CONSIDER THE VIEW THAT FIRMS ARE A DEVICE TO ECONOMISE ON TRANSACTION COSTS.

The true nature of the market mechanism has been debated for as long as it has been in existence. The firm, a unit within that mechanism, clearly plays a fundamental role in the resource allocation in todays society. The firms own internal mechanism stands in stark contrast to that of the market whereby centralised planning becomes the defining characteristic in the allocation of resources (Coase 1937, p.387). The debate is why these firms exist. One hypothesis, as quoted in the title of this paper, is from the New Institutional Economists (NIE) standpoint and is probably the dominant view in contemporary economics. They propose that the firms existence, and its relative size, is derived from the possibility of gaining a competitive advantage over the dispersed market mechanism which is comprised of individuals conducting mass transactions co-ordinated through the price mechanisms. The advantage can be found in reducing the transaction costs by co-ordinating resources internally (within the firm) instead. While other alternative hypotheses exist, this paper will consider the hypothesis from the Marxist school as the logical antithesis. It too comes from a sustained tradition, and as a consequence of the global downturn, is seeing something of a revival. They argue that whether or not hierarchical control (the firm) is more or less productively efficient than an externally dispersed set of transactions is arbitrary, and that firms exist and grow because of their greater ability to accumulate capital (albeit at the direct exploitation of the worker), and that it is this which gives them a competitive advantage. This paper will argue that while the marginalists (in this case the NIE) offer a partial explanation of why firms exist and grow, only sufficient explanatory power can be found from the Marxist perspective. The NIE theory and neoclassical economics in general, to the irony of this paper, are largely products of the Marxists in the sense that all previous economic theory had assumed a labour theory of value as a starting point, which Marx himself had assumed and normalised making it very difficult to accept this presupposition and not be accused of being a Marxist (Harvey 2008). This new marginalist outlook stipulated consumers and producers constantly adjusting their decisions which would optimise the resource allocation in society. The rationale behind the firm came initially from Coase and Commons and was elaborated upon by Williamson. They present a rigorous analysis of the inbuilt inefficiencies of the competitive market mechanism. Essentially all transactions, whether between individuals, institutions or hybrids, carry costs. Williamsons starting point is a state of perfect competition comprised of just individuals; In the beginning there were markets (Ankarloo, Palermo 2004, p.413). From here he breaks with the classicalists in two key respects. First in his behavioural assumptions of the individual, no longer are they perfectly rational but limited by the scope, quality and quantity of information available meaning their rationality becomes bounded. The individuals principle source of information in the market place is price and under this assumption it is no longer completely reflective of market conditions and transaction costs begin to arise, as Coase puts it (1937 P. 390)

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of organising production through the price mechanism is that of discovering what relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information. The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.

