The Theory of the Firm Revisited

Abstract

Abstract From the birth of modern economics in 1776 to 1970, a span of almost 200 years, only two works seem to have been written about the theory of the firm that have altered the perspectives of the profession—Knight’s Risk, Uncertainty, and Profit (1921) and Coase’s “The Nature of the Firm” (1937). This neglect is attributable fundamentally to the preoccupation of economists with the price system; the study of the price system, characterized as it is by Marshall’s representative firm and Walras’s auctioneer, undermines serious consideration of the firm as a problem solving institution. Coase’s contribution is seminal for several reasons, but certainly for calling attention to the absence of a theory of the existence of the firm and to the importance (to this theory) of the fact that markets do not operate costlessly. Nonetheless, the theory of the firm is still incomplete and unclear in ways that are discussed in the middle part of this paper. A more complete theory of the firm must give greater weight to information cost than is given either in Coase’s theory or in theories based on shirking and opportunism. This is discussed in the last part of this paper. Information cost figures importantly in transaction cost theory because information cost is an important component of transaction cost. It also figures importantly in Knight’s risk-sharing and in agency theories of the firm. Its importance, however, is more fundamental than even these theories contemplate. It is useful therefore to begin this paper with a discussion of why the costless information that is assumed in the perfect competition model renders the model ineffective for studying the firm.

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