FROM:Justin Yoon, Muhammad Taha

MEMO

TO: Rajiv Krishnan Kozhikode

FROM:Justin Yoon, Muhammad Taha

DATE:May 10, 2013

SUBJECT:

In his article, “What is a firm?”, Alfred D. Chandler (1992) illustrates the historical and continuing similarities between firms operating in society. Furthermore, he ties his findings to four economic theories - “the neoclassical, the principal-agent, the transaction cost, and the evolutionary.” (Chandler 1992, 484) - to the emergence and evolution of modern day enterprises.

In order to understand where the firm began and how it emerged into what it is today, it is imperative to know exactly what a firm is. Chandler begins his article by providing a concrete and serviceable definition:

“A firm is a legal entity - one that signs contracts with its suppliers, distributors, employees and often customers. It is also an administrative entity, for if there is a division of labor within the firm, or it carries out more than a single activity, a team of managers is needed to coordinate and monitor these different activities. Once established, a firm becomes a pool of learned skills, physical facilities and liquid capital. Finally, ‘for profit’ firms have been and still are the instruments in capitalist economies for the production and distribution of current goods and services and for the planning and allocation for future production and distribution” (483).

Having understood what it means to be a firm, we can now explore the dynamics of its relation to the four economic theories of the firm and the similarities amongst differing enterprises in terms of their history and growth.

Industrial firms began to expand in number and emerge as an economic entity as “modern transportation and communication networks were completed” (484). The ease of communication and access to resources contributed to the sudden boom in production, thereby attracting more firms towards the industrial sector of the economy. This created another evolutionary effect as “potential for greatly increased speed and volume of production of goods generated a wave of technological innovations … creating what historians have properly termed the Second Industrial Revolution” (484). This cycle of increased production and technological innovation paved ways for existing industries to grow while providing opportunities for new industries to form.

When it comes to the established theories of the firm, the neoclassical and principal-agent theory “contribute little in their present abstract formulations” (488). According to Chandler, the neoclassical depicts the “firm as a legal entity with a production set … from which a manager, acting rationally with full information, chooses the set most likely to maximize profits or present value of the firm” (488). The principal-agent theory is similar to the neoclassical in that it “accepts the neoclassical firm as a production set but gives it a managerial hierarchy” (488). The principal-agent theory focuses on the owners of the firm and their ability and duty to educate their managers in such a way that the managers can implement their own agendas that they see as optimal. According to Chandler, although both theories agree that the firm is a “legal entity that contracts with outsiders … neither deals with the firm’s physical facilities, and human skills and the resulting revenues on which the current profitability and future health of the enterprise depend” (489).

The transaction cost theory Chandler mentions in the article is related to organizational capabilities. He illustrates that managers in the organization should focus on transactions, which will influence the profit organization make while human skill and facilities play an important role in transactions. The costs of production and transactions have a close relationship with markets and Chandler found that the transaction is the firm and its physical and human assets compare to the theory Williamson put forward. For a firm, the asset is not only a transaction, but also includes the facilities and skills of workers. In terms of technology, organizations can still improve the competitive advantage when firms enter the market. In contrast, training managers are the ways of seeking out and capturing market opportunities.

Chandler is sympathetic to the recently articulated evolutionary theory of the firm. The central concept of Nelson and Winter is that of routines. “In evolutionary economics, the specifics of the ways firms relate to owners, customers, and input suppliers are subsumed under the heading of organizational routines,” (Richard & Nelson 1982, 173). They define ‘routine’ in a highly flexible way, much as ‘program’ (or, indeed, “routine”) is used in computer programming (97). For them, “routines are the skills of the organization’ that in turn become its ‘genes’” (134). The three important things we must mention here is the strategy, its structure, and its core capability. Strategy tends to define a desired firm structured in a general way, but not the details. Structure involves how a firm is organized and governed, how decisions are actually made and carried out, and thus largely determines what it actually does, given the broad strategy. Finally, “strategy and structure call forth and mold organizational capabilities, but what an organization can do well has something of a life of its own” (19-21). We can get the most important information is firm can focus on macroeconomic explain why this legal, contracting, transacting entity carry out the processes of production and distribution, of increasing production, economic growth and transformation.

With the development of the neo-classical theory, evolutionary theory, transaction cost theory and principal agent theory over the past decade, organizations are starting to realize the move further ahead from the classical notion of economic theories into a more dynamic theories which places the emphasis on the people. Hence, in 1996, Grantt introduced the Knowledge based theory of the firm. According to Nelson and Winter a firm's knowledge (or capability) as the "input- output combinations achievable with all possible mixes and levels of activities known to the firm" (pp. 63-64). The state of the firm can be advanced by absorbing the knowledge or building new concepts.The knowledge-based theory of the firm considers knowledge as the most strategically significant resource of the firm. It acknowledges the importance of knowledge-based resources as they are very difficult to imitate because they are subtle and hard to understand as they involve talents that are elusive and whose connection with results is difficult to discern, (Lippman & Rumelt, 1982). The knowledge based theory emphasizes the interaction among individuals or group of people for knowledge sharing and creation. It is considered as an important asset for the company.The knowledge based resources should look at intangibles rather than the tangibles. An important aspect about the knowledge-based view of the firm is the value to create strategy, which is very important in differentiating knowledge transfers from tangible good transfer. It is important to know that tangible goods tend to depreciate; however, knowledge growth leads to the development of competence in the company that requires huge investment in training. In the near future, knowledge will be considered as important an asset for the organization and this will help to move away from the notion of the bottom-up approach. Instead it will help foster an environment in the organization that ultimately will help the organization grow, innovate and succeed.

As depicted within Chandler’s article, the characteristics of firms in terms of their growth and beginnings are very similar. No matter what theory of the firm was used to explain the dynamics of the relationship between differing enterprises, they all led to the same conclusion: not only did differing firms have comparable histories, but they also behaved in likeness of one another. Moving further ahead, the knowledge based theory illustrates another example of firms altering their behaviours relatively during the same time period. It can be seen that the theories presented in the article as well as the newer knowledge based theory are a firm’s response to the changing dynamics of society; therefore, firms are forced to adjust their methods in order to remain competitive. As history shows, theories are constantly developed to explain phenomena, and has time goes by, the theory may either be improved upon, or replaced altogether. Such is the situation in regards to the firm that it seems probable in the future, when today’s theories and methods become less applicable, firms will continue to behave similarly to remain competitive amongst each other, thereby creating newer theories to help explain the change in behaviour.

CITATIONS

Chandler, A.D. (1992). What is a firm?: A historical perspective. European Economic Review, 36(2/3): 483-492.

Lippman, S., & Rumelt, R. (1982). Uncertain immutability: An analysis of inter-firm differences in efficiency under competition. Bell Journal of Economics, 13: 418-438.

Richard R. & Nelson, S. G. (1982). Evolutionary Theory of Economic Change. Cambridge,

Massachusetts: Belknap Press.