The Firm as Extra-Market Specialization

0:00Those of you who were here in this room for the last session, you were here for my application of what I'm going to show you now. So this is where you will actually learn what the heck I was talking about last time. Hopefully, I would say. So in this presentation, I will tell you a little bit about my inspiration for this. And I'm developing an Austrian theory of the firm. And let me see here. None of my competitors are here. The Austrian Theory of the Firm Anyway, my inspiration for developing this theory then I will show you the model for what the firm is, where it comes from, what it does, why are there firms, basically, and then the implications of this theory and the conclusion. Now you can see why it's very different from the previous talks.

0:54So for the inspiration, the transaction cost view is probably the most dominant view out there. It says, listen to this, it says that there are costs to transacting in the market. Who would have thought? Well, this is actually kind of a new thing in neoclassical economics. And the theory basically says that since it's costly to find people to trade with, it's costly to find the right products and so forth, Sometimes it's easier to rely on authority in a firm, so basically the theory says that the firm is a small state, where the owner of the firm or the entrepreneur or the manager is simply directing resources, and he's a slave owner more or less.

1:43Now, in the transaction cost view of the firm, there are two people who are really the big stars. You have Ronald Coase and Oliver Williamson. Both got Nobel Prizes for basically the same work. Well, not exactly the same, but the same kind of work. So, I'll tell you a little bit about what Ronald Coase says and what Oliver Williamson says. and they would say that they're compatible but I would say that they're not and of course I said firms here are hierarchies they're based on authority the market is horizontal and and well so Ronald Coase his main thing was to identify that There are costs to using the price mechanism, it's just, it's not totally free to go out there and look for goods, look for labor workers, contract with people, I mean, I don't have to explain this, we all know this, it's pretty obvious, right? If nothing else, it's going to take a little time to find these people, right? Now, he identified the firm as an island of conscious power,

3:07Which goes back to the hierarchy, the authority-based firm. The entrepreneur or manager, the role of this guy, he uses this word, the entrepreneur, which is nothing even close to what we would call an entrepreneur as Austrians. What it means is a manager, or maybe a president in the state. And he identifies that there are two different ways of organizing production in the market. Either horizontally through contracting, or just trading, or hierarchically within a firm, through authority. Those are the two different ways. And the firm exists simply because you get around the problem with cost of transaction in the market.

3:58It is cheaper, basically, with socialism, because you just point and people run that way. Directing is cheaper than actually trading with them. You can see why I also claim Ronald Coase is a socialist. And Walter Block, by the way. Well, Walter Block claims he's a socialist. Okay, so part of Ronald Coase's theory is basically that you can instantaneously switch between market organizing and firm organizing. So there is no difference in how you do things contracting in the market and how you do things within the firm. The only difference is the guy with the mustache directing resources within the firm. That's the only difference. Now Oliver Dr. Williamson, he says, I agree with Coase. Same definition, and same reasoning, basically.

5:00But he bases it on asset specificity, saying that, hey, wait a minute, resources aren't exactly the same always, which is also no surprise, but it's also a new thing for neoclassicals. What he says is that if you have a transaction between two parties, and one of them will People have to invest in a resource that is very specific for this transaction. Imagine a coal mine and a transportation firm. If you will need to invest in a railroad to that coal mine, then after you have invested in building this railroad, the coal miners can just say, nah, we're not going to use you unless you lower your price drastically.

5:45Which means that there is a hold-up problem, which is the basis for Williamson's theory. You would never make this investment at all, because the other guy will just screw with So the only solution is to integrate within a firm and have one guy with a mustache instead of two. So in the market you would simply not have this transaction at all. You can only do it within a firm because everybody will go, no, I'm not investing. So it would never happen at all. But that's not what Coase says at all. Coase says that it's the same thing and depending on how costs change a little bit, just switch back and forth.

6:32Firm, market, firm, market. That's not possible for Williamson because he says either there's a firm or there's nothing at all. So the firm must be different from the market. Now that made me think what is different with firms and markets, right? And if it's a very specific asset for this transaction that makes it be a firm to Williamson, Then, aren't firms more highly specialized than the market? Boehm would probably say no, even though his theory says yes, it's really strange, but I say yes, there are differences and a firm is more specialized.

