Home > Uncategorized > Theory of the firm

Theory of the firm

from David Ruccio

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.

Now, for the rest of us—citizens, nonmainstream economists, and academics in disciplines outside of business and economics—both the history of corporations and the prevailing neoclassical theory of the firm present so many problems it’s hard to believe Friedman’s ideas are still taken seriously. Long before Citizens United, corporations have exercised a great deal of influence both inside (over their workers) and outside (in politics and in the wider society). That’s why the corporation has been a contested institution—legally, economically, politically—since its inception. Similarly, the neoclassical theory of the firm (initially in its “black box” form, then when the owner-manager agency problem was raised) has swept most of the serious problems under the theoretical rug.*

But for the scholars gathered at Harvard, the key issue (as presented in the brief paper coauthored by Harvard Business School faculty members Paul Healy, Rebecca Henderson, David Moss, and Karthik Ramanna [pdf]) was a relatively narrow one: 

if firms have the power to generate profits not only by producing socially beneficial goods and services, but also by tilting public policy and the “rules of the game” to their advantage (whether through aggressive lobbying, effective use of the revolving door between political and corporate appointments, or campaign contributions), then the core assumption that firms can maximize social value by maximizing shareholder value may not hold, and framing managerial responsibility as simply a matter of maximizing shareholder value may well be inappropriate.

Having read the paper, it is extraordinary that there’s no real history—no story about the invention of the corporation as a legal “person,” no Louis Brandeis or the Progressive movement, no Knights of Labor or United Mineworkers, no mention of the role of International Telephone & Telegraph in overthrowing Salvador Allende in Chile, no Massey Energy killing 29 miners in the Upper Big Branch mine. It’s as if the problem of corporate power only emerged after the 2010 Citizens United decision.

Still, from the perspective of neoclassical economics, even that problem looms large. According to the reigning paradigm (which guides much policy and is taught to hundreds of thousands of students every year), under conditions of perfect competition, free markets (including firms that maximize shareholder value) lead to Pareto-efficient outcomes. But if corporations (whether single firms or industries) can shape the institutions of the market (or the rules and ethical customs that help to maintain them), then all bets are off: “Maximizing shareholder value by deliberately distorting critical market institutions or regulations for private advantage seems unlikely to lead to the maximization of social value.”

That’s why the participants in the Harvard conference were caught between the real implications of Citizens United (that corporations can increasingly bend the social rules to their private advantage) and their continued adherence to the neoclassical theory of the firm (according to which maximizing shareholder value also maximizes social value).

I suppose it’s no surprise, then, which won out at the Harvard conference:

“I went into the conference with the understanding that one could question the premise of the Neoclassical paradigm in economics through logical arguments—e.g., the inconsistencies between Friedman’s assumptions and Stigler’s theory. I left with a sense that logical arguments on their own are unlikely to carry the day, because the Neoclassical paradigm is so powerfully ingrained into the discipline, into the fabric of modern economics,” says Ramanna.

*Including the problem neoclassical economists share with many of their heterodox counterparts, namely, what exactly does it mean that corporations maximize profits or shareholder value? First, how do we define profits or shareholder value, i.e., what is the appropriate metric, over what time horizon should it be defined, and how should it be measured? Second, corporations do many different things, such as exploit workers, give lavish pay to top managers, attempt to eliminate rivals, chart particular short-run and long-term growth path, buy favors and influence legislation, hoard cash, accumulate capital, and so on—why reduce all of what they do to a single dimension?

  1. April 16, 2016 at 2:08 pm

    The neoclassical assumption about competition is simply, wrong. You can have neoclassical economics or you can have mathematics, but not both in the same universe. http://www.johnmlegge.com/blog/maths-of-competitive-equilibrium/

    • April 16, 2016 at 6:41 pm

      don john (or is it don jaun?) –i looked at that article.

      i think its 99% correct but 1% wrong.See SMD theorem.

      there is a general equilibrium (see ingrao and israel—the invisible hand). but it is point, or a set of measure zero. think of flipping a coin—it might turn out to be a heads, or a tails, or stand up on its side–thats a structurally unstable equilibrium.

      same with a roling ball on a mountain—it could fall one way or another way or stay on top. if its a conservative system the equilibrium is that it will be in perpetual motion—-go down one side, back up to the to the top and reverse. this is an attractor.

      harmonic oscillators, pendulums, etc do this.

      if you have a chaotic system, then it gets complex. it will never repeat the exact same trajectory but will stay in the chaotic attractor or ‘equilibrium’. (see David Ruelle in RMP—review of modern physics, and if you want to go out there there are other people in UK and Canada, and many more. It will drive you crazy. eg http://www.maths.qmul.ac.uk/~beck/ not jeff beck of ‘blind faith’ band’ or beck of ‘im a loser’ songs ).

      as dr. pangloss said , quoted by voltaire, ‘this is the best and only possible perfect world’–leibniz played pangloss in a movie if i recall correctly.

