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Journal of Economic Literature 2011, 49:1, 101–113 http:www.aeaweb.org/articles.php?doi=10.1257/jel.49.1.101

Thinking about the Firm: A Review of Daniel Spulber’s The Theory of the Firm

Oliver Hart*

In this review, I describe how economists have moved beyond the firm as a black box to incorporate incentives, internal , and firm boundaries. I then turn to the way that the theory of the firm is treated in Daniel Spulber’s book The Theory of the Firm: with Endogenous Entrepreneurs, Firms, Markets, and . Spulber’s goal is to explain why firms exist, how they are established, and what they contribute to the economy. To accomplish this, Spulber defines a firm to be a transaction institution whose objectives differ from those of its owners. For Spulber, this separation is the key difference between the firm and direct exchange between consumers. I raise questions about whether this is a useful basis for a theory of the firm.( JEL D21)

1. Introduction remained the basic unit. The general merchant bought and sold all types of prod- irms are an essential part of the economy. ucts and carried out all the basic ­commercial FHowever, as Daniel Spulber points out functions. By the 1840s, such tasks were being in The Theory of the Firm: Microeconomics carried out by different types of specialized with Endogenous Entrepreneurs, Firms, enterprises. However, it was still true that Markets, and Organizations (Cambridge these enterprises were personally managed University Press 2009), the modern firm is by their owners or by managers who worked a relatively recent phenomenon. From the closely with the owners. It was only in the sec- earliest times to the eighteenth century, busi- ond half of the nineteenth century that the ness was carried out by farmer, artisans, and world saw the emergence of the modern cor- merchants (Spulber, p. 103). According to poration, a multiunit enterprise operated by Alfred D. Chandler, merchants still ruled teams of salaried managers who had little or the (American) economy in 1790. The family no equity in the firm (Chandler 1977, p. 17; Chandler 1990, pp. 1, 14).1 * Harvard University. I am very grateful to Phillippe Today, of course, the large is Aghion, Bengt Holmstrom, Andrei Shleifer, and Luigi ubiquitous and often operates in multiple Zingales for helpful comments and to Jonathan Hall for research assistance. Research support from the National Science Foundation through the National Bureau of Eco- nomic Research is gratefully acknowledged. 1 See also Adolf A. Berle and Gardiner C. Means (1932).

101 102 Journal of Economic Literature, Vol. XLIX (March 2011) countries.2 Many people work in such literature on organizations by noneconomists, ­. In 2007, Wal-Mart, the largest in particular sociologists and organizational U.S. employer, had 1.8 million employees.3 behavior theorists. This literature is undoubt- In 2001, a randomly selected employee in the edly interesting and important in its own way, United Kingdom worked in a firm with 934 but my opinion is that it is not yet at a stage of other employees.4 But, in spite of the fact that theoretical or empirical precision that it can large public companies dominate the eco- be incorporated into mainstream economic nomic landscape in advanced countries, there thinking. I will also only touch on the vast lit- are many other types of firms that are still erature on firms’ financing decisions. important: sole proprietorships, family-owned After discussing the state of the literature, enterprises, partnerships, cooperatives, mutu- I will turn to how the theory of the firm is als, nonprofits, and government-owned firms.5 treated in Daniel Spulber’s new book. This raises a natural question: should we be looking for one theory that encompasses all 2. The Textbook View of the Firm of these forms? Or should we be looking for several different theories? In most modern microeconomic text- One problem any economist faces in analyz- books, the firm is still represented in purely ing the firm is one of definition. To pose a ques- technological terms as a production function tion that is often asked but rarely answered (at or .6 The firm is presided over least satisfactorily)—what is a firm? Is a firm by a manager who acts on behalf of the own- circumscribed by its legal status or by its eco- ers. Since the firm is typically supposed to nomic activities? This question is quite impor- operate under perfect and there tant if, for example, one wishes to understand is a complete set of markets, the owners the motives for mergers. The fact that this unanimously want the manager to maximize question is so difficult to answer may be one or —this increases their reason that the theory of the firm is one of the wealth and their set of consumption possibil- less developed and agreed-upon areas of eco- ities—and this is what he is supposed to do. nomics. The theory of the consumer does not While this is a caricature of the modern suffer from the same problem. Although indi- firm, there