Contractual theories of the firm
Stemming from managerial theories, property rights theory rejected the idea of a firm as an entity who maximizes profits and assumed instead individuals, each maximizing their own utility, under different property rights structures, and with positive transaction costs.
Armen Alchian and Harold Demsetz (1972) start from the incentive problem of team production (non-separable output) among the owners of resources. It is resolved by the introduction of a monitor, whose incentive is guaranteed by giving him the right to negotiate the contracts of the team, the right to the residual income and the right to sell both these rights. This bundle of rights defines the owner-manager of the capitalist firm, and actually results in its efficiency. Attenuation of at least one of these rights diminishes efficiency, as it is the case in cooperative or not-for-profit firms. However, there is no problem of separation of ownership (right to residual income) and control. On the contrary, the large corporation exploits the separability of private property rights: it enhances specialization in decision-making, and managers are competitively controlled by the markets for control and ownership. These authors view the firm as a collection of resources related by contracts. The firm as an organization does not exist and the employment contract is not specific: the firm “has no power of fiat, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting between any two people” (Alchian and Demsetz 1972: 777).Managerial theories were also integrated into neoclassical theory with the reinterpretation of the conflict between shareholders and managers in terms of agency theory, initially developed to analyse tenancy problems (Stiglitz 1974). Relations inside the firm, between owners and managers, monitors and workers, are formalized by designing complete contracts (specifying all contingencies) as optimal solutions to agency problems.
Studying different forms of financing (equity and debt), Michael Jensen and William Meckling (1976: 310) define firms as “simply legal fictions which serve as a nexus for a set of contracting relationships among individuals”. They extend Alchian and Demsetz’s focus on the residual claimant beyond the team problem: “contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on” (ibid.). The specific problems of the corporation are thoroughly analysed: ownership structures (ibid.), markets for managers inside firms (Fama 1980), separation of the moments of decision (Fama and Jensen 1983). Again, the firm is not distinguished from the market, and the figure of the entrepreneur eventually disappears (Fama 1980). The firm is a pacific and efficient space of resolution of conflicts by contracts between free and equal wills.Building on managerial and behavioural theories, Williamson (1975) rejected Alchian and Demsetz’s explanation of the firm using Coase and Simon: bounded rationality prevents agents from designing contracts that would specify all future contingencies; contracts are therefore “incomplete”. He detailed the relative advantages of hierarchy: it extends the domain of rationality through specialization of decisions and reduced communication costs, has control mechanisms and enhances coordination. In contrast to market contracts, the firm contract (hierarchical and incomplete) allows adaptation by authority and internal resolution of disputes. But the loss of incentives through prices and cognitive limits lie at the origin of the organizational costs. The firm’s boundaries are therefore explained by a trade-off between the powerful incentives of the market and the protection and coordination of the firm. This explanation of the firm had an important consequence for antitrust policies: mergers may not aim at gaining monopoly power, but at minimizing transaction costs, in which case they may be favourable to growth.
Williamson (1975) also focused on the internal organization of the firm: he reinterpreted Chandler’s (1962) historical account of the passage from the functional or unitary form of capitalist enterprise to multidivisional as evidence of the superiority of the latter over the former. Transaction costs theory would later insist on the role of asset specificity: specific investment ex post locks partners of the exchange into a bilateral monopoly; since the contract is incomplete, there is a risk of one party behaving opportunistically to appropriate the quasi-rent of the investment. Vertical integration protects against this risk of hold-up (Klein et al. 1978; Williamson 1985). Williamson (1979, 1985) then introduced hybrid forms between the two polar cases of firm and market, such as franchises or joint ventures. The theory of the firm here became the theory of organizations, also including intermediate forms. Since production is divided into multiple transactions analysed as contracts, the firm is viewed as a contract.Still in this contractual perspective, the “new property rights” or “incomplete contracts” theory (Grossman and Hart 1986; Hart and Moore 1990) was derived from property rights theory, but, following Williamson, added that contracts were necessarily incomplete due to transaction costs and bounded rationality. Ownership of an asset is defined as giving the owner the right to determine the use of the asset that is not contractually determined, namely, the right of residual control, whose allocation determines behaviour and performance. The firm is a collection of owned physical resources, and the best allocation of residual control rights depends on the size and specificity of investments over these assets.
These contractual theories of the firm, pertaining to new institutional economics, conceive the firm as a set of exchanges and in this sense they do not really distinguish it from the market. Because uncertainty is not so radical and rationality not so bounded, and because technology and preferences are given, there is no role for the entrepreneur, whose non-specific services can be contracted. Simon (1991: 42) himself rejected this view: “the attempts of the new institutional economics to explain organizational behavior solely in terms of agency, asymmetric information, transaction costs, opportunism, and other concepts drawn from neoclassical economics ignore key organizational mechanisms like authority, identification, and coordination, and hence are seriously incomplete”. In contrast, competence-based theories have focused on the successes of firms, which exist in the first place, instead of having a firm substituting for a defective market.