The Nature of the Firm

Abstract

Economic theory has suffered in the past from a failure to state clearly its assumptions. Economists in building up a theory have often omitted to examine the foundations on which it was erected. This examination is, however, essential not only to prevent the misunderstanding and needless controversy which arise from a lack of knowledge of the assumptions on which a theory is based, but also because of the extreme importance for economics of good judgment in choosing between rival sets of assumptions. For instance, it is suggested that the use of the word “firm” in economics may be different from the use of the term by the “plain man.”11 Joan Robinson, Economics is a Serious Subject, p. 12. Since there is apparently a trend in economic theory towards starting analysis with the individual firm and not with the industry,22 See N. Kaldor, “The Equilibrium of the Firm,”Economic Journal, March, 1934. it is all the more necessary not only that a clear definition of the word “firm” should be given but that its difference from a firm in the “real world,” if it exists, should be made clear. Mrs. Robinson has said that “the two questions to be asked of a set of assumptions in economics are : Are they tractable? and : Do they correspond with the real world?”33 Op. cit., p. 6. Though, as Mrs. Robinson points out, “more often one set will be manageable and the other realistic,” yet there may well be branches of theory where assumptions may be both manageable and realistic. It is hoped to show in the following paper that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall, the idea of the margin and that of substitution, together giving the idea of substitution at the margin.11 J. M. Keynes, Essays in Biography, pp. 223–4. Our definition must, of course, “relate to formal relations which are capable of being conceived exactly.”22 L. Robbins, Nature and Significance of Economic Science, p. 63. It is convenient if, in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist. Let us consider the description of the economic system given by Sir Arthur Salter.33 This description is quoted with approval by D. H. Robertson, Control of Industry, p. 85, and by Professor Arnold Plant, “Trends in Business Administration,” Economica, February, 1932. It appears in Allied Shipping Control, pp. 16–17. “The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive.” An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.44 See F. A. Hayek, “The Trend of Economic Thinking,” Economica, May, 1933. The economic system “works itself.” This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives. This is necessarily so if there is to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.55 See F. A. Hayek, op. cit. Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X an…