Theory of the firm

Posted: 14 April 2016 in Uncategorized
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The problems surrounding the central institution of capitalism—the corporation—are so widespread and enormous they’ve even provoked concern in sympathetic quarters, such as the Harvard Business School.

This past November, Harvard hosted a conference during which participants attempted to grapple with the tensions between Milton Friedman’s theory of the firm—according to which firms can and should only benefit society by focusing on maximizing shareholder value—and the growing political influence of corporations after Citizens United—when it has become increasingly easy for firms to tweak the rules of the game in their favor.

Now, for the rest of us—citizens, nonmainstream economists, and academics in disciplines outside of business and economics—both the history of corporations and the prevailing neoclassical theory of the firm present so many problems it’s hard to believe Friedman’s ideas are still taken seriously. Long before Citizens United, corporations have exercised a great deal of influence both inside (over their workers) and outside (in politics and in the wider society). That’s why the corporation has been a contested institution—legally, economically, politically—since its inception. Similarly, the neoclassical theory of the firm (initially in its “black box” form, then when the owner-manager agency problem was raised) has swept most of the serious problems under the theoretical rug.*

But for the scholars gathered at Harvard, the key issue (as presented in the brief paper coauthored by Harvard Business School faculty members Paul Healy, Rebecca Henderson, David Moss, and Karthik Ramanna [pdf]) was a relatively narrow one:

if firms have the power to generate profits not only by producing socially beneficial goods and services, but also by tilting public policy and the “rules of the game” to their advantage (whether through aggressive lobbying, effective use of the revolving door between political and corporate appointments, or campaign contributions), then the core assumption that firms can maximize social value by maximizing shareholder value may not hold, and framing managerial responsibility as simply a matter of maximizing shareholder value may well be inappropriate.

Having read the paper, it is extraordinary that there’s no real history—no story about the invention of the corporation as a legal “person,” no Louis Brandeis or the Progressive movement, no Knights of Labor or United Mineworkers, no mention of the role of International Telephone & Telegraph in overthrowing Salvador Allende in Chile, no Massey Energy killing 29 miners in the Upper Big Branch mine. It’s as if the problem of corporate power only emerged after the 2010 Citizens United decision.

Still, from the perspective of neoclassical economics, even that problem looms large. According to the reigning paradigm (which guides much policy and is taught to hundreds of thousands of students every year), under conditions of perfect competition, free markets (including firms that maximize shareholder value) lead to Pareto-efficient outcomes. But if corporations (whether single firms or industries) can shape the institutions of the market (or the rules and ethical customs that help to maintain them), then all bets are off: “Maximizing shareholder value by deliberately distorting critical market institutions or regulations for private advantage seems unlikely to lead to the maximization of social value.”

That’s why the participants in the Harvard conference were caught between the real implications of Citizens United (that corporations can increasingly bend the social rules to their private advantage) and their continued adherence to the neoclassical theory of the firm (according to which maximizing shareholder value also maximizes social value).

I suppose it’s no surprise, then, which won out at the Harvard conference:

“I went into the conference with the understanding that one could question the premise of the Neoclassical paradigm in economics through logical arguments—e.g., the inconsistencies between Friedman’s assumptions and Stigler’s theory. I left with a sense that logical arguments on their own are unlikely to carry the day, because the Neoclassical paradigm is so powerfully ingrained into the discipline, into the fabric of modern economics,” says Ramanna.


*Including the problem neoclassical economists share with many of their heterodox counterparts, namely, what exactly does it mean that corporations maximize profits or shareholder value? First, how do we define profits or shareholder value, i.e., what is the appropriate metric, over what time horizon should it be defined, and how should it be measured? Second, corporations do many different things, such as exploit workers, give lavish pay to top managers, attempt to eliminate rivals, chart particular short-run and long-term growth path, buy favors and influence legislation, hoard cash, accumulate capital, and so on—why reduce all of what they do to a single dimension?

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