Academic journal article Journal of Corporation Law

The Conception That the Corporation Is a Nexus of Contracts, and the Dual Nature of the Firm

Academic journal article Journal of Corporation Law

The Conception That the Corporation Is a Nexus of Contracts, and the Dual Nature of the Firm

Article excerpt

Melvin A. Eisenberg*


In 1976 Michael Jensen and William Meckling first formulated the conception that the corporation is a nexus of contracts in their famous article The Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.1 Since that time, the conception has dominated the law-and-economics literature in corporate law.2 The validity of this conception, however, cannot be established by economic analysis. That does not make the conception invalid, but it does mean that its validity must be examined along other dimensions. In this Article, I will examine the conception along several such dimensions, including its descriptive validity, its bearing on important problems of corporate law, and its intellectual coherence. I will show that the nexus-of-contracts conception is unsatisfactory as a positive-that is, descriptive-matter, in part because the corporation has a dual nature: In one aspect, it consists of reciprocal arrangements; in another, it is a bureaucratic hierarchy. The nexus-of-contracts conception captures only one of these two aspects of the corporation. I will also show that the conception lacks intellectual coherence and often gets in the way of clear thinking by substituting conclusory assertions for careful analysis.


It is useful to begin by reviewing the intellectual history of the Jensen and Meckling article. That history begins with Ronald Coase's landmark paper, The Nature of the Firm.3 In that paper, Coase characterized the boundaries of the firm as the range of exchanges over which the market system was superseded and resource allocation was accomplished instead by authority and direction:

[I]n 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 and Y, except insofar as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so.

... Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneurcoordinator, who directs production.4

Coase argued that activities will be included within a firm when the costs of using markets-that is, contracts-are greater than the costs of direction by authority.5 The essential issue in the theory of the firm, therefore, was why some economic activity takes place within firms, so that the activity is directed by authority, while other economic activity takes place across markets, so that the activity is determined by contract.

Coase did not explicitly define the firm in his paper. Implicitly, however, he defined the firm to consist of the activities under the direction of the entrepreneur, who in turn was defined as the person or persons who take the place of the price mechanism in the direction of resources.6 Coase stated that the question what constitutes a firm can be approached in practice by considering the relationship of employer and employee.7 One of the essentials of this relationship, he said, is that the employer must have the right to control the work of the employee.8 "We thus see," he concluded, "that it is the fact of direction which is the essence of the legal concept of employer and employee"-and, by extension, of the firm.9

In their paper Production, Information Costs, and Economic Organization,10 Armen Alchian and Harold Demsetz objected to the Coasian conception of the firm, and emphasized instead the role of team production within the firm and the role of agreement and monitoring in team production. …

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