7:24So let's walk, I'll walk you through my model and show you what a firm is and where it comes from. So the model. So I start from the same point of view, the same point where both Coes and Williamson start, especially Coes, what do they call atomistic competition, which really means that everybody is self-employed, running around trading and that's it. You don't have any very advanced production structures or anything like that. It's a one-man show and they trade with Others. It's a bunch of crusos, if you like. Now, I assume that you will have greater efficiency through the Division of Labor. It shouldn't be a very provocative statement, but you never know. I presented this to mainstream economists, and it's not always the case that I really agree with this, it really terrifies me, but that's another matter, okay, so I really just, I talked about this before, so let's just jump into the model right away, so what I say, what I assume here, from the beginning, atomistic competition,

8:50You cannot specialize what you do more than anybody else. If you specialize and you make a very, very small thing, very, very specific thing, then you have to find someone who can use this little thing. Otherwise, there's no point in doing it. So if everybody's running around trading with each other, everything needs to be compatible. Otherwise you can't trade with anyone and so we will all starve. So there has to be some kind of level of specialization in society, in the market, or at least in the part of market which we look at right now. So we would have necessarily the case that each factor, be it, thinking about it as a labor factor is probably easier than anything else, but the specialization level has to You can't be basically the same as the standard in the market.

9:49You can't be very unique. If you're very unique but you can't buy inputs from anyone because that wouldn't make you unique, you can't sell your outputs to anyone because that wouldn't make you unique. It's impossible. You would be incompatible with everybody. You would have to find an island because you are the Robinson Crusoe, basically. So in this starting point, we would have the case that the market for each factor is basically endless. What I'm saying here is that the number of little n is the minimum number of buyers and sellers that are available to you. The maximum available to you is basically endless, because you have this standardized level of specialization.

10:43Everybody can trade with everybody, so everybody would be infinite basically, at least to an economist. So you would have this kind of graph for a factor. What I'm saying here is that you have the market size, the number of people that you can buy from and sell to, which is this axis here. You have your specialization level on this axis here. And what I'm saying is that if you specialize further than this market standard level, Your market, the numbers of buyers and sellers that you can trade with, will very quickly diminish and go almost to zero.

11:28Of course, if you specialize to a lesser degree, well, down here you would find Robinson Crusoe doing everything for himself. Then, why would anyone trade with you? Because you're so freaking inefficient. And everything you do is too expensive, so why would they trade with you? They would trade with someone else, right? Someone who's more efficient in doing what he does. So if you specialize a lot, that would make you really efficient at what you do, but your market would go to zero. You would be totally alone in what you do. and I say this is si, little si, is the specialization level for that factor and it is here the specialization standard level in the market plus your specific deviation from that standard, be it positive or negative, it doesn't matter.

12:27So, if we look at this model, you can't really specialize alone, right? If you do that, you're going to starve to death, which would be pretty stupid, and which I guess would be, evolutionarily speaking, no offense to anyone, then the stupid people would specialize and die off, so we would only have smart people, which means the world would be libertarian, which is a good thing, but economically speaking, specializing is not a good idea. But what if they co-specialize? If I work with Matt and we say, hey, why don't we specialize together and do something that we can use standardized inputs that are available in the market, produce standardized outputs that are compatible with the market, but we do something that no one else does, just simply because we work together. We divide the task into smaller tasks. The tasks are not compatible with the market, but the totality is.

13:42So we have this formalization of this. This is me. This is math. This is the degree to which we specialize that is in addition to the market standard level. And of course it's greater than zero. Now the effect of this is that for us two, we can trade with a minimum of one with each other, right? And the maximized level here will go to one, two, depending on what the way we're looking at it, right? So we would have high complementarity with what we produce. Because what I produce, only Matt can use.

14:30What Matt produces is dependent only on what I do. So we have to go together, right? So what we do here, is we take in a production process, if we think about a little more advanced market, where you have three tasks to produce something that is directly consumable. We divide the middle task into smaller tasks that are not really compatible with anybody else to trade with. Think of an easy example, growing corn. Now you put the seeds in the ground, you water the stuff, Well, what you can do is find people who are really, really good at going to the river and getting water, and people who are really, really good at spreading water over ground.

15:19Well, so you divide the watering task, which used to be one person, into two or three people who are really, really good at those small things, very specific things. They get really efficient at doing that. at doing that. Stupid example, I agree, but it tells the story pretty clearly. So what you would have here is a situation where we would have to coordinate because we're incompatible with the market as it is. But how do we do that? That's the question, right? So what I'm saying is, of course, that the entrepreneur does this.