is no doubt that it is a very useful viduals may be infinitely complicated, at least one. The approach can be used to understand we know what their boundaries are. how firms’ production choices respond to In this review, I will describe what I see as changes in and taxes and to predict the the current state of the theory of the firm and aggregate behavior of an industry. Moreover, what the main unresolved questions are. It once the assumption of perfect competi- goes without saying that my focus is selective. tion is dropped, the approach can be used to I will not, for example, discuss the very large study the strategic interaction between firms. In fact, a large part of the modern literature relies on the produc- 2 There are over 64,000 multinational firms that oper- 7 ate across national boundaries and the foreign affiliates of tion function view of the firm. multinational firms employ more than 53 million people. See Spulber, p. 110. 3 http://www.walmartfacts.com/featuredtopics/?id=3, 6 See, e.g., Walter Nicholson and Christopher Snyder accessed February 2, 2007. (2006). 4 See (2008). 7 See, e.g., (1988). Note that, even under 5 There are approximately 20 million firms in the imperfect competition, the assumption that the owners of (Spulber, p. 110). Approximately 6,500 firms the firm want it to maximize profit or market value can be are traded on the three major U.S. stock exchanges (see justified if each owner consumes a negligible amount of the CRSP US Stock Databases). firm’s product. Spulber discusses this in chapter 3. Hart: Thinking about the Firm 103

However, for many purposes, this view of and risk sharing.9 In more recent work, the the firm is inadequate. For example, it has emphasis has been on getting the agent to little if anything to say about optimal execu- take the right kind of action (see Holmstrom tive compensation or about firms’ financing and Paul Milgrom 1991).10 In this multitask- decisions. It also does not help us to under- ing literature, high-powered incentives are stand the determinants of firm boundaries costly not because they expose the manager or the internal organization of large firms, to too much risk but because they cause or why some firms are cooperatives, or the the manager to focus on the wrong kinds of nature of the that firms write with activities from the owners’ perspective. For each other. In the 1970s and 1980s, there example, the manager on a high-powered was an explosion of work in response to these incentive scheme may be so concerned to limitations. Let me turn to this. increase his wealth that he might engage in dubious practices, such as manipulating the 3. Opening the Black Box: Incentives accounts. This will be a particular problem if the manager expects to leave the firm and The textbook model supposes that the his incentives are short-term. We saw some manager is an automaton who acts in the of the negative consequences of account owners’ . One way to enrich the basic manipulation in Enron and related cases in model is to allow for the possibility that the the early 2000s. manager has goals of his own. For example, In the one period model, the the manager may like the easy life, or may optimal incentive scheme may be complex; enjoy perks, or may be an empire builder. for example, it may be highly nonlinear. In a The owners would like to prohibit these multiperiod environment, however, this can activities to the extent that they interfere lead to gaming as the manager moves profit with value maximization but, if some of the from one period to another to maximize the manager’s actions are hidden or the manager marginal impact on his incentives. Under has private information about his environ- some conditions, Holmstrom and Milgrom ment, this may be impossible. As a result, the (1987) show that, in a dynamic environment, goal of profit or value maximization will not the optimal incentive scheme is linear. As be achieved.8 a practical application, this would suggest The conflict of interest between managers that it might make sense to allocate equity and owners is the focus of the by now vast rather than stock options to managers. Stock principal–agent literature. In the early moral options discourage managerial effort if the hazard models of James A. Mirrlees (1999) options are “out of the .” Of course, if and Bengt Holmstrom (1979), the manager they are “far out of the money,” they may also is supposed to be risk averse and the optimal encourage excessive risk taking. compensation off incentives

9 A related part of the literature supposes that the man- ager has precontractual private information. See chapter 2 of Patrick Bolton and Mathias Dewatripont (2005) for 8 In focusing on the conflict of interest between own- a summary. ers and managers, I am taking a rather U.S. or U.K.centric 10 See George P. Baker (1992) for related work. Another view of the world. In many countries, there is little separa- important extension, carried out by Holmstrom (1982), tion between ownership and management; see Rafael La has been to the case of multiple agents and the free rider Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer problems that arise when there is team production (see (1999). For firms in such countries, the more relevant con- also Armen A. Alchian and 1972). Tirole flict may be between managers and workers. (1986) studies collusion in the presence of multiple agents. 104 Journal of Economic Literature, Vol. XLIX (March 2011)

