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This is a free essay sample about two major firm theories: transaction cost (neo-classical) and managerial. The paper highlights major features of both theories, identifies its major contributors. Major differences between the specified theories are being analyzed minutely in this custom essay sample.

Firm Theories

Introduction

Economy is an immense science which embraces hundreds and even thousands issues related to a huge variety of scopes of activity. A major branch of economics, microeconomics, is concerned with the issues of small organizations and individuals, their features, the principles of behavior on the market, competition, market price, decision making process in the scarce of resources, types of markets and so on. The matters of firms are very important today when more than 50% of all businesses are small businesses which operate in conditions of strong competition, tight budget and time pressure. From the very beginning many economic theories were founded on the inference that companies operate in the condition of perfect competition market and correspondingly, all further researches implied the same. When economists realized that, indeed, most companies do not operate in perfect competition there have been lots of new theories worked out. Among variety of firm theories like neoclassical (transaction cost theory), new institution economics, managerial and behavioral we focus two major firm theories elaborated by different research organizations with the course of time – transaction cost and managerial.

This paper explores two different theories of a firm (namely – Managerial and Neo-Classical theories, which are different radically in many questions and aspects), their differences and similarities, and conducts their comprehensive comparison.

 Neo-classical theory

The views of neo-classical economists are considered to be traditional for most economic problems. Maybe it is because the foundations of this theory are very pragmatic and practical. Fundamentally, neo-classical theory was developed by the representatives of marginal school and consequently it is based on marginal concepts of economy which imply that all market institutions (companies, individuals and government) are focused on obtaining the maximum profit from every activity or operation on the basis of all information available about market opportunities. In that way marginalism premises that all subjects on the market have complete information about supply and demand, and make decisions reasoning from this knowledge. So the main idea of neo-classical economics is concerned with the utility or profit maximization and of course this school has its own original firm theory. This theory is widely known as neo-classical or transaction cost theory. Firm theory tries to give a unique and precise definition of a firm (but this target is not achieved and indeed there is plenty of various firm definitions), describe and explain the reasons and purpose of the firm creation, the operating guidelines, how firms affect the market conditions, the price mechanisms and much more questions. The theory was founded by Ronald Harry Coase, the Nobel Prize laureate, who claimed that the main question of this theory is why firms appear. He explored the nature of firms and tried to find out why simple exchange (sell/buy) operations among individuals can not be necessary and sufficient criteria for the existence of market economy. Ronald Coase considered that the manufacturing process can be carried out without formal organizations.  In other words, the questions of this theory are why people do not work by themselves, seeking employees, and the presuppositions of firm establishment.

Ronald Coase has proved that market operations are costly and thus firms spend money while operating on the market. These costs can be generally classified in accordance to their features: - money spent on obtaining information (about supply and demand, the prices etc) and search; - money spent on goods and services; - money spent on organization; - money spent on contracts and agreements, support of the long-term contracts, negotiations etc. Economists named these expenditures as transaction costs which are related to the usage of the market. An important note is that transaction costs include not only money but time and efforts also. When firms perform their business transactions or activities, except for money, they spend much time searching potential clients, partners, analyzing competitors or other market factors, collecting and processing financial or any other information etc; firms’ representatives use much energy and efforts so as to achieve the goals and fulfill their charge. In order to decrease transaction costs firms appear because internal firm’s relations cause less transaction costs (less or even absent) than external but there are certain limits for internal production: the firm will grow until the internal transaction costs will come up with the same external (other firms’ costs). So the size of transaction costs defines the nature of transaction – within or outside the firm (on the market), or to put this in another way – to produce or buy, correspondingly. Among other reasons for emergence of firms there are the desire of some people to work under the supervision in exchange for money, the desire to supervise others in exchange for money and decrease of transaction costs. Coase distinguishes several reasons for increase of firms’ internal transaction costs: the growth of a firm (because the number of contracts and negotiations also increases), increase of resource utilization, erroneous usage of equipment and environmental changes (implies economic changes and their uncertainty) that firm is not available to adjust to in a timely manner. Internal transactions can be cheaper, nevertheless they have certain disadvantages like incomplete and distorted information, inadequate prices comparing to market and the evaluation of overall performance. So the firm theory adds up to the optimal choice of allocating resources and choosing the right transaction which maximizes the profit by minimizing the transaction costs of the firm.

