The theory of the firm has been one of the most exciting fields of economic research over the last twenty years. Yet despite a vast amount of work, no consensus has been reached on the nature of the firm. Theories of contracts, transaction costs and entrepreneurship vie with each other to form the foundation for a truly comprehensive theory of the firm. Each of these theories has its own idea of what the key issue is, and naturally claims that it alone addresses this particular issue head on. This paper sets out a general framework within which all the key questions in the theory of the firm can be brought together and discussed at once. The range of different issues discussed is summarized in Figure 1. The pattern of the figure reflects the nature of the synthesis attempted in this paper.
The framework is based upon the concept of volatility. It is supposed that the economic environment is continuously disturbed by shocks of both a persistent and transitory nature. Persistent shocks provide a stimulus to the formation of new firms or the radical restructuring of existing firms. Persistent shocks are intermittent and diverse, and are usually dealt with by improvisation. This improvisation is effected by the entrepreneur who founds the firm. By contrast, transitory shocks are repetitive and conform to a more limited number of types. They are dealt with routinely using procedures devised by the entrepreneur. Applying a division of labour to the implementation of these procedures creates the organisation of the firm.
Information on shocks is costly to collect and communicate. The initial impact of shocks is localised and dispersed, which means that some people get to learn of them before others. Those 'in the know' buy up resources which have become more valuable as a result of the shock, in order to make a speculative gain. The gain is realised when the resources are deployed to a more profitable use. The most significant type of shock, so far as firms are concerned, is one which creates a new market opportunity. The shock could be a change in tastes, factor costs, technology, social values, or indeed anything that impinges on the gains from a particular type of trade. A firm is created whenever an entrepreneur speculates that certain resources - including labour time - should be acquired in order to create a new market of some kind.
Market opportunities normally have to be realised through intermediation. Intermediation reduces transaction costs which would otherwise inhibit trade. It is also a profit-extraction mechanism for the entrepreneur. The organisation of intermediation has many different aspects, which are explained below; it is these different aspects that are followed up in different theories of the firm. Embedding all these issues in a common framework clarifies the connections between them. It also reveals a common theme - namely the importance of synthesising information and of ensuring that the information that is synthesised is true. It is the synthesis of different kinds of persistent information that brings firms into being, and it is their skill in subsequently synthesising transitory information which, together with the quality of the initial synthesis, governs their subsequent success.
There are two main reasons, it seems, why this general framework has not been presented before. One is that economic theories of the firm have placed too much emphasis on production and too little on market-making. This in turn reflects an excessive concern with material flow in conventional economics, and too little concern with information flow instead. The second is that theories concerned with the formation of firms - such as theories of entrepreneurship - have remained somewhat divorced from theories of the routine operation of firms found in the literature on organisational behaviour and operational research. This has meant that the synthesis of persistent information discussed in the former theoretical tradition has not been integrated with the synthesis of transitory information considered in the latter. …