A parallel literature to the principal–agent agency and information problems explain one was developed in corporate finance the use of one rather than the other is still at about the same time in order to explain a somewhat unresolved issue in the corpo- a firm’s financial structure. In the textbook rate finance literature. In practice, both model, where the manager acts on behalf seem to be important to control managerial of shareholders and markets are complete, misbehavior. the Modigliani–Miller theorem tells us In the standard principal–agent literature, that financial structure is irrelevant in the it is usually supposed that the owner chooses absence of taxes (see Franco Modigliani and the optimal incentive scheme. But, in the Merton H. Miller 1958). To explain financial context of a large public company, share- structure, Michael C. Jensen and William holders are often dispersed and managers H. Meckling (1976) suppose that manag- are in charge (with some constraints imposed ers like perks (fancy offices, corporate jets, by the board of directors). In this case, it etc.). They consider a manager who initially is more natural to suppose that managers owns 100 percent of a firm. In this situation, choose the incentive scheme and in some the manager will have no incentive to take cases also the capital structure.11 Not surpris- excessive perks since he bears the full con- ingly, the implications of this are significant. sequences of such behavior. But now sup- For example, if managers choose their own pose the firm has to raise capital. One way to incentive scheme, they may opt for high pay do this is to issue equity. However, this will rather than (high) pay for performance. This dilute the manager’s stake and, since he is issue has been relevant in the recent debate no longer the 100 percent residual income on executive compensation.12 claimant, he will start to behave inefficiently: a dollar spent on perks may be worth less 4. Opening the Black Box: Firm than a dollar to the manager, but it may still Boundaries be worth more than a dollar in dividends that has to be shared with outside shareholders. The textbook view of the firm takes firm It might be better for the firm to borrow boundaries as given. The firm is associated since this keeps the manager’s equity stake with a production set but it is not asked intact: as the 100 percent residual claimant, where this comes from. Yet, in practice, firm he bears the full consequences of inefficient boundaries are constantly changing. Firms behavior. At the same time if the firm bor- are continually merging and demerging, rows too much, then the debt will become and insourcing. In 2006, the risky and this will encourage the manager to worldwide value of gamble with the company’s funds: the upside exceeded $4 trillion.13 What determines this of such a gamble is enjoyed by the equity- activity? holders, that is, the manager, while the The analysis of this issue began with downside losses are borne by the creditors. Ronald H. Coase’s famous 1937 article on The optimal mix of debt and equity trades , and two Nobel prizes off these effects. have now been awarded for work in this It is interesting that Jensen and Meckling area: one to Coase in 1991 and another to use classic principal–agent ideas to derive implications about optimal capital structure rather than optimal incentive schemes. The 11 See Jeffrey Zwiebel (1996). 12 See, e.g., Lucian Bebchuk and Jesse Fried (2004). relationship between capital structure and 13 See The Economist, “Mergers and Acquisitions,” Jan- incentive schemes and the extent to which uary 13, 2007. http://www.economist.com/node/8522024. Hart: Thinking about the Firm 105

Oliver E. Williamson in 2009. Coase first have to be revised or renegotiated ex post. raised the question of why any transactions Williamson argues that this renegotiation take place in firms if markets are so good at process is costly. The parties will engage allocating resources. Coase suggests that the in opportunistic and wasteful behavior to answer is that using the market is costly. The improve their position. Given the two most important are (i) discovering presence of private information, renegotia- what the market prices are and (ii) negoti- tion may fail altogether. As a result, a consid- ating a contract for each exchange transac- erable amount of surplus may be lost. tion. According to Coase, these costs are Williamson and Klein, Crawford, and avoided inside the firm because bargaining Alchian argue that, in circumstances like is replaced by authority: an employer tells these, it might be more efficient for the