Jankovic Firm

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Volume 16,Number1 2010 Article 3

Journal des Economistes et des

Etudes Humaines

Firm as a Nexus of Markets

Ivan Jankovic, University of Windsor

Recommended Citation:

Jankovic, Ivan (2010) "Firm as a Nexus of Markets,"Journal des Economistes et des Etudes

Humaines: Vol. 16: No. 1, Article 3.

Available at: http://www.bepress.com/jeeh/vol16/iss1/art3

DOI: 10.2202/1145-6396.1241

2010 Berkeley Electronic Press and IES-Europe. All rights reserved.


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Introduction

My aim in this paper is to outline the heterodox Austrian theory of the firm. What

I call here an orthodox or mainstream Austrian theory of the firm is an attemptto reshape a Coasian notion of the firm as a centrally planned hierarchy, by

merging it with general Austrian theory of the market process andentrepreneurship. The principal Austrians of the present (Klein and Foss, 2005,

Foss 1994, Langlois and Foss, 1997) developed a theory of the firm by trying to

synthesize this Coasian notion of the firm as a hierarchical entity dominated by

commands and orders, with a distinct Misesian theory of entrepreneurship andmonetary calculation as preconditions of rational economic planning. This

approach is entirely rejected in this paper and the contractual "agency" theory of

Alchian-Demsetz, Jensen-Meckling, Fama is accepted instead as a basis for theAustrian-neoclassical synthesis. Although this approach has been hinted at by

some Austrian scholars (Mathews 1996, Salin 2002, Boudreaux and Holcombe,1989) its full implications have never been spelled out.

In the section 1, after explaining the basics of Coase's theory of the firm, I

will proceed with my critique of it, focusing specifically on its central

assumptions of the explanatory power of the category of transaction cost and its

definition of the firm by using the relationship between the managerial andtransaction costs as a criterion. In the section 2, I will explore the assumptions of

the ''orthodox'' Austrian concept of the firm, and then evaluate it, proving that the

same objections against the orthodox Coasianism apply equally to AustrianCoasianism. In outlining the nexus of market theory of the firm in section 3, I will

rely upon the Austrian heterodox theory (Schumpeter, Kirzner, Mathews, Salin),

as well as on some neoclassical mainstream contributions (Alchian and Demsetz,Jensen and Meckling, Fama, Cheung), to undermine a sharp division between the

firm and the market, and specifically to challenge the notion of entrepreneurshipas being absent from the firm. I will also try to show that any theory, in which the

firm is understood as a basic unit of analysis violates one of the fundamental

methodological tenets of sound economic theory methodological individualism.Apart from that, I will use Mises/Rothbard's argument regarding the relative

inefficiency of non/price allocation of capital goods to question the idea of the

firm as a centrally planned entity. In the fourth and the final section, I will further

refine the nexus of markets theory by questioning the idea of a firm as a unit ofanalysis by introducing the problems of cartels and vertical integration, and

showing that it is very difficult to give a satisfying theory what the firm is, asopposed to cartels and diverse types of contracts, such as hive rental or servicecontracts. In concluding, I will briefly summarize the results.

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Jankovic: Firm as a Nexus of Markets

Published by Berkeley Electronic Press, 2010


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1: Inception of modern theory of the firm: Ronald Coase and beyond

Ronald Coase expressed his vision of the firm through his famous formula

pertaining to the firm as a tool for minimizing the "cost of using the marketmechanism". It implied that a firm existed as a way to provide an individual with

the opportunity to carry out transactions on the open market. Within thetransaction costs, Coase further differentiated the costs of obtaining the

information about business opportunities costs of setting and monitoring the

contract etc (Coase, 1937). Coase's primary assumption is that the firm shows up

because of an imbalance between the cost of using the information from the openmarket and the cost of organizing and monitoring the production within the firm

