Theory of The Firm

The one question that is often asked of me is what makes a firm successful, why do some firms flourish, and others go out of business. Obviously, that is a very difficult question to answer. There are many reasons why some firms fail, and some succeed, some has to do with luck, but many has to do with strategies and the abilities of the entrepreneur that runs the company. But I want to start off at a more basic question, before we delve into why some firms survive and others don’t, that is why firms exist in the first place. And to understand that we have to go back to Adam Smith and his book The Wealth of Nations that was written in 1776. Most people don’t realize that Adam Smith was not only an economist but also a moral philosopher. In fact, one of his most famous books was The Theory of Moral Sentiments. The Wealth of Nations created the field of economics and provided the four basic cornerstones. They are: The beneficial power of self-interest The division of labor, or specialization The importance of freedom The ability of markets to self-organize, to have spontaneous order To understand this just have to look at the manufacturing involved in making a pin, Adam Smith pointed out that in order to make a pin it takes 18 distinctive operations. One person who is not properly trained could make maybe 20 pins a day. But if the various operations were divided among 10 highly trained employees, they could make 4,800 per man. This is the power of self-interest, specialization, freedom and self-organizing markets.   That still does not answer the question of why there are firms. For example, in a market couldn’t each of the 10 men by their services. Why would you form a firm to employ all 10? This is something that was addressed by Coase in his 1934 article that appeared in the Economics Journal. Coase basically stated that firms exist because they can reduce cost. The firm’s created internal hierarchies that allows the firm to operate at lower cost than the market. For example, in the market you have to negotiate with each person separately. If they were employed by the same employer, the need for negotiation would be mitigated reducing time and money spent on contracts whether they were formal or informal contracts. Adam Smith discussed and implied that markets have many similar traits as those in biological evolution. Nelson and Winters put forth the assertion that just like evolution selects those traits most appropriate to the environment, the market selects business traits that can thrive and grow. Companies that have appropriate competencies, learning ability and routines that are in line with current market conditions will produce excess profits. Companies that produce these profits will grow and thrive in those that do not, will end up in bankruptcy. The big question is, what actually makes some company successful? Stephen Klepper an economist did an extensive study and published a paper in 2002 that addressed this issue. This study analyzed successful companies in the automobile, television and pharmaceutical industries. The conclusion shows that companies that entered the market early were able to grow rapidly. This growth produced excess cash flow and if it was reinvested into the company through R&D those companies survived. The research and development activities enabled the company to develop efficient methods and lower cost which made it better able to compete and drive rivals out of business. Some examples used were General Motors that was started in the 1930s yet still survives pharmaceutical companies like Pfizer and Bristol which of survive since the early 50s. It needs to be pointed out that R&D includes not only research and development in the traditional sense, but also methods that can be applied to a business-like Google. Research and development enable them to build better algorithms, understand their customers better and improve some products like U-Tube. Alchian, another famous economist pointed out that imitation being a primary source of innovation, without the necessary money a time required by extensive R&D. In conclusion companies that apply Adam Smith’s lessons and focus on their self-interest and specialize in high value core competencies will produce excess profits. Firms that are more efficient than the markets and have lower cost will be able to reinvest in research and development (use imitation when helpful) to improve their products and reduce cost. By having products that are needed and wanted by consumers and delivering them efficiently and at lower cost this will drive out and keep competition limited. The cycle will perpetuate itself and the company will grow until it exceeds a specific scale where the law of diminishing returns will stop its growth.