par- an employee what to do and (within limits) ties to vertically integrate, that is, to carry out the employee obeys. However, authority has the transaction under the umbrella of a sin- its own costs. First, as a firm gets bigger, the gle firm. Within a single firm, bargaining is entrepreneur or manager running it will find replaced by authority. As in Coase (1937), an it increasingly difficult to organize the firm’s employer tells an employee what to do and activities given his or her limited (intellec- within limits he obeys. There is a consider- tual) capacity. Second, and related to this, able amount of empirical evidence consistent the person in charge will make mistakes. with the conclusion that vertical integration Coase’s questions about why firms and is a likely outcome in the presence of large markets coexist are brilliant, but his answers relationship-specific .14 are less satisfactory and it has been left to The theories of Williamson and Klein, others to make progress. To mention one Crawford, and Alchian are largely informal problem: why cannot an overstretched man- and leave open important questions such as ager hire another manager to help him out? how authority is enforced in an integrated Also, it seems optimistic and unrealistic to firm, what the costs of integration are, and suppose that placing a transaction inside a even what integration means. In a 1986 firm eliminates all haggling: there are many paper, Sanford J. Grossman and I developed examples in practice of serious and costly a framework for answering these questions disagreements inside firms. (Grossman and Hart 1986; see also Hart and In the 1970s, Williamson (1971, 1975), and John Moore 1990). We argued that an impli- later Benjamin Klein, Robert G. Crawford, cation of contractual incompleteness is that and Alchian (1978), made significant prog- not all decisions that have to be made in a ress on understanding the costs of using relationship will be fully specified in the ini- markets. Williamson focused on a situation tial contract. A key question is: who makes where parties make relationship-specific the unspecified decisions? We argued that investments. These are investments that the owner of a nonhuman asset has the right are worth more inside a relationship than to decide how the asset should be used in cir- outside. A classic example is an electricity- cumstances not covered by the contract: the generating plant that sites near a coal mine. owner has residual rights of control. We also Ideally, a transaction involving relationship- identified a firm with the nonhuman assets it specific investments would be governed by possesses. a long-term contract but, in practice, such contracts are hard to write because of the difficulties of anticipating the future. Any 14 See the survey by Francine Lafontaine and Margaret such contract will be incomplete and will Slade (2007). 106 Journal of Economic Literature, Vol. XLIX (March 2011)

Our approach yields a theory of asset own- the same time, the model is restrictive in that ership and firm boundaries. In our formal it is based on efficient ex post renegotiation, model, parties renegotiate their incomplete which means that it is unlikely to be helpful contract once an uncontracted-for contin- in understanding the internal organization of gency arises: this renegotiation occurs under large companies (see below).16 symmetric information (both observe the In recent work with coauthors, I have tried contingency). The parties therefore reach an to broaden the property rights approach so ex post efficient outcome. However, the divi- that it can cast light on internal organization sion of surplus depends on the allocation of (see Hart and Moore 2008, Hart 2009, and asset ownership. Suppose you and I can both Hart and Holmstrom 2010). In these newer undertake noncontractible investments that models, which use some behavioral ideas, make us more productive as long as we have allocations are ex post inefficient and the access to asset A. If I own A, then I can use allocation of authority matters (see below). my residual control rights to deny you access In a sense, this work can be viewed as a (“hold you up”), thereby reducing your share “merger” of the transaction and prop- of the ex post surplus. Under reasonable erty rights literatures. Whether this merger assumptions, this will reduce your incen- will be successful remains to be seen. tive to invest. On the other hand, if you own asset A, then you can use your residual con- 5. Opening the Black Box: What Goes trol rights to hold me up, and knowing this on Inside the Firm I will invest less. Under plausible assump- tions, it can be shown that ownership of asset Lafontaine and Slade (2007) have esti- A should be allocated to the party whose mated that the value of transactions in U.S. is more important. firms is approximately equal to that in U.S. The theory explains why it is better for an markets. Raghuram G. Rajan and Luigi agent sometimes to be an independent con- Zingales (1998) have found, in a sample