(costs of management). If transaction costs are higher than the costs of

management the firm will appear, and if marginal transaction costs are risingcompared to marginal management costs, the firm will tend to grow (Coase,

ibid.). The boundary of the firm is defined by this point of equilibrium betweenthe managerial and transaction costs. The principal innovation of this Coase'searly paper was an idea of possibility to combine the impersonal, allocative

mechanism of market prices with the hierarchical model for organizing activities

within the firm. This puzzling dichotomy, however, came as both a discovery and

a new problem; a discovery because none before him thought of the firm as anentity which is, in an organizational sense, competing with the market, and a

problem because it was not clear how to apply a standard economic analysis in

such a changed environment.Although Coase tended to transcend some basic features of a standard

perfect competitive equilibrium analysis, his assumptions about transaction costs,

as well as all subsequent attempts of his followers to give a sense to the notion,were nevertheless deeply rooted in that analysis. As Harold Demsetz has pointed

out (Demsetz, 1988), all theoretical conceptualizations of the transaction costparadigm rested on the idea that (at least some) information is complete, free and

perfect, notably information about the comparative costs of production of the

same item in the two separate firms. This idea represented a residue of the oldperfect competitive equilibrium conception, which included perfect information

as a crucial condition. According to Demsetz, the decision to "buy-or-make" (to

carry out a transaction via open market or within the firm) in the framework of

any paradigm of transaction costs is made only on the basis of the relationbetween the transaction and management costs. It is supposed implicitly that two

firms must produce the same item at the same cost.1 In that way, the rejected

1 It seems that Coase himself was well aware of the inappropriateness of his analysis of the factors

determining the nature of the firm and the extent of its operations, primarily due to ignoring the

problem of production cost. In the article "Nature of the firm influence" he described his

previous emphasizing of the dichotomy transaction vs. managerial costs, and the relative neglect

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assumption of free information appears in a residual mode as availability of

information on relative production costs: "Although information is treated as

being costly for transaction or management control purposes, it is implicitly

presumed to be free for production purposes," (Demsetz, ibid., 148).However, this is a wrong assumption which distorts the picture of how a

decision "buy-or-make" is made. A firm can continue with internal productioneven in the case that transaction costs are null and managerial costs positive, if the

productive efficiency of the firm is sufficiently higher than the productive

efficiency of the second-best firm. It can also continue to buy inputs on the market

even if its managerial costs are null, if the productive efficiency of the supplyingfirm is much higher. If all firms disappear with null transaction costs (as one

would expect), does that mean managerial costs in this situation also become

null? Obviously not, because the individuals also have the costs of organizingproduction no matter how they are linked with the other individuals.

Therefore, the real decisions of buying or making must be made on thebasis of an assessment of the overallcosts and benefits of the internal productionversus the open market purchase. That assessment includes not only the ratio

transaction/managerial costs, but also the relative production costs, the state of

technology, innovations, etc. Thus, transaction costs/managerial costs ratio would

be just one, and by no means the most important factor in the buy-or-makedecision. When a firm buys the inputs from another firm, it thereby pays the

managerial costs of that other firm. Also, by producing its own item from inputs

bought on the open markets it pays the transaction costs of purchase of inputs. Anopen market purchase does not eliminate the managerial costs, just as internal

production does not eliminate the transaction costs! The final conclusion could be

that it is not possible to draw an analytically clear distinction between openmarket purchase and internal production, i.e. between the market and the firm

as categories! In their famous paper, Klein, Crawford and Alchian confirmed theDemsetz-Alchian early finding, "Once we attempt to add empirical detail to

Coase's fundamental insight that a systematic study of transaction costs isnecessary to explain particular forms of economic organization, we find that his

primary distinction between transactions made within a firm and transactions

made in the marketplace may often be too simplistic. Many long-term contractual

of the production cost in his initial paper from 1937: "In that article, I did not explore factors that

could lower the organization costs in one firm in relation to other firm. It is sufficient if the maingoal is to explain why firms exist. But if one wishes to explain institutional structure of production

in system as a whole, than it is necessary to unfold the reasons why costs of organizing certainactivities across the firms are different," (Coase, 1937). But in in the work of the Coase's very

influential disciple, Oliver Williamson, we can find a much sharper exclusion of the production

cost from the analysis, and a complete rehabilitation of the traditional neoclassical conception of

cost, (see, Langlois & Foss (1997)).

