In Chapter 1 of The Capitalist and the Entrepreneur (available for purchase and as a PDF download), Peter Klein relates some Austrian and “Austrian-friendly” contributions to the theory of the firm: specifically to the understanding of what determine the extent of a firm. What factors play a role in the “make or buy” decision? Should we make widget X in-house (thereby extending the firm), or should we just buy it off the market (thereby limiting the extent of the firm)?
Most textbook analyses of the firm consider the question to be primarily a matter of technological trade-offs. But, in 1937, economist Ronald Coase introduced an entirely different way of looking at the issue. Coase introduced the “transaction cost” approach to analyzing the firm, which Professor Klein summarizes very clearly:
“The market mechanism entails certain costs: discovering the relevant prices, negotiating and enforcing contracts, and so on. Within the firm, the entrepreneur may be able to reduce these “transaction costs” by coordinating these activities himself. However, internal organization brings another kind of transaction cost, namely problems of information flows, incentives, monitoring, and performance evaluation. The boundary of the firm, then, is determined by the tradeoff, at the margin, between the relative transaction costs of external and internal exchange. In this sense, firm boundaries depend not only on technology, but on organizational considerations; that is, on the costs and benefits of contracting.”
Klein then tells us how the Austrians introduced another downside to extending “internal organization” which places an upper limit on the extent of a firm: the calculation problem. In the socialist calculation debate, Ludwig von Mises demonstrated how market prices for factors of production are necessary for economic calculation, which in turn is necessary for the really efficient allocation of resources. Therefore, any socialist commonwealth must suffer from a severe “calculation problem”, because market prices for the means of production cannot exist without private ownership of those means.
Murray N. Rothbard extended Mises’ analytical framework, by explaining how firms, in deciding upon optimal internal factor-of-production allocations, are dependent on prices set by external markets for those factors of production. Therefore, if a firm “vertically integrates” to the extent that it starts to completely subsume whole markets for its factors, it will start to suffer from calculation problems with regard to those factors.
This analysis proves that the anti-capitalist bogeyman of The Sole Supreme Firm (as exemplified in the film Wall-E in the form of the Wal-Mart parody “Buy’N Large”) is just as much of a phantom as is the successful socialist commonwealth. As Gennady Stolyarov II wrote in his review of Wall-E:
“the film makes the Marxian assumption that it would be possible for a single corporation to take advantage of ever-increasing returns to scale and thereby subsume the entire world — and still remain profitable and continually patronized by everyone. But as Ludwig von Mises showed as far back as 1920 in Economic Calculation in the Socialist Commonwealth, without the presence of multiple providers of goods in the economy, the single dominant firm is in the same position as a socialist central planner. In the real world, BNL would have no market price signals to help it discern consumer demand for and the relative scarcity of resources. It would not be able to engage in rational economic calculation and would make decisions arbitrarily. Surely, this state would not please many consumers, and the BNL monopoly would be short lived at most.”
Coase’s contribution to the theory of the firm laid largely fallow for decades, until Rothbard and Williamson picked it up and extended it. And Rothbard’s Misesian extension of the Coasean framework was largely unused, even in Austrian circles, until now. This is yet another reason why Klein’s new book is so important, and why it would be a wonderfully fascinating experience to learn about this promising new emphasis in Austrian theory from Klein himself in his Mises Academy course Entrepreneurship in a Capitalist Economy, starting June 7.