, and firm theory. The book is a nice short read and it seems fundamentally correct. While it is not a perfect book2, the Austrians are again asking the interesting questions.
I am ashamed that it took me so long to discover Sautet. Hopefully this post encourages readers to glance through Sautet’s work. This book was an invitation to inquiry (to steal a phrase from Pete Boettke) on a topic that is understudied. I know I will keep looking in the field.
1. Sautet has a long part on the purpose of abstract models at the beginning of the book that is wonderful. He contrasts his own use of an abstraction as an intellectual foil to the real world, compared to other economists who use this abstraction as a goal like in the case of perfect competition.
2. Sautet spends most of his time engaging Hayek, Kirzner, Williamson, and Coase, instead of engaging the real world outside the window. This is a typical problem in Austrian economics. I love these economists as much as anyone, but you are not learning about the real world, nor are you convincing skeptics by appeals to “authority.”