Obviously, all the business activities are concerned with certain calculations and forecasts, which can help to minimize the transaction cost of a firm with a certain probability. The entrepreneurship does not play significant role in the firm theory except for mechanical activities like calculations, coordination and some others.

The next significant and important contribution into the development of neo-classical firm theory or transaction cost theory was made by Oliver Eaton Williamson, who shifted the direction of the theory towards management and behaviorism.

The contribution of Oliver Eaton Williamson into the development of transaction cost theory has shifted the focus of the theory towards such concepts as behaviorism, management and contribution of managers into the success of the firm.

Managerial theory

Managerial theory of a firm is mainly focused on the contribution of management (entrepreneurship) into the economy (read transactions). Williamson researched different governance types or management approaches to different complex situations, and explores how they can affect the transaction cost and their efficiency.

Today researching the managerial practices and approaches are very popular and major economic schools are engaged into the development of these theories. In his works Oliver identified different managerial approaches along with the major transaction’s features, and combined these elements into a coherent system of interaction. The model of a firm includes the assets, management and market conditions (at the beginning there were three basic conditions: monopoly, oligopoly and imperfect competition). The main element is management because it can affect the situation on the market under certain circumstances by means of marketing, expansion or reduction of production volumes, price variation etc. The main question of managerial approach is how to make the optimal decision with the means of two variables – price and expenses.

There are lots of principal differences between neo-classical and managerial firm theories. The first one is concerned with the primary presuppositions about the economy: transaction cost theory claims that market agents have complete information about the market conditions and prices, whereas managerial approach includes the following clause: the information can not be perfect, it can not be complete and thus all contracts on the marker are incomplete because of uncertainty of economic environment, human factor (mistakes, misunderstandings and communication errors) and so on. Due to incomplete information and contracts the concerned theory infers that the next basic presupposition of neo-classical theory is not true also – under the above described conditions market agents (subjects) can not make absolutely rational decisions or simply behave in the most rational way maximizing their profit. So this difference is very important because it is related to the foundations of the theories and, in summary, managerial approach implies that individuals and companies do not always act rationally due to the lack of information or its distortion, and incomplete contracts. From this point, economists have developed a new concept of opportunism or opportunistic behavior. It means that when some terms are missed in the contract, for example, the one or another contract party will surely try to benefit from this. For instance, when the contract does not specify the terms of delivery or installation (assembling) of some commodity it will benefit the supplier, because supplier could reasonably fleece another party of all its money (and most probably it will be so). Opportunism is related to the desire of people to get as much as it possible (meanness and covetousness). Subsistence of opportunism increases business risks and uncertainty of market environment for all market players. Internalizing the transaction is the chance to cope with opportunism in case when the same external transaction is frequently repeated.

The second major difference is that transaction cost theory leaves no place for entrepreneurship. Neo-classical school considers that a firm is a production function – the ‘black box’ – which has some inputs and outputs, and the efforts of entrepreneurship were not taken into consideration. All the decisions within a firm (concerned with resources allocation and make or buy decision) are come to mathematics and, of course, are optimized.

In the opposite, managerial theory refutes such approach and assigns the most important roles in the firm to the management and entrepreneurship. But if there is a clear understanding of firms’ objectives (to grow, increase profit etc), unfortunately, there is no consensus in the question of diverse objects of managers and owners of a firm. The concerned firm theory states that managers have different vision from the same of owners: managers are interested in their own benefits (or salary) and they know how to deal with it because their salary depends directly on the sales volume. In order to get more money managers focus the sales and make their best to increase sales volume to the maximum, and basically it is not bad for the firm’s interests, isn’t it? The owners’ objective is aimed to maximize profit. At the beginning profits increase along with increasing sales but there is a certain limit. There is a point when with the increase of sales volume profit start to decrease. Therefore managers have a certain control over the profit of the owners and it is directly depends on the managers’ decision or discretion. That is why managerial firm theory is also called discretion theory.

