Tuesday, February 4, 2014

The firm existence puzzle and how we solve it

One of the more coherent criticisms of our new theory of return-seeking firms is that it’s not really about firms and their organisation, but rather more about markets as a whole. Apparently modern theories of the firm no longer seek to answer questions about inputs, outputs and prices, but instead look for answers about why firms exist in the first place, what determines their boundaries, how they are internally organised and so forth.

From a scientific point of view it is quite strange to drop this question, perhaps ticking it off as satisfactorily answered, despite evidence to the contrary. I certainly agree that questions about the existence of firms are inadequately addressed, in fact assumed away, in the mainstream theory. But that doesn’t mean that the determination of inputs, outputs and prices is a distinct separate issue. Why shouldn’t these factors also be key determinants explaining firm existence, size and organisational structure?

In our theory of return-seeking firms we generate a prediction about firm size based on input cost structures. Returns to scale determine a minimum size of a firm or ‘production unit’ in general (however its internal organisation is structured).

To be clear, the decision in our model is a simultaneous choice of firm size, in terms of how many resource inputs to combine, prices to set, and subsequently output choices. Thus, be default our model makes the connection between production costs and firm size via economies of scale.

We can appeal to notions such as incomplete contracts and transaction costs to explain why owners of resources choose to coordinate into single entities of particular sizes. If combining resources generates returns to scale because of reduced transaction costs, these become simply an additional benefits from scaling within-firm production. It is optimal to continue to increase the size of a single firm’s operations until the rate of return is maximised. If costs can be reduced by shrinking the size of operations, such as by splitting resources in competing companies, then it will also pay to do so. Hence it seems obvious that firms will choose to avoid facing increasing unit costs by choosing their size, including capital investment, appropriately.

The intuitive story I have in mind to support this model prediction starts with imagining that every dollar of costs necessary for a firm to spend on production comes from a different investor. To expand output in the face of increasing cost you need to add more investors (who share profits in proportion to their contribution). You do this only if the overall rate of return on the total costs is increasing. Once you hit that maximum rate of return, adding additional investors to cover greater costs reduces both profits and returns, and hence the value of a share, for existing investors. In the extreme case of a flat firm demand curve, the resulting size of a firm is one that exhausts available economies of scale.

Thus we have a testable prediction about firm size, which is that economies of scale will almost never be exhausted at the firm level. The evidence in favour of this prediction is quite strong, with most surveys of firm costs structures showing increasing returns to scale with few exceptions.

In fact the much stronger prediction from our theory is that production never occurs in a single firm where strictly decreasing economies of scale exist. What this means in practice is that if producing one unit of a good within a single firm is more expensive than producing component parts in different firms, then the single firm will not emerge, and the smaller firms will produce where they exhibit economies of scale in production.

Additionally our model supports the well understood trade-offs that occur with firm mergers; between cost reductions and market monopolisation. If mergers reduce the possibility for competitors to emerge or expand, they may still be beneficial for consumers if cost reductions are large enough.

While the research agenda into a theory of the firm no longer sees cost structures as a key determinant of a firm’s existence, our theory suggests that the link is instead rather fundamental.

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