of tractor (own the asset she works with) and forty-three countries, that two thirds of the sometimes to be an employee (not own the growth in industries over the 1980s came asset). No individual should own all the assets from growth in the size of existing firms. and similarly there should not be a single Thus it is clear that a great deal of economic firm in the economy that owns everything. activity takes place inside firms. The Grossman–Hart–Moore (GHM)— or property rights—model is an operational vehicle for analyzing the costs and benefits of 16 One advantage of the more formal approach in GHM integration, and I think that it is fair to say that is that it may help to answer some questions that an infor- mal approach cannot. Suppose a firm creates a new entity it has become a workhorse in the literature. It out of some of its operations but retains complete control provides useful comparative statics properties over the new entity. Is it easier to motivate workers in the and has implications concerning the owner- new entity than when they were in-house employees? According to GHM, the answer is no: nothing has changed. ship of synergistic assets. Also, there is by now I’m not sure what more informal approaches would say a fair amount of evidence consistent with the about this. I was involved in a legal case along these lines. implication of GHM that one of the costs of In Black and Decker v. U.S.A., Black and Decker argued that they created a new entity to manage employee and integration is that it is hard to elicit efficiency- retiree health care benefits for efficiency rather than tax 15 enhancing investments from employees. At reasons. I argued for the U.S. government that there was no efficiency rationale since control did not change. The case was settled. More recently, I was involved in a second case, WFC Holdings (Wells Fargo) v. U.S.A., which raised 15 See Lafontaine and Slade (2007). similar issues. This case went to trial (a verdict is awaited). Hart: Thinking about the Firm 107

Explaining the organization of this activ- organization decision rights are “loaned, not ity would seem to be an important goal for owned” (Baker, Gibbons, and Murphy 1999). economists.17 Unfortunately, while there is a Call the loaning of decision rights the for- massive literature on these issues, progress mal allocation of authority. (That is, formal has been slow in the sense that there is no authority is temporary legal authority.) An consensus on the best models to use. One example would be someone being allocated a problem is that most models in this area fail budget to purchase equipment. How should to distinguish between inter- and intra-firm such decision rights be allocated? Bolton transactions. and Dewatripont (1995) use team theory to One part of the literature studies how study this question. They consider a situation production, information collection and pro- where subordinates have more information cessing, and communication tasks should be than a boss. The boss can ask the subordi- allocated given that no single person knows or nates to transmit their information but this can do everything. Papers in this area include is costly and takes time. Alternatively, the Roy Radner (1992), Radner and Timothy boss can forego communication and let the van Zandt (1992), Bolton and Dewatripont subordinates decide themselves. Bolton and (1994), and Luis Garicano (2000). This part Dewatripont show that centralization will be of the literature follows the team-theoretic preferred to decentralization if decisions in approach of Jacob Marschak and Radner the organization are highly interrelated but (1972) in supposing that all members of the not if they are independent. team have the same objective function. It is Jensen and Meckling (1992) analyze a typically assumed that members of the same similar situation but introduce a conflict of team work in a single organization but it is interest between subordinates and bosses. not explained why. Thus this work does not They emphasize that lower down members inform us directly about internal organiza- of an organization have better information tion: it tells us as much about how society than their bosses but may have the wrong does or should solve task assignment prob- goals. The advantage of centralization is that lems as about how firms do. the boss will maximize the right thing; the A second part of the literature studies disadvantage is that she will be uninformed. the allocation of decision rights. As back- Wouter Dessein (2002) and Ricardo Alonso, ground, it is useful to remember that legal Dessein, and Niko Matouschek (2008) control rights in (most) large organizations extend this type of analysis to the case where reside with the board of directors (typically the boss can elicit information from the sub- elected by the owners). Thus any allocation ordinates so as to improve her decision mak- of authority to someone inside an organiza- ing, and where their willingness to report tion is temporary or provisional: the board truthfully may