  2. blocke the
    April 16, 2016 at 9:02 pm

    “Now, for the rest of us—citizens, nonmainstream economists, and academics in disciplines outside of business and economics”

    You don’t have to go outside of academics in business and economics in order to find a different story, you just have to go outside the British and American academic community. When I discussed how German academic business economists conceived of the firm in terms of Efficiency for the community instead of ROI, right after WWI, in The End of the Practical Man (1984) nobody paid any attention. When I repeated the argument in my book, The Collapse of the American Management Mystique, 1996, Michel Albert, author of Capitalidm contre capitalism (1992), which contrasted the US idea of the firm with the Rhineland model, praised the work for demystifying the US idea of casino Capitalism by presenting alternative models. This stuff on the theory of the firm is just nonsense; the issues have been debated. It is just that the Harvard Business School has a stake in casino capitalism and will not challenge it.

  3. Eubulides
    April 17, 2016 at 5:20 am


    April 3, 2005
    An Early Advocate of Stock Options Debunks Himself

    FIFTEEN years ago, Michael C. Jensen…


    A. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin – it feels really great when you start out; you’re feted on television; investment bankers vie to float new issues.

    But it doesn’t take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: “Holy Moley! How are we going to generate the returns?” They look for legal loopholes in the accounting, and when those don’t work, even basically honest people move around the corner to outright fraud.

    If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

    Q. Are you suggesting that executives be rewarded for driving down the price of the stock?

    A. I’m saying they should be rewarded for being honest. A C.E.O. should be able to tell investors, “Listen, this company isn’t worth its $70 billion market cap; it’s really worth $30 billion, and here’s why.”


  4. April 17, 2016 at 5:31 am

    I’m dismissing discussion of the usual obvious observations here about maximization and optimization being unknowns and unknowable in any firm or useful sense. Mart Malakoff’s appeal to chaos mathematics is appropriate for explanatory purposes although I’m not sure it adds much to our understanding. At bottom the problem is that economists (and others) have managed to make institutionalized economic actions a primary determining factor in the modern world. Other such institutions have been pushed aside in favor of economics. The church, family, military, and even democracy have been superseded and in certain times and places replaced by economics. The firm, one of these economic institutions is just a little more nuts and dysfunctional than the others. But the results are the same. How does one go about replacing what has become the major basis of modern life? At least without destroying the entire society in which it exists? Even if neoclassical economics were defeated and pushed out tomorrow the central problem remains. Most all modern societies are economics societies, whatever form that economics takes. The solution as I see it is to return balance to our societies by removing economics from its leading role and allowing the other institutional factors to reassert themselves – art, religion, family, government, politics, etc. Then economists might be more willing to make what they do more useful and comprehensible, since they would no longer be the only or primary center of attention.

  5. blocke the
    April 17, 2016 at 9:13 am

    Proprietary conceptions of the firm, which have warped into director primacy in firm governance have become standard in economics and management MBA education, but the firm and its purpose have been described and debated in other societies differently. I learned that when I read into the discussions about the firm and its purpose in German academic businesss economics, that went on postWWI in German journal literature. I pointed it out in my book, The End of the Practical Man (1984), repeated it in The Collapse of the American Management Mystique (1996). Germans tried to maintain a different view of the firm after the Second WorldWwar, as Michel Albert pointed out in his 1991 book on the difference between Rhineland and US casino Capitalism (Capitalisme contra Capittalism). America won the Cold War and imposed, especially in our era of financialization, its view in the globalized economy of its creation. But there are traditions, both in business economics, and in the world of praxis that people can use to remove the US version of the economics of the firm and let other institutional factors reassert themselves.

  6. Jordi Llanos
    April 17, 2016 at 10:48 am

    Firm theory of neoclassical school was refuted by Piero Sraffa in 1926 “THE LAWS OF RETURNS UNDER COMPETITIVE CONDITIONS”. From this point onwards, there is not firm theory in popperian terms. http://www.newschool.edu/nssr/het/texts/sraffa/sraffa26.htm

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.