16:06So let's test if this is compatible with transaction cost theory. Now first of all, the market is just one standard level of specialization, that's a little bit too much maybe. So let's think about it as a range instead, where you can specialize a little bit up and down depending on who you meet and talk to and everything, because we're not exactly the same. So the market level where you're still compatible with everybody else is S plus or minus F, which is the minimum or maximum. Now in this case, transaction cost, that is finding someone to trade with, negotiating with people, that cost would increase the further from S you go, right?

16:52You have most people along the standard. If you specialize a lot further, the number of people you have to find to trade with will diminish. You will still find them, probably, but the transaction cost will increase. Now, this would seem to corroborate transaction cost theory, because why would you specialize further, because your transaction cost would go up, you had to do something else, right? And specializing to a lower degree than the standard level would mean that you're less efficient, which is stupid. So there are really no incentives at all for labor factors to specialize outside of this scope, this range.

17:43It just doesn't happen. Like I said before, they would starve to death. and they would try not to specialize close to the limits of this range either because the transaction costs are too high. You wouldn't find anyone to trade with. Or only three people instead of three billion. I mean, why would you do that? So, what are the implications of this? Let's have a look at this.

18:13Already? I'm gonna take more time, sorry. So, think about an entrepreneur who imagines a new way of doing things. Think about the watering. He realizes, hey, if I have one guy making the bucket, one guy going to the river, one guy filling the bucket, maybe that's more efficient. So he imagines this new structure. He establishes it. He has to own and risk capital of his own and he has to coordinate this whole thing because the labor factors wouldn't do it themselves and of course they wouldn't even know what he's imagined, right? So he would get all these people together and teach them, hey, if you do this and you do that and you trade under my surveillance Surveillance and I'll lead you to it, then that is a possible solution and we will be more efficient than anybody else and we can make money and split the proceeds. It's easy.

19:18Now, what this means also is that we don't really have any authority within the firm. What we have is leadership from the entrepreneur, right? He will guide the factors to specialize and co-specialize so that you would have this new production structure that did not exist before and could not exist without the entrepreneur and without these factors actually specializing this way. So there is no authority, there is no guy with a mustache. There is a leader, sure, and there is someone with imagination, someone who can see something that he really wants to realize. So, the implications, continue on that.

20:03We can think of three different kinds of markets, theoretically. We can think of one where there are no entrepreneurs at all, just labour factors. They would all stay within the range, right? And they would all stay pretty close to the standard level. Some will be a little bit above, maybe. No one would really go below because that would mean inefficiency and you would lose money. That means no real progress. It's a pretty static market. Now, in the second market here, we have only entrepreneurs, only people envisioning these new production structures, only people trying to find others to actually realize what they're imagining.

20:49Well, not much would happen here either, because someone would have to say, no, my idea wasn't as good as yours, so I'll just work for you. Now, that's not really how we see an entrepreneur, right? They don't really give up their idea and say, no, you were better. They want to try it. So what we have, the optimal solution, if you will, is a market where you have a few entrepreneurs and you have many labor workers. So you have a few leaders, a few imaginative leaders, Finding new ways of doing things, leading these factors to specialize and co-specialize in a certain way and try it out, because you don't know if it's profitable or not. If it is, then you're going to make profits, but otherwise not.

21:36Let's see here, I'm almost done. So the question here is, how do we test this? Well, we could do it the praxeological way, but that would not give me a doctorate. So I have to do it another way. What I will do is do this through agent-based modeling, doing a computerized simulation, starting with a lot of people just plugging different values, some are entrepreneurs, some are not, in these three different kinds of markets, and test if this actually works out, if firms will actually emerge. The conclusions of this little thought experiment and this paper is that the transaction cost economics definition is insufficient. It does not explain how firms emerge. It might explain The difference between a firm and the market, fine, but where did the firm come from?

22:52You have to explain that, right? Now with specialization as a perspective on this, division of labor perspective, what it suggests is that there is an explanation that explains what a firm is, through being an island of specialization if you will, why firms exist, simply because you can make money How firms emerge, which is a question that the mainstream does not even look at, because it implies that the market is dynamic and then everything just falls apart. And it explains what the firm's boundaries are as well. So, potentially, this may provide good answers to all the questions asked in the literature since 1937 and still no answers are out.

23:44So, what we have is a dynamic productivity rationale that explains firm emergence and not just the cost-based justification for what is or what is not in certain situations. And of course, most importantly, it adds the entrepreneur to market analysis, because that guy is not in neoclassical economics at all. You might use the word sometimes, but there is no visionary, there is no one imagining anything, there is no leader. There is only the atomistic competition. And that's my contribution. Thank you.

24:29Thank you very much.