depend on whether they have of directors always has the legal right to been delegated some decision rights. take the decision back at a moment’s notice. These papers do not consider firm bound- To use Baker, Robert Gibbons, and Kevin aries. The members of the organization could J. Murphy’s felicitous language, inside an be agents in different firms. In other words, the results could be telling us about the allo- 17 An interesting account of recent trends in the inter- cation of decision rights across several firms nal organization of large companies can be found in rather than within a single firm. John Roberts (2004). For some recent empirical work Philippe Aghion and Tirole (1997) is the on the determinants of internal organization, see Daron Acemoglu et al. (2007) and Nicholas Bloom and John Van first paper to develop a theory of author- Reenen (2007). ity that takes into account firm ­boundaries. 108 Journal of Economic Literature, Vol. XLIX (March 2011)

Aghion and Tirole argue that a boss can Economics and Management Strategy. He credibly allocate authority to someone by has obviously thought a lot about firms. ­overloading herself so that she is less informed Before I describe his perspective, let than this person, and that this may be a way me note that there is much of interest in to motivate subordinates to generate ideas: this book. Spulber has a broad view of the if the boss is uninformed, subordinates know theory of the firm and he includes interest- that their ideas will usually be implemented. ing discussions of the history of the firm as That is, even though the boss has legal author- an institution and legal aspects of the firm, ity, the subordinate has “real” authority in going back to partnership in the Roman the sense that the subordinate gets his way. Empire. Many readers will not have been Aghion and Tirole show that, in some cases, exposed to this material and will find it very it may be better to motivate subordinates useful. through the vehicle of real authority than by When I started to read Spulber’s book, I transferring legal authority to them. expected that he would emphasize topics Aghion and Tirole’s theory is about the 3–5 above. But he does not. These topics are choice between real and legal authority mentioned but they are not the focus of the rather than about formal authority in the way book. Spulber’s perspective is different. that we have defined it here. In their model, Spulber’s goal in writing his book is stated temporary legal authority is not an effec- right away: “The Theory of the Firm seeks tive way to motivate someone since the boss to explain (1) why firms exist, (2) how firms can always take back the authority ex post are established, and (3) what firms contrib- (unless reputational forces are at work; see ute to the economy” (p. ix). To accomplish Baker, Gibbons, and Murphy 1999). Hart this goal, Spulber needs a definition of a and Holmstrom (2010) give formal authority firm. Here it is: “The firm is defined to be a role by introducing a friction. Their paper, a transaction institution whose objectives which builds on Hart and Moore (2008), differ from those of its owners. The separa- supposes that a reversal of formal authority tion is the key difference between the firm causes subordinates to feel aggrieved and and direct exchange between consumers” (p. to shade on performance. This discourages 63). Spulber uses this definition to argue that a boss from reversing a prior allocation, and consumer organizations such as clubs and so the allocation of formal authority serves as basic partnerships are not firms. The reason a commitment device. Hart and Holmstrom is that “the objectives of consumer organi- (2010) show that the delegation of author- zations cannot be separated from those of ity within an integrated firm can be a use- their owners” (p. ix). Similarly, many family ful compromise between fully centralized are not firms, and nor are worker integration and nonintegration: delegation cooperatives, nonprofit organizations, or allows subordinates to get their way when public enterprises (chapter 1, pp. 42–61). decisions mean more to them than to the At the same time, clubs (and worker and boss, while the boss can always reverse if the consumer cooperatives and partnerships) outcome is sufficiently important to her. become firms if and when a market is cre- ated in memberships. 