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relationships (such as franchising) blur the line between the market and the firm."

(Klein et al, 1978)

In his later works, Harold Demsetz goes even further, denying any real

explanatory power to the category of transaction cost. According to him, althoughtransaction costs undoubtedly exist and have impact on economic activity, this is

analytically useless for answering the questions on why and where the firm ismore efficient than the market in resolving the problem of economic

coordination between the individuals within the producing team and outside it.

Demsetz explains that the role of transaction cost in explaining the manner in

which organization responds to these problems is like the role of gravity in

explaining chemical reactions; gravity influences chemical reactions, but seldomis it the key variable whose behavior importantly explains variations in the

reactions observed," (Demsetz, 1988, p. 151). Gravity surely influences chemicalreactions, but dozens of other phenomena also influence them, and gravity also

influences dozens of other phenomena apart from the chemical reactions. By thesame token, the genesis, extent and characteristics of the firm are certainlyaffected by transaction costs in some way, but they are also affected by the prices

of commodities on the world market, by the productive efficiency of rival firms,

by specific knowledge of firms' members and many other factors. On the other

hand, transaction costs (uncertainty, incomplete knowledge) exert an influenceapart from the firm and the market on a wide variety of activities of individuals

outside the economic system. Any transaction includes the cost of acquiring the

opportunity to carry it out. To speak about that cost as the key determinant of thegenesis and structure of the firm deprives the notion of the transaction cost of any

serious predictive power, or as Demsetz ironically notes means tocome closer to

definition of transaction costs as the costs of resolving problems, (ibid., p. 152).How do we, in spite of these theoretical weaknesses of Coase's concept of

transaction cost, come to adopt the idea of the firm as a hierarchical rather than acontractual entity? The standard explanation says that the hierarchical nature of

the firm can best be seen in how production is organized within it, because

monitoring and issuance of orders are everyday practice, as well as the hiring andfiring of the workforce. Bosses and subordinates do not cooperate via price

mechanism, but rather give orders and comply with them; they make and carry

out economic plans (Coase, 1937, Williamson, 1985).

Yet, things could be seen from an entirely different perspective, in whichthe coordination within the firm has been explained as just one specific market-

based contractual arrangement (Alchian and Demsetz 1972, Jensen and Meckling1976, Fama, 1980, Salin 2002). A market includes, among its other functions, avoluntary system of contracts between two or more parties. Decisions on making

contracts are free and ex ante at least, efficient. They are useful for both parties,

otherwise they would not have been made in the first place. In that connection, a

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firm is only a specific and often a complicated nexus of contracts between the

owners, managers, workers etc. To put it shortly, a firm is a nexus of contracts

between the various individuals with different interests and different contributions

to a joint business enterprise. An owner brings in capital and material resources.He hires managers to operate his plants and organize production processes.

Managers hire workers and include them together in cooperative locus. Workersoffer their services for the monetary and non-monetary remuneration, fixed or

flexible. All of them meet each other on the various markets and negotiate in

order to make arrangements which will allow them to improve their economic

interests. If they reach an agreement, that does not mean anything more than anexchange of legitimately owned resources, whether those resources include

physical capital, organization skills or working efforts. Methodologically

speaking, there is nothing specific concerning firms that we cannot observe in theordinary open market: "The firm does not own all its inputs. It has no power of

fiat, no authority, no disciplinary action any different in the slightest degree fromordinary market contracting between any two people. I can "punish" you only by

withholding future business. That is exactly all that any employer can do. He can

fire; I can fire my grocer by stopping to purchase from him. There is no otherdifference," (Alchian and Demsetz, 1972, 777).