This then opens up a space where such discrepancies in information can be exploited; the economic actors that suffer from bounded rationality are potential victims and suspects of opportunistic behaviour. Calculated efforts to mislead, disguise, obfuscate and confuse are thus admitted (Williamson 1989 p. 139), in essence guileful behaviour becomes a prominent part of the analysis. In an effort to formalise such exchanges and provide security against such behaviour, actors will enter into contractual negotiations. Unfortunately this requires the contract to be complete, and under the assumption of bounded rationality is impossible. If anything the guileful behaviour becomes embedded and even enforced by law. Such costs of inadequate information can be exacerbated if one party, consciously or not, possesses more relevant information about the transaction than the other and this asymmetry of information can lead to adverse selection, moral hazard and information impactedness. In the context of incomplete contracts it becomes apparent that there is likely to be underinvestment in specialist assets by actors who perceive themselves as likely sufferers of this phenomenon. This is because if an asset lacks technical efficiency, i.e. its productive purpose cannot be changed without significant cost, the investor is at the mercy of his trading partners who are themselves now in a position of authority. While the type of asset specificity varies, as do their ramifications (Williamson 1989 p, 143), they are united in being viewed as principle cause of transaction costs. All of this is set against the backdrop of uncertainty within the market framework. It seems improbable that a firm would emerge without the existence of uncertainty (Coase 1937 p. 392). This leads us onto the second break between the NIE and the classicalists; the view that the firms evolution is seen as becoming an organizational entity rather than a mere production function (Williamson 1989, p.138). The firm thus possesses a critical feature that the market does not; it has access to distinctive governance instruments. This is not to say that firms avoid transaction costs, the coordination problem remains, but under certain circumstances these costs may be reduced. This can be particularly true in the case of reducing negotiating costs as a consequence of asset specificity and can be transcended through vertical integration as it in principle eliminates the asymmetry of power and allows for sufficient investment as dictated by supply and demand. Other advantages the firm has over the market include reducing the problem of bounded rationality as incomplete contracts are reduced, and opportunism is reduced by the use of authoritarian hierarchical control. (Williamson, 1975, p. 40). The size of the organisation then depends on its ability to reduce transaction costs through its internal mechanism compared with what they would be if left to the market. Coase (1937 p.394) answers the question Why do market transactions still exist, why is there not one big firm? Specifically as a firms capacity rises beyond a given point so do the relative transaction costs. The Marxist critique of such an analysis begins with Williamsons starting point, that initially there were just markets. However, he could equally begin with there just being a single dominant institution and work backwards. The problem is that there becomes an equivalency with respect to Pareto economics between these two setups, but by referencing pure markets as an historical starting point he

idealizes them with no analytical justification (Ankarloo, Palermo 2004 p.417). The assumption of a system which never existed and the story of processes which never happened make the understanding of the real system problematic (Ankarloo, Palermo 2004 p.420). The concept that markets predate other forms of production is clearly false if one considers, as Engels puts it Production may occur without exchange, but exchangeby the very fact that it is only an exchange of products cannot occur without production (Engels, 1976, p. 186 cited in Ankarloo, Palermo p.421). Another fatal blow dealt to this starting assumption is if we begin with markets; does that include labour markets? Who or what is that labour sold to? NIE inevitably focuses on a very specific aspect of the relations among the institutions of capitalism: the partial substitutability of certain institutions in performing their allocative function. This conception of capitalist institutions limits their economic role to that of pure resource allocation and obscures the fact that the problem of resource allocation can be defined (and solved) only if other functions are performed (production, in the first place, but also regulation of both production and exchange). This means that the nature of capitalist institutions cannot be understood simply by discussing their substitutability in resource allocation, but requires an examination of their complementary roles in the working of capitalism (Ankarloo, Palermo 2004 p.427). The Marxist reasoning behind the role of the firm comes from the necessity of the owners of the means of production (the capitalists) to be able to subject labour power purchased from the market place within an internal mechanism so that their produce may be marketable. The success of the firm as an institution was not because of lower transaction costs but because it substituted workers control over production for capitalist control of production. The critical difference between these two groups is the former seeks to maximise utility in the present while the latter seeks the accumulation of capital over time (Marglin 1974 p36). Resolving this debate without advocating one ideology over the other is impossible as a complete answer requires both schools of thought to be viewed within their wider theoretical framework. One definite conclusion that can be abstracted on is that this debate is likely to be thrown headlong into popular discussion as markets become ever more centralized over time. Structures [are altered] as competition and crises drive forward the process of concentration and centralisation. Capitalism gets older - it ages.... in 1910 the biggest 100 firms in Britain accounted for 16 percent of total national output. Already by 1970 this figure had risen to 50 percent. (Thomas 2008). Given the weakness of NIE perspective with respect to its historical assumptions it still offers a solid analysis of the problems inherent in markets. However this weakness becomes critical when analysing why firms exist at all and that to find a sufficient solution one has to look at actual historical trends. The Marxists offer a solid alternative explanation for the rise of the firm yet this paper does not directly ascribe to either school of thought as to do so would require a much more rigorous and complete investigation into the nature of capitalism. Word count: 1601.

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