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Law, Economics, and the Theory of the Firm Buffalo Law Review Volume 52 Number 3 Article 8 7-1-2004 Law, Economics, and the Theory of the Firm Michael J. Meurer Boston University School of Law Follow this and additional works at: https://digitalcommons.law.buffalo.edu/buffalolawreview Part of the Law Commons, and the Legal Theory Commons Recommended Citation Michael J. Meurer, Law, Economics, and the Theory of the Firm, 52 Buff. L. Rev. 727 (2004). Available at: https://digitalcommons.law.buffalo.edu/buffalolawreview/vol52/iss3/8 This Essay is brought to you for free and open access by the Law Journals at Digital Commons @ University at Buffalo School of Law. It has been accepted for inclusion in Buffalo Law Review by an authorized editor of Digital Commons @ University at Buffalo School of Law. For more information, please contact [email protected]. Law, Economics, and the Theory of the Firm MICHAEL J. MEURERt Economic analysis of the law assumes the "shadow of the law" influences the behavior of businesses. Thus, busi- ness people consider the costs and benefits of contract litigation when they make decisions about contract per- formance, they consider the costs of tort litigation when they make investments in safety, they consider the costs of violating a regulation when they make decisions about regulatory compliance, and so on. Economic models of law typically abstract from organizational detail and treat busi- nesses as if they are represented by a single manager who controls the firm's behavior and acts to maximize its profit. This abstraction simplifies analysis but, not surprisingly, it limits the ability of analysts to fully explore some important legal policy questions. This Essay suggests ways to improve economic analysis of business and the law by better inte- grating the theory of the firm into law and economics schol- arship.1 When law and economics scholars peer inside a busi- ness organization and distinguish managers from the firm, they use the principal-agent framework.2 This framework assumes manager-agents make choices to maximize their own utility rather than profit, as desired by the share- holder-principals. Normally, managers care about their firm's profit, but they sometimes have conflicting prefer- t Professor of Law, Michaels Faculty Research Scholar, and Co-Director, Institute for Business, Law & Technology, Boston University School of Law, [email protected]. I thank Sean Chao and Walead Esmail for able research assistance. 1. See Alfred D. Chandler, Jr., OrganizationalCapabilities and the Theory of the Firm, 6 J. ECON. PERSP. 79 (1992). Socio-legal studies has long been attentive to the nature of the firm and the impact of law on the behavior of managers within firms. See, e.g., Barry D. Baysinger, Organization Theory and the CriminalLiability of Organizations 71 B.U. L. REV. 341 (1991). 2. See infra text accompanying notes 15-19. 3. For example, "[m]anagers... have no incentive to degrade the quality of the contracts that they write; after all, these contracts create the wealth that 727 728 BUFFALO LAW REVIEW [Vol. 52 ences explained by sloth, risk aversion, interest in personal gain, and other considerations.! Principal-agent analysis accounts for this agency problem and helps scholars deter- mine whether the law can improve the performance of managers,5 and whether a legal sanction will have its intended deterrent effect.6 There is some confusion in legal scholarship about the relationship between the principal-agent framework and the theory of the firm.7 Frequent linkage of agency theory and the theory of the firm in corporate law writing may give non-economists the false impression that the two are the same. Agency theory is a tool economists use to study the firm, as well as markets and politics. It addresses the problems that arise whenever a principal delegates author- ity to an agent.8 The theory of the firm (a subfield of the economics of organization) uses agency theory and other tools to understand why firms exist, what determines the boundaries of the firm, and how firms should be organized.9 After clearing away this confusion I try to accomplish two goals. First, I show the theory applies in many domains outside of corporate law. The key point to understand is that the economics of organization has much to teach us about middle management. Corporate law writing is mostly concerned with top management and its relationship to financial markets, and corporate law scholars have drawn the managers later can divert." Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of Contract Law, 113 YALE L. J. 541, 551 (2003). 4. See HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE 35, 40, 77 (1996) (discussing agency costs in business organizations). 5. A primary goal of corporate law is mitigation of agency costs. See WILLIAM T. ALLEN & REINIER KRAAKMAN, COMMENTARIES AND CASES ON THE LAW OF BUSINESS ORGANIZATION 11 (2003). 