The impression that the firm is entirely specific, or even radically differentin nature than other forms of voluntary contractual and spontaneous cooperation,

stems from the fact that the entrepreneur and the worker have different costs

related to the monitoring or maintaining the adherence to a contract. For anemployee to monitor contractual adherence by his employer, it is sufficient to

establish whether the contracted upon sum of money is paid to him, and to

demand contract enforcement either via the court or an alternative avenue, if theobligations of an employer have not been met. On the other hand, the managers or

owners of a firm often have to proceed through a much more complicatedoperation to estimate whether employees properly execute the duties they have

undertaken by contract. Continuous, exhaustive, resource and time consuming

monitoring is a part of contract enforcement on the side of the entrepreneur (Salin,2002). Therefore, many theorists (including Coase) seem to believe that in the

relationship between the owner, worker and the entrepreneur there is some

asymmetry, or even that such a pattern of organization is not contractual

whatsoever, but rather a hierarchical one. Asymmetric relationship betweenworkers and managers in monitoring contract adherence gives a false impression

of a hierarchical structure. But, as we have seen, the organizational pattern of thefirm is purely contractual, just as in any other case of market cooperation.

2In

2 In their famous paper, Alchian and Demsetz identify the relation employer/employee with therelation consumer/producer: "Telling an employee to to type this letter rather than to file that

document is like my telling a grocer to sell me this brand of tuna rather than that brand of bread"

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transaction cost theories we are expected to visualize the firm as a micro-state

within the market, with its own managerial military and police to issue orders and

monitor their execution. In such an analytical environment, individualist

perspective is basically lost. A significant contribution of Alchian-Demsetzs newperspective was the emphasis on methodological individualism through the

concept of the firm as a legal facet of various sets of contracts. In Alchian andDemsetz's work the concept of the firm is related to resolving the moral hazard

problem occurring in team work, essential to the firm's operations. The firm is not

an instrument of minimizing the transaction costs, but of measuring the marginal

contribution of the team members to the value of its output. It is an instrument ofresolving the principal-agent problem (Achian and Demsetz, 1972). The

individualist concept of the firm can survive in such an environment, unlike in the

Coasean framework.Generalizing the Demsetz-Alchians findings, Jensen and Meckling widen

the scope of agency theory to apply it to all forms of institutions in which theprincipal-agent problem is present. That way, the theory of the firm as a uniqueentity disappears, that is, it becomes a part of a wider program of explaining how

in the framework of various contractual systems the costs and benefits of

principal-agent relations are distributed. The concept of a firm that has some

essence ("nature") that is first discovered by careful analysis and thendifferentiated from the "market, is finally abandoned. Jensen and Meckling

clearly describe this changed notion of the firm: "it makes little or no sense to try

to distinguish those things that are inside the firm (or any other organization)

from those things that are outside of it. There is in a very real sense only amultitude of complex relationships (i.e., contracts) between the legal fiction (the

firm) and the owners of labor, material and capital inputs and the consumers ofoutput," (Jensen and Meckling, 1976, 10). Simply, a firm is a changing and

flexible net of contractual relationships between individuals that have their ownseparate interests, motivations and goals. Therefore, according to Jensen and

Meckling it is besides the point to question what the "objective function of the

firm" is, and whether or not the firm could possibly have some "socialresponsibility", outside their drive for making profit. Even maximization of profit

strictu sensu could not be taken as a firm's objective function, not because

something else is its objective function, or because people in the firm do not make

the profit, but because they also do a lot of other things (work for salaries, payinterests, sell products, gain prestige, etc.). Different individuals within the firm

have different objectives to achieve and thus, they all have different objectivefunctions. Only individuals have objective functions, not collectives. I. Therefore,a firm does not have neither the profit nor "social" functions, since it does not

(Alchian, Demsetz, 1972, s.779)

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have any subjectivity whatsoever. Firm is a fiction, it does not really exist3

Jensen and Meckling define a firm as "legal fiction which serves as a focus for a

complex process in which the conflicting objectives of individuals (some of whom

may represent other organizations) are brought into equilibrium within aframework of contractual relations " (Jensen and Meckling, ibid.,11). If so, the

concept of ownership of the firm also must be redefined. The ownership overcapital is ownership over just one of the possible sets of inputs, the others being

managerial or working services, all assembled within the "firm" by a nexus of

contracts. A firm cannot be owned because a set of contracts cannot be owned. As

Fama says: "Ownership over capital should not be confused with ownership of the

firm. Each factor in a firm is owned by somebody. The firm is just set of contractscovering the way inputs are joined to create outputs and the way receipts from

outputs are shared among inputs," (Fama, 1980). This also means that a firmcannot plan, because only individuals can plan.

