While ordinary contracts facilitate efficient specialization according to comparative advantage, a special class of contracts among a group of joint inputs to a team production process is commonly used for team production. Instead of multilateral contracts among all the joint inputs' owners, a central common party to a set of bilateral contracts facilitates efficient organization of the joint inputs in team production. The terms of the contracts form the basis of the entity called the firm--especially appropriate for organizing team production processes.
Team productive activity is that in which a union, or joint use, of inputs yields a larger output than the sum of the products of the separately used inputs. This team production requires--like all other production processes-- an assessment of marginal productivities if efficient production is to be achieved. Nonseparability of the products of several differently owned joint inputs raises the cost of assessing the marginal productivities of those resources or services of each input owner. Monitoring or metering the productivities to match marginal productivities to costs of inputs and thereby to reduce shirking can be achieved more economically (than by across market bilateral negotiations among inputs) in a firm.
The essence of the classical firm is identified here as a contractual structure with: 1) joint input production; 2) several input owners; 3) one party who is common to all the contracts of the joint inputs; 4) who has rights to renegotiate any input's contract independently of contracts with other input owners; 5) who holds the residual claim; and 6) who has the right to sell his central contractual residual status. The central agent is called the firm's owner and the employer. No authoritarian control is involved; the arrangement is simply a contractual structure subject to continuous renegotiation with the central agent. The contractual structure arises as a means of enhancing efficient organization of team production. In particular, the ability to detect shirking among owners of jointly used inputs in team production is enhanced (detection costs are reduced) by this arrangement and the discipline (by revision of contracts) of input owners is made more economic.
Testable implications are suggested by the analysis of different types of organizations--nonprofit, proprietary for profit, unions, cooperatives, partnerships, and by the kinds of inputs that tend to be owned by the firm in contrast to those employed by the firm.
We conclude with a highly conjectural but possibly significant interpretation. As a consequence of the flow of information to the central party (employer), the firm takes on the characteristic of an efficient market in