6. Daniel Spulber’s New Book The intellectual stimulus for Spulber’s approach is Irving Fisher’s famous separation Daniel Spulber is the author of many books theorem (Fisher 1930). Fisher addressed and articles on the firm and related topics, the separation of the firm’s investment deci- and is the founding editor of the Journal of sions from owners’ consumption and ­ Hart: Thinking about the Firm 109 objectives. As Spulber says: “Under reason- process in which the conflicting objectives of able assumptions the firm’s optimal invest- individuals . . . are brought into equilibrium ment decisions are independent of the within a framework of contractual relations” preferences of its owners and independent (p. 311). Even if Jensen and Meckling go too of how the investment is financed” (p. 65). far—the New York Times, for example, prob- The firm’s owners are affected by the firm’s ably has some fairly well-defined goals, and decisions only through their wealth. We many firms seem to have significant corpo- appealed to a version of this theorem in sec- rate cultures—it is not clear that the concept tion 2 when we justified the assumption that of an objective function is a valid basis for a firms maximize profit. theory of the firm. The Fisher separation theorem is obvi- Nor is it clear that Spulber’s test is empiri- ously important but it is not clear that it cally relevant. Suppose that I want to know provides a good basis for defining a firm. whether a public company A is likely to There are some very important institutions engage in value-reducing acquisitions. We in the United States that almost everyone know from much research in corporate would regard as firms, but it is not clear that finance18 that it may be significant whether they pass the Spulber test. Bill Gates is still company A has a large shareholder or a significant owner of and quite involved whether company A’s CEO has substantial in Microsoft, so is Microsoft a firm? Larry stock options, but whereas the first may dis- Page and Sergey Brin are significant own- qualify the company as a firm according to ers of and (even more) involved in Google, Spulber’s test, the second does not. so is Google a firm? Will these organizations It is also not obvious that Spulber’s defi- become firms only when their founders are nition yields useful theoretical -offs or long gone? Similar questions arise in vary- insights. Let’s consider one of Spulber’s lead- ing degrees with respect to other companies ing examples, a worker cooperative. In chap- with large and active owners, e.g., News ter 6, Spulber starts by describing Benjamin , Berkshire Hathaway, CBS, and Ward’s (1958) basic model of a cooperative. the New York Times. Suppose that identical workers are each Apart from the fact that many natural endowed with one unit of labor and can firms seem to fail the test, there is also the earn a market w. There is a technology question of how to apply the test. How can described by the production function we say empirically whether an entity has an objective function that differs from that of its (1) Q F(L), = owners? How do we learn what the objec- tive function of a firm is? Should we ask the where L is labor and Q is output and F > 0, ′ CEO? A representative member of the orga- F 0. Output is sold at a competitive ′′ < nization? More generally, does it even make p. There is a fixed cost of production K. sense to talk about the objective function of The worker cooperative chooses employ- an organization? Jensen and Meckling are ment L to maximize each member’s share of dismissive of the idea in their well-known surplus, 1976 article. They argue that “. . . the person- pF(L) K alization of the firm implied by asking ques- (2) ​ − . tions such as ‘what should be the objective _L function of the firm’ . . . is seriously mislead- ing. The firm is not an individual.It is a legal 18 See, e.g., Randall Morck, Shleifer, and Robert W. fiction which serves as a focus for a complex Vishny (1988). 110 Journal of Economic Literature, Vol. XLIX (March 2011)

The first order conditions are Clearly (7) is maximized by setting L L*. = Moreover, the original owners are better off pF(​ Lˆ ​) K than if they did not use a membership fee (3) − pF (​ Lˆ ​). _ ˆ = ′ and set L ​ Lˆ ​. L​ ​ = Another equally good option for the In other words, the average revenue product ­owners is to sell their technology to an out- of labor is equated to the marginal revenue sider for pF(L*) wL* K and let her run it − − product. The partnership is viable at the as a profit-maximizing firm. scale L​ ˆ ​ only if each member receives more What do we conclude from this? Spulber than her outside option: deduces that we should not describe the basic worker cooperative (without a membership pF(​ Lˆ ​) K fee) as a firm since its objective cannot be (4) _ − w, L​ ˆ ​ ≥ separated from that of its owners; while the worker cooperative with a membership fee which we assume in what follows. (and of course the standard profit-maximiz- Call the above the “basic” worker coopera- ing firm) is a firm since the Fisher separa- tive. Compare this to a standard profit-max- tion criterion is satisfied. My conclusion is imizing firm that chooses an different. I think that both forms of worker level satisfying cooperative (as well, of course, as a profit- maximizing firm) are firms, but one form is (5) pF (L*) w. more efficient than the other. If the world is ′ = as described above, then in equilibrium we It is easy to show that L​ ˆ ​ L*. That is, a would expect to see the basic worker coop- ≤ worker cooperative operates at an ineffi- erative being replaced by one with mem- ciently low scale. The reason is that, given bership fees or by a