Although all of this is essential for the Austrian theory of the firm as well(and will be included in our proposal of how to remodel it), the theory in itsneoclassical form has serious problems. One of the basic weaknesses of the

neoclassical contractual notion of the firm was the absence of the theory of

monetary calculation and entrepreneurship and although indirect, the adoption of

an assumption of perfect knowledge via completeness of contract, certainty andrationality of economic actors (Zingales, 1998). It is correct to say that both

transaction costs and contractual theories were in various ways rooted in

neoclassical assumptions about information, knowledge and competition. Also,that is the reason to believe that the conventional agency theory of the firm needs

the Austrian concepts of monetary calculation, entrepreneurship and plan

coordination in order to be better founded. The choice of the mainstream Austriantheory of the firm was to try salvaging Coase's theory by incorporating it into

Austrian framework. I think a much better approach would be to salvage thecontractual agency theory by incorporating it, in a similar way, into the Austrian

argumentative setting of calculation and entrepreneurship. In what follows I will

try to outline some basic avenues along which that can be achieved.

3 As far as profit mazimization is concerned it is possible to posit it as a supreme end of those who

have a property eployed for investment purposes, but they are just one of the contracting partieswithin the firm. In this (methaphorical) sense promoting the "social" function of the firm only

could mean that the owners should stop striving to achieve profit, but accept to work to achieveother goals, such as "fairness", other people's well being and so on. It would imply that someone

should be an owner, bear the cost and risk of conducting business, and let someone else reap the

gains of his effort, that is, decide on how residual income is to be divided. For the classical

analysis of why a firm has no social responsibility of any kind, see Friedman (1970)

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2. The standard Austrian view of the firm

The basic categories, missing in both the contractual and Coasian paradigm of the

firm are, according to the Austrian critique, entrepreneurship, monetarycalculation and inter-temporal allocation of productive factors.

Entrepreneurship in the wider sense is a consistent part of the humanaction, actually its synonym. Man acts in various ways (not only as an economic

actor-entrepreneur), using certain means to achieve ends. He undertakes actions in

order to achieve the state of affairs which he anticipates as desirable compared

with the present one. If there were no gap between the present and desirable statesof affairs there would not be any room for entrepreneurship in this wider sense of

the word. At the same time, entrepreneurship means accepting and coping with

uncertainty concerning the future. If we knew what the future would be, no onewould undertake any action whatsoever. The overall behavior of man has built in

itself the implicit assumption of dealing with uncertainty. Therefore,entrepreneurship as a way of dealing with the uncertainty is a universalphenomenon of human action. It is, as Mises puts it, a praxeological fact (Mises,

2004).

It is clear that, according to this wider praxeological definition, every

economic actor would be an entrepreneur at the same time (for he is facinguncertainty, unavoidable opportunity cost and incomplete information about the

world and future). The economic entrepreneurship is a somewhat narrower notion,

it does not include every actor, but only those that use the material means toachieve the material ends (profit, earnings). The economic entrepreneurship

means praxeological entrepreneurship plus monetary calculation on the basis of

price mechanism. An entrepreneur is the one who risks material assets in order toorganize a production process he believes could result in products that can bring

him financial gain. He acts on the basis of the prices of production factors (labor,capital, raw materials) which he purchases on the open market and uses according

to his plans, guided by anticipation of future earnings from the particular use of

those factors, compared with the (hypothetical, opportunity) costs of that use.Also, he, just like any other entrepreneur, faces uncertainty concerning the future.

If his anticipation of the future consumer demand turns out to be correct, he will

gain profit. Accordingly, if his anticipation was misdirected, he will incur

financial loss, and possibly, bankruptcy.At the same time, an entrepreneur must take into account (to estimate ex

ante) both what the most viable way of production will be and where on thepreference scale of the consuming public a particular product is. He mustcalculate an outcome on the basis of uncertain knowledge about the unknown

magnitude and take the risk with his own or delegated money for those

calculations: "The business of the entrepreneur is not merely to experiment with

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new technological methods, but to select from the multitude of technologicallyfeasible methods those which are best fit to supply the public in the cheapest way

with the things they are asking for most urgently, " (Mises, 1951, p.110).