The third important difference is concerned with ‘produce or buy’ decision, or transactions. Managerial approach connects it with the specificity of firm’s assets. Specific assets influence the decision of firms to buy or produce something, depending on the transaction cost and the choice available. For instance, company has the choice to buy spares and particular, or to produce them. ‘Buy decision’ is concerned with uncertainty, risk and opportunism due to the same nature of potential partners (suppliers). ‘Produce decision’ is concerned with the transaction costs, costs for resources, technology acquirement etc. In addition due to the physical assets specificity the costs of production can increase significantly if the equipment or machinery depends on each other and would not work with other equipment (incompatibility). There is also human resource specificity – employees may refuse to work with each other for many reasons, including psychological and multinational barriers. Thus the company has the third option – to buy the producer of spares and particular, and make it a part of larger enterprise. Such approach is called vertical integration. Of course company has to find optimal decision and maximize profit. The specificity of firm’s assets defines its limits or boundaries along with the ability of staff grow and efficient transfer of authority. Obviously, managerial approach gives an important role to firm’s assets: “Assets are said to be highly specific when their value in the present (best) use is much greater than their value in the second-best use.  Investment in such assets exposes agents to a potential hazard:  once investments are made and contracts are signed, unanticipated changes in circumstances can give rise to costly renegotiation” (Nicolai Foss, Peter Klein, 2004).

The fourth important difference is the question of firm growth. Both theories have different opinions on this account.  According to neo-classical theory the firm will grow until the internal transaction costs will come up with the same external (other firms’ costs). After internal transactions will exceed external there will be no sense to grow for the firm. Managerial approach claims the growth of the firm depends on several factors as the specificity of its assets, frequency of repeat transactions and uncertainty. Later managerial scholars introduced new fact that the growth of the firm is also limited by the human factor or firm’s ability to increase the staff team without detriment to efficient management. Another growth requirement is demand increase if there is no demand increase – there is no reason for firm growth also (in accordance to growth-oriented theory).

Of course there are many other differences in two different theories of a firm and the exploration of all of them (even if it is possible) can take many years and thousands pages. It is also not the goal of this paper which purpose is to shed some light on the main differences of the concerned theories.

Conclusion

 The primary objective of the paper is fulfilled and it is time to finalize the main points of the research. The economics pays a lot of attention to the questions of firm nature, the reasons for establishment of firms, their driving principles and other aspects of their activities. There are many different opinions and views on these issues. This paper is concerned with the two major theories if a firm – neo-classical and managerial. It explores their differences and highlights main features of both theories.

Neo-classical or transaction cost theory is the origin of firm theory and it assumes that all market agents act independently, have perfect and complete information about the market, act in order to maximize their profit in the condition of scarce of resources. Managerial theory is more advanced in this question and reasonably refutes the availability of perfect and complete information, and hence prejudices the possibility of rational behavior of market agents due to incomplete information. Neo-classical theory considers a firm to be a ‘black box’ which transforms inputs into outputs or a production function. It does not recognize the role of entrepreneurship but claims that all firm’s decisions can be optimized by certain calculations. Management theory shifts from this approach and endows management (or entrepreneurship) with the major role in allocating resources in the conditions of imperfect information. Managerial theory states that profit can not be maximized without perfect information but it can be satisfying only. The basic model of the firm varies from the ‘black box’ concepts and implies that firm has expenditures and sales volume (or profit). Managers can affect them by certain activities adjusted to different market conditions. Managerial theory emphasizes the conflict of interests of shareholders and managers because they are driven by different forces. Managerial theory pays a lot of attention to the specificity of firms’ assets, mergers and acquisitions, uncertainty of economic environment, human factors, opportunistic behavior etc.

So the concerned theories have different views on the nature of firms, driving forces (interests), growth limits and capacities, market conditions and so on. From the very foundations they differ in presuppositions about information and market agents’ behavior. But all they have the right for existence and, moreover, they were objective in some way but hitherto nowadays. Today these approaches evolved and continue evolving because they have rationale for sure.

References