profit-maximizing firm. equal treatment of members, the coopera- Moreover, for me the intellectual underpin- tive has to share surplus with new members, ning of this result is not so much the Fisher which means that increasing employment is separation theorem as the Coase theorem expensive. (Coase 1960). As Spulber points out, there is a simple In this simple setting of perfect informa- solution to this inefficiency: the cooperative tion and perfect contracts, the basic worker can charge a membership fee. Assume that cooperative is never optimal. Nor is what the initial owners possess n units of labor Spulber calls a club. To understand why themselves, where n L*. Suppose they clubs and worker cooperatives are sometimes ≤ hire L n new members and charge each observed, Spulber introduces two alternative − a membership fee f. Given that surplus is assumptions. The first is that there is a trans- shared equally, f can be set such that action cost of setting up a profit-maximizing firm or introducing membership fees. The pF(L) K second is that there is asymmetric informa- (6) − w f, _L − = tion. The implications of the first are obvi- ous. To understand the second, consider the and so each original owner obtains case where there is not a single market wage w. Instead, the opportunity costs of work- pF(L) K L n (7) ​ _ − _−n ​ f ers are idiosyncratic and are known only to L + ​(​ ) them. Then a profit-maximizing firm, or a 1 ​[ pF(L) wL K] w. cooperative that sets entry fees, may cause = _​ n − − + Hart: Thinking about the Firm 111 inefficiency by trying to price (or wage) dis- to become an entrepreneur on the basis of criminate between workers. A basic coop- market opportunities and individual pref- erative that simply opens its doors to anyone erences, endowments, and other charac- who wants to join up to a certain limit might teristics. The individual is an entrepreneur be more efficient. during the period in which he devotes effort Indeed there is a small but growing lit- and resources to establishing a firm. If the erature in organizational economics that entrepreneur succeeds in establishing a firm, studies the circumstances in which “nonstan- he then becomes an owner of the firm. The dard” forms such as consumer cooperatives, value of the ownership rights provides the worker cooperatives, nonprofits, or publicly basis for the returns to the entrepreneur. owned firms perform better than standard Spulber introduces the concept of the for-profit firms.19 Much of this literature is foundational shift (p. 152). Before the foun- influenced by Henry Hansmann’s 1996 book dational shift occurs, the objectives of the and examples include Ryan Bubb and Alex startup enterprise cannot be separated from Kaufman (2009), Hart and Moore (1996), those of the entrepreneur. The startup enter- Hart, Shleifer, and Vishny (1997), Edward prise is not fully formed for this reason. After L. Glaeser and Shleifer (2001), and Jonathan the foundational shift occurs, the firm is Levin and Steven Tadelis (2005). This litera- established and the entrepreneur becomes ture treats all these “nonstandard” forms as an owner of the firm. firms but distinguishes between them either Spulber is clearly right that entrepreneurs on the basis of who has voting rights and can are important in setting up firms and that therefore choose the firm’s policy or on the their reward often comes from their owner- basis of the incentive schemes they are likely ship stake. However, aren’t the people who to use (the idea is that a nonprofit can more set up a school, university, journal, or golf credibly commit to a low-powered incentive club entrepreneurs too? And isn’t this true scheme than a for-profit). While Spulber even if the behavior of these institutions is cites quite a bit of this literature, he does not always influenced by the preferences of their really use it. trustees, board, editors, members; in other The point is that the modern literature words, even if a foundational shift never tries to derive the behavior of organizations occurs? from primitives such as governance structure or managerial incentives. It does not suppose 7. Conclusions that different organizations have different objective functions. I have described what I see as some of There is much more in Spulber’s book the key issues in the theory of the firm and than I have covered. There is interesting also how this topic is dealt with in Daniel material on the neglected role of the entre- Spulber’s book. The overlap is not great. It preneur in economics as well as chapters is possible that there will be some conver- on the firm as an intermediary and a mar- gence in the future. For example, firms have ketmaker. For Spulber, entrepreneurs play a cultures and norms that can be very impor- central role because they are the prime mov- tant.20 Given this, different firms may behave ers in creating firms. An individual decides as if they have different objective functions. This raises the question: should we take a

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