6. See infra text accompanying notes 29-36. 7. See infra text accompanying notes 8, 9. 8. Agency models have been used by law and economics scholars in relation to a variety of topics unrelated to the theory of the firm including the contract law doctrine, the client-attorney relationship, and the relationship between administrative agencies and Congress. For an introduction to agency theory and the law see Agency Models in Law and Economics, in CHICAGO LECTURES IN LAW AND ECONOMICS (Eric A. Posner ed., 2000). 9. For an excellent introduction to the economics of organization see PAUL MILGROM & JOHN ROBERTS, ECONOMICS, ORGANIZATION & MANAGEMENT (1992). Some review articles accessible to lawyers include Roy Radner, Hierarchy: The Economics of Managing, 30 J. ECON. LIT. 1382 (1992) and Bengt Holmstrom & John Roberts, The Boundaries of the Firm Revisited, 12 J. ECON. PERSP. 73 (1998). 20041 THE THEORY OF THE FIRM 729 on the theory of the firm to analyze the behavior of top managers. But the theory can also help scholars analyze tortious behavior, contract breach, discrimination, regula- tory violations, and other activities directed by middle management that are constrained by law. Second, I relax the assumption that the firm is represented by a single manager-agent, and apply lessons the theory of the firm teaches about decentralization. Probably most of the firm's activities of interest to legal scholars are influenced by more than one manager. Understanding the deterrent effect of the law on a firm's behavior requires understanding how authority is assigned within a firm and how managers interact. I. DISENTANGLING THE THEORY OF THE FIRM FROM AGENCY COST THEORY In 1937, Coase launched the theory of the firm by ask- ing why some economic activities are governed by the market and others are governed by the firm. He argued that high transaction costs associated with market govern- ance of certain activities pushed these activities inside the firm, where the exercise of authority would avoid transac- tion costs.' ° The theory was mostly neglected until the 1970s when Oliver Williamson and others began to flesh out the notion of transaction costs." Theoretical work on transaction costs spawned empirical work on the bounda- ries of the firm. Typically, the empirical work asked why firms conduct certain activities in-house and other related activities are contracted out. The empirical results gener- ally support the transaction cost theory, showing that activities tend to be brought inside the firm12 when markets are likely to exhibit high transaction costs. The original theories of Coase and Williamson were both deficient in terms of their characterization of the firm. They treated the firm like a black box in which authority 10. See generally Ronald Coase, The Nature of the Firm, 4 ECONOMICA 386 (1937). 11. See, e.g., OLIVER E. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS AND ANTITRUST IMPLICATIONS (1975). 12. See Michael D. Whinston, Assessing the Property Rights and Transaction-Cost Theories of Firm Scope, 91 AM. ECON. REV. 184 (2001); Michael D. Whinston, On the Transaction Cost Determinants of Vertical Integration, 19 J. L. ECON. & ORG. 1 (2003). 730 BUFFALO LAW REVIEW [Vol. 52 avoids transaction costs.' 3 The size of the firm was limited by vague appeal to costs of bureaucracy that increased with firm size. Modern research on the firm opens up the black box and gives a better account of how firms are organized and the costs and benefits of firm governance. In an early example, Alchian and Demsetz's influential theory of team production focused on monitoring as an important function of management in a firm."4 They claimed that firms are organized in ways such that managers can effectively moni- tor joint effort by teams of workers. And more importantly, they claimed that a team of workers benefits by contracting with a manager to monitor their effort and help them main- tain efficient levels of effort. Financial economists Jensen and Meckling pioneered the integration of the team production theory and the prin- cipal-agent framework in their study of the relationship between shareholders and CEOs." They noted that CEOs are not always faithful agents, they entertain motives other than maximizing the value of shares in the firm, and this divergence of interest creates an agency cost that must be controlled through monitoring and providing the CEO with appropriate incentives. 6 Their synthesis has been widely adopted by corporate law scholars under the rubric of the firm as a nexus of contracts. 7 Under this view, top man- 13. Williamson's work grew more sensitive to this problem over time. See OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM 131-62 (1985). 14. See Armen A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization,62 AM. ECON. REV. 777 (1972). 15. See Michael C. Jensen & William H. Meckling, Theory of the Firm: ManagerialBehavior, Agency Costs and Ownership Structure, 3 J.
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