To achieve this end, it is not at all sufficient for an entrepreneur to executethe tasks that the neoclassical school acknowledges the "manager" should execute,

namely to organize the production within the cooperative unit called a firm,according to the plan adopted in advance by someone else. Such a view of the

entrepreneur's role reduces his activities to the horizon of an ordinary clerk who

takes the overall outer structure of the market as a given framework to which he

must adjust. On the contrary, the real entrepreneur works on the capital markets inuncertain conditions, where he tries to use incomplete information to gain the

profit. His job is quite different from that of an ordinary bureaucratic clerk who

acts in the given informational framework in which he just executes his assignedtask of achieving the technical optimum known in advance. Creativity of the

market process lies in an entrepreneur's changing of the circumstances, in hisability to adapt to changing consumer choices, by devising and adopting betterproduction techniques and less expensive ways of producing, distributing and

advertising products. He is an instrument of adaptation of the market process to

the unpredictable consumer demand. In Mises' writings, the firm is not in focus of

analysis, but the entrepreneurial function a feature of a businessman that heoperates in the capital markets to provide inter-temporal allocation of scarce

goods between the various branches of industries: "The market of the capitalist

society also performs all those operations which allocate the capital goods to the

various branches of industry. The entrepreneurs and capitalists establishcorporations and other firms, enlarge or reduce their size, dissolve them or merge

them with other enterprises; they buy and sell the shares and bonds of alreadyexisting and of new corporations; they grant, withdraw, and recover credits; in

short they perform all those acts the totality of which is called the capital and

money market. It is these financial transactions of promoters and speculators that

direct production into those channels in which it satisfies the most urgent wants ofthe consumers in the best possible way," (Mises, 2004, pp. 707-708).

The famous debate on economic calculation in socialism between the

Austrian school of economics (Mises and Hayek) and their socialist opponents

(Neurath, Lange, Lerner and others) was the main theoretical battlefield where we

can discern the significance of monetary calculation for the theory of the firm.Without reviewing the debate more in depth, it would be sufficient to refer to

Mises' famous argument for the impossibility of socialism: if there is no privateproperty, there is no supply and demand for goods, services and productionfactors. If in some society there would not be supply and demand, there also

would not be the prices of consumption and capital goods. If there wouldn't be

prices, there is no economic calculation (economic planning) whatsoever, because

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the planner (entrepreneur or the government "manager", nevermind) cannot know,

even if properly motivated to work and make plans, neither what has to be

produced, nor in what quantity, by combination of what specific factors etc, so

socialism necessarily leads to economic chaos and wasting of resources (Mises,1990).

One of the Mises foremost disciples, Murray Rothbard, employed thisclassical calculation argument to resolve the issue, which even today put in

trouble the orthodox theory of the firm, both in its transactional and agency

variety. This is the question set by Coase himself in his seminal paper: why is all

production not located in the one single firm, or cartel, that is: where lies theupper boundary of the vertical integration? Rothbard's answer goes as follows:

one big firm cannot exist because independent profit centers within it could not

know in the absence of an external market to calculate the transfer prices, i.e.prices of intermediary production factors which they exchange, and production

would be increasingly inefficient (Rothbard, 1962). Therefore, for him, just likefor Mises, in order for a firm to be able to calculate its cost and profit, it is notsufficient to have a market-based prices for the consumption goods; it is by far

more important to have market prices for the capital goods. If one firm

swallows the external markets, then the transfer prices within that big firm

would cease to reflect the real availability and opportunity costs of goodsanymore and would become as artificial and arbitrary as prices set by the socialist

central planner.4

Automatically, the Misesian signal that too expensive

production factor sends to an investor - get out of me - would not functionanymore. Entrepreneurs would start to waste the resources increasingly, investing

in the wrong projects. Thus, according to Rothbard, the upper boundary of the

firm's growth is a boundary of survival of independently existing markets for itsproduction factors. The full-blown socialism could be best described as one big

firm that swallowed an entire market in all goods and services, both final andintermediate ones.

