The Evolution of the Firm

A few weeks ago I discussed The Rise of the Global Superstar Company based on a recent special report on the subject by The Economist.  The report noted that the decade-long trend toward increasingly concentrated global firms is somewhat surprising. 

“The rise of the giants is a reversal of recent history…  In the 1980s and 1990s management gurus pointed to the demise of size as big companies seemed to be giving way to a much more entrepreneurial economy.  Giants such as AT&T were broken up and state-owned firms were privatised.  High-tech companies emerged from nowhere.  Peter Drucker, a veteran management thinker, announced that ‘the Fortune 500 [list of the biggest American companies] is over.’ That chimed with the ideas of Ronald Coase, an academic who had argued in ‘The Nature of the Firm’ (1937) that companies make sense only when they can provide the services concerned more cheaply than the market can.”

Professor Coase’s views on the firm changed quite a bit over the years.  In 1937 he published The Nature of the Firm, a seminal article which along with other major contributions earned him the 1991 Nobel Prize in economics.  In the article, Professor Coase provided a simple answer to the question: Why do firms exist?  He explained that, in principle, a firm should be able to find the cheapest, most productive goods and services by contracting them out in an efficient, open marketplace.  However, markets are not perfectly fluid.  Transaction costs are incurred in obtaining goods and services outside the firm, such as searching for the right people, negotiating a contract, coordinating the work, managing intellectual property and so on.  Thus, firms came into being to make it easier and less costly to get work done.

Through much of the 20th century, firms kept expanding and adding people within their base countries and around the world.  All that growth led to ever larger, multi-layered hierarchical organizations.  It also often led to a bureaucratic culture that made it difficult to embrace new ideas and compete against faster moving startups, especially once the digital technology revolution kicked into high gear in the latter part of the century.

Over the past 20 years, the Internet radically lowered the transactions costs of obtaining goods and services outside the firm.  As a result, firms started to rely on business partners for many of the functions once done in-house.  In addition, the intense pace of global competition forced companies to focus their energies on their true points of differentiation instead of squandering competitive advantage by dispersing focus and investment on capabilities easily available in the marketplace.

Nevertheless, not only are large companies alive and well, but as The Economist points out, “the most striking feature of business today is not the overturning of the established order.  It is the entrenchment of a group of superstar companies at the heart of the global economy.  Some of these are old firms, like GE, that have reinvented themselves.  Some are emerging-market champions, like Samsung, which have seized the opportunities provided by globalisation.  The elite of the elite are high-tech wizards—Google, Apple, Facebook and the rest—that have conjured up corporate empires from bits and bytes.”

Why is this happening?  Do we need a different answer to the question Why do firms exist? than the one given by Professor Coase almost 80 years ago, - firms make sense only if they can do things more cheaply than the market can.  As The Economist points out,  “Since firms continue to occupy a central place in the modern economy despite the enormous advances of the market in recent years, there must be other factors at work.”

Among the key such other factors is the ability to address complex technical and management problems.   This is particularly important because of the growing complexity of the products, services, systems and solutions companies are now developing.  Complexity generally results in unanticipated consequences and increases the risks of something going seriously wrong.

As firms increasingly rely on supply chain partners, one of their major challenges is how to best manage their distributed operations across a global network of interconnected companies.  This requires not just good IT systems and well defined, data-driven processes, but also good human communications and coordination.  Firms that aspire to be effective ecosystem leaders must have good social skills and trust-based working relationships with their various supply chain partners, so they can better collaborate, innovate and deal with the unexpected problems that will surely arise now and then.  Firms with strong, internal management practices are in the best position to extend such practices to their external ecosystem partners.

Finally, is it time to reassess Coase’s transaction-cost theory of the firm?  In fact, Professor Coase, - who passed away in 2013 at the age of 102, - addressed this question directly in a truly remarkable video presentation at a 2009 conference in his honor.  Professor Coase, then 99 years old, first apologized for not being there in person, because he now gets very tired and was not feeling well.  He then proceeded to talk with a sharpness of mind we would all wish on ourselves at 39, let alone at 99.

He wanted to clarify some concepts that he felt he had not quite gotten right in The Nature of the Firm, - which he now thought of as little more than an undergraduate essay, - and proceeded to explain the difference between markets and firms.  Markets are artificial creations, not something that one can find that exist on their own.  Markets appear when people decide to create them.  They then negotiate with each other and work out the necessary contracts to make them come about.  Sometimes markets work out, and sometimes they don’t.  

“Firms are a little different,” Professor Coase then said.  “Firms are usually based initially on the family, and they exist in that form, to a large extent today.  But firms are not to be analyzed the way I did it in The Nature of the Firm, [which] talked about the firm as if it was an entity in economic theory. . .  Firms are organizations in which the different parts of the firm have an interchange with other parts of the firm,… it is a sociological problem not an economic problem…”

“I discovered that there were friendships and antagonisms within firms,… one part of a firm would feel that another part is always going to mess up what they were doing.   It operated in a very different way from the way it does in economic theory where you have a firm maximizing profits, knowing all the things that affected them and acting accordingly.  In fact it’s very difficult to imagine a firm acting the way that is described in the textbooks”

In other words, as The Economist put it:  “Companies are not just a way of keeping transaction costs to a minimum.  They are proof that when people are trying to solve common problems, they are wiser collectively than they are individually. Such collective wisdom can accumulate over time and be embodied in corporate traditions that cannot be bought in the market.”

Comments

[Robert Cohen]

Thanks for the interesting thoughts about the nature of the firm. A number of economists who studied the multinational firm tried to push their thinking beyond Coase, concerned that the firm faced far more complex challenges and a need to manage them in a more sophisticated way. The challenges in the age of digital transformation are even greater and difficult to address. My own research suggests that given the shortages of data analysts, software programmers, and orchestration managers for cloud computing, large firms have an easier time attracting and building substantial specialized teams with the new skills required. This would also contribute to a more rapid growth of bigger firms than smaller ones, one of the very interesting facts you note at the beginning.

[John Hagel]

Thanks for pointing out the evolution of Coase's perspective. At the Center for the Edge, we have written extensively about the need for a big shift from scalable efficiency to scalable learning as the rationale for large organizations - https://dupress.deloitte.com/dup-us-en/topics/innovation/institutional-innovation.html This is very consistent with Coase's view of the firm's ability to accumulate collective wisdom over time. The point that we emphasize, though is that scalable efficiency and scalable learning are in fundamental opposition with each other and firm leaders will need to choose which rationale they will use to drive and sustain the growth of their enterprises.

[John Reiners]

Lots of interesting ideas. One of the most important recent changes that you refer to in earlier posts is the growth of digital platform businesses. They promise to dramatically lower the costs and friction involved in accessing markets and delivering solutions, through effective collaboration. This will have significant impact on the nature of the firm and the responsibilities of managers. For platform owners, as well as participants, management of a firm's own resources is just one success factor. It may be far more important to manage the market by orchestrating a network of collaborators. A whole new set of skills become important - network management, curating content, ensuring effective market matching between supply and demand - + a whole additional set of KPIs. In particular managers will need to focus to a much greater extent outside their own firms.