Four Theories of the Firm

7 December 2006 at 11:55 am Peter G. Klein Leave a comment

| Peter Klein |

This week in my PhD course, “Economics of Institutions and Organizations,” we discussed Bob Gibbons’s paper ”Four Formal(izable) Theories of the Firm” (JEBO, 2005; working-paper version here). Lest readers think I oppose formalization per se, let me take a moment to strongly recommend this paper, which provides an excellent summary and synthesis of several critical issues in the economic theory of the firm. (This review is also pretty good.) While the paper can be read profitably even without working through the mathematical models, Gibbons’s training in formal theory was obviously an asset in sorting out the similarities and differences among theories, harmonizing the diverse and sometimes-confusing terminology in this literature, and identifying the core assumptions of various approaches.

Gibbons distinguishes among four theories of the firm: rent seeking, property rights, incentive systems, and adaptation. Rent seeking is his label for TCE as expressed by Williamson and Klein, Crawford, and Alchian (1978). Students find the formulation of TCE in rent-seeking language, a la Tullock — “individually optimal (but socially destructive) haggling over appropriable quasi-rents” — useful and informative. Gibbons also provides an excellent discussion of the differences between TCE and the property-rights approach, showing that Grossman, Hart, and Moore’s model is not “a formalization of Williamson” (a distinction also emphasized by Williamson in his 2000 JEL piece and by Mike Whinston here and here).

I find particularly intriguing Gibbons’s identification of two distinct theories of the firm in Williamson’s writings. He identifies an “adaptation” theory of the firm, in which hierarchy serves to facilitate “adaptive, sequential decision-making,” that is independent of Williamson’s better-known rent-seeking theory. The basic ideas are in Williamson’s 1971 AER paper and his 1975 book Markets and Hierarchies. (I’d add Williamson’s 1991 JLEO paper, “Economic Institutions: Spontaneous and Intentional Governance,” as well.) The roots are also in Simon’s (1951) ”Formal Theory of the Employment Relationship” (one of Nicolai’s favorites). As Gibbons notes:

The key theoretical challenge in developing such a theory is to define an environment in which neither contracts ex ante nor renegotiation ex post can induce first-best adaptation after uncertainty is resolved, so that the second-best solution may be to concentrate authority in the hands of a “boss” who then takes (potentially self-interested) decisions after uncertainty is resolved. This emphasis on he boss’s authority places the adaptation theory together with the rent-seeking theory in making control the central issue in the theory (whereas the incentive-system theory ignores control in favor of incentives and the property-rights theory blends the two).

While Williamson tends to emphasize authority as a means of mitigating rent-seeking over appropriable quasi-rents, Gibbons argues that authority can provide a rationale for integration even the absence of relationship-specific investments. Nicolai’s and my approach to entrepreneurship as judgmental decision-making under Knightian uncertainty (e.g., here and here) can be interpreted, similarly, as an adaptation approach to the firm. (Shockingly, Gibbons does not cite us in his survey — what are they reading over at MIT these days?) In short, Gibbons’s discussion of adaptation provides insights into the theory of entrepreneurship as well.

NB: Gibbons’s lecture notes, available on his web page, are also very good.