The majority of authors who write in the Austrian tradition conceive the

firm along this Mises/Rotbard broadly set model: they assume the firm is a

4 The fact is that socialist countries could economically survive only because they compared

relative prices in the West and adopted them home. In the absence of information based on a

capitalist economy in the outside world, socialism would colapse within the few months, resulting

in mass famine, shortages and teror (just like it really happened each time when some pure sort of

socialism was launched in compete isolation from the capitalist world, such as Stalin's in somephases, Mao's china or Pol Pots' Cambodia). Nikita Khruschev himself should not have to read

Mises in order to understand that "if the whole world would became socialist, we still should leaveSwitzerland to be a capitalist state, to find out the structure of prices for a socialist world. In a

position similar to Khruchev's, a director of state enterprise would be caught in a situation that

would "swallow" markets for all production goods. He would be forced to demand the creation of

at least one additional firm to find his own transfer prices.

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Coasian central planning entity which operates in a broader market setting. They

emphasize the role of the entrepreneur or financial speculator, as opposed to a

manager within the firm, the role of uncertainty and risk-taking with physical

assets when it comes to entrepreneurship, and treat the firm as an instrument ofentrepreneurial judgment in a quest for profit opportunities (Foss and Klein, 2005,

Foss 1994, Langlois and Foss,1997, Klein 1996, Klein and Klein, 2001).However, I think this perspective is headed the wrong way.

3. Firm as a nexus of markets

This standard Austrian theory of the firm inspired by Mises's and Rothbard's

analyses, consists broadly speaking of three parts: a Coasean central planning

unit, an entrepreneur/speculator, and an independently existing market. Ourcontention is that the first part of the equation (the firm as the central planning

entity) should be completely removed, and replaced by the theory of the firm asa nexus of various markets.

First off, if we accept Mises's previously considered idea about the strong

distinction between an entrepreneur/speculator and mere manager or worker, we

have no basis for the concept of the ''firm'' as an entity that represents a unit of

analysis at all. Specifically, we are bound to reject Mises's own strong insistence(echoed by Klein and Foss and other orthodox Austrian theorists of the firm) that

an entrepreneur controls the factors of production' in the sense that he exerts the

authority and central planning control over those factors of production,including the workforce. If the key role belongs to the entrepreneur, and not to the

firm, it is then from a praxeological point of view much more appropriate to

analyze the ''firm's'' operation in terms of multiple contracts and the buying/sellingarrangements of the entrepreneur with the outside providers of services to him

(members of his firm), than in terms of the firm's commanding authority overits assets and its joint planning of activities within the outer market

framework. The emphasis on the firm seems to be a form of confusion

stemming form the imprecise and metaphorical use of language. We do not haveany straightforward explanation as to why we have to resort to the concept of the

firm as a central planning ''island'', in order to describe the voluntary

arrangements among the free individuals.

Secondly, the general concept of the firm as a central planning entityoperating in the environment characterized by the presence of free market prices

is even more problematic when we confront it with the basic Misesian paradigmof the economic calculation. Mises's iconic argument against socialism was that inthe absence of market prices, rational economic planning would not be possible at

all. Market prices are indispensable analytical and cognitive tools for

entrepreneurial speculation with privately owned capital, without which,

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according to Mises everything would be a leap in the dark (Mises, 1990, p.).

However, if this is so, how then can the very same absence of monetary price

coordination of economic plans within the firm suddenly become a virtue? If the

very possibility of rational economic planning critically depends upon thepresence of market prices, how then can the firm, understood as a central planning

and hierarchical island in the ocean of the market transactions, represent acontribution to the economic efficiency rather than an obstacle to it, or, for that

matter, to exist at all? By accepting the Coasiean notion of the firm as central

planning minimizer of the market transaction costs, the Austrians ironically

accepted the notion of central planning as a solution for the shortcomings of themarket.

This problem, a failure of the orthodox Austrian analysis of the firm to

even notice this blatant inconsistency between the general Misesian calculationargument and the Coasean theory of the firm, is painfully obvious when we read

both Rothbard and younger Austