WorldSys: Austrian Home Study Course, Week 16

1 Why does [Peter] Klein characterize the traditional theory of the firm as “a calculus problem”?

Standard economics treats firms as single-agent black boxes obeying the outputs of a ‘production function’, an approach which is appealing because it can be analyzed with the tools of calculus.

2 In neoclassical theory, what is a production function?

It’s simply an equation capturing a relationship between physical output and factors of production (such as capital goods and labor). The production function be used to do things like establish an upper bound on productive capacity given constrains on some input.

3 Mainstream economists have grown dissatisfied with certain aspects of the orthodox approach, but (according to [Peter] Klein) what is the “more serious problem” that they generally overlook?

The more serious issue is that the story of business firms is almost always told from the manager’s viewpoint, even when the manager isn’t the owner. But in cases in which someone owns the business and puts up investment capital they must decide how much authority to delegate to the manager. In an important way, therefore, the owner is the one calling the shots, even if they aren’t much involved in the day-to-day running of the business.

The fact that the mainstream approach completely overlooks the role and function of the owner is a serious problem.

4 What are the “two alternative perspectives” on the firm?

The entrepreneur-promoter perspective sees the firm as an entrepreneur in the Misesian sense; that is, as an entity that purchases factors of production at today’s prices for the promise of an unknown and uncertain reward in the future.

The capitalist perspective sees the owner as a kind of ‘decision-making capital’ and ‘residual claimant’ with the firm’s objective as the maximization of the owner’s profit.

5 What is the Coasian explanation for the sizes of different firms?

Coase realized that the boundaries of a firm were determined in large part by transaction costs. A firm operating in the open market can choose to outsource the production of a certain good, or hire a marketing team, or hire people to do market research, or it can choose to do these (and other) things internally. The are obvious costs associated with taking the former route, but it’s important to not overlook the costs of taking the latter route: people must be hired and fired, performance must be monitored and critiqued, etc.

So, the process of determining at the margin whether a given task is worth doing externally or internally is a decisive driver of firm size.

6 Beginning with the Coasian framework, what two elements does Klein add for an Austrian theory of the firm?

The idea that firms have an entrepreneurial function insofar as they bear uncertainty, and they utilize economic calculation to evaluate the decisions they make. The owners and managers of a business firm fit the Misesian definition of an entrepreneur as an uncertainty-bearing entity that takes risks by acting on a vision which could end in total failure.

7 According to Rothbard, what provides an upper limit to the size of a firm?

To contextualize this question we first note that there is a blind spot in the economics literature around the costs of internally governing a firm. Much effort has been put into analyzing inter-firm transaction costs but much less into analyzing intra-firm transaction costs.

Put another way: why does a given entrepreneur not take one less or one more action in the governance of his enterprise? What marginal calculations are driving firms towards being a certain size?

Rothbard believed that it was the socialist calculation problem rearing its head. We all know that any centralized authority attempting to plan an economy faces a hopeless computational thicket. There just is no way to organize and act upon the information distributed throughout a market without so badly distorting price signals as to make them meaningless. From that point it becomes impossible to make even basic economic decisions.

At a certain size similar issues begin to plague large firms. Rationally allocating resources to different divisions within a company requires an external market generating prices so that meaningful counterfactual comparisons can be made. The size of the firm, therefore, is constrained by the need for external markets for all its goods, allowing for sensible prices between its subdivisions and efficient use of resources.

8 What is the “principal-agent problem”?

The problem of analyzing the relationship between the owner of an enterprise and its manager, roles often occupied by different people. How is it that owners decide on the correct amount of authority to delegate to the manager, how do they monitor managerial performance, etc.

9 How do capital markets, and in particular takeovers, allow shareholders to rein in management?

Incentivizing managers can be a tricky issue because they often wield enormous discretionary power while monitoring and   be tricky. As with other things one of the best ways to ensure managerial discipline is to have an external market for corporate control. That is, allow mergers and takeovers. If a manager underperforms badly enough often enough, eventually someone will buy his enterprise and replace him.

10 What are the four areas that Klein believes an Austrian theory of corporate governance should address?

Looking at the ways in which firms constitute an investment, examining how internal and external capital markets are related, comparing various corporate governance strategies, expanding upon the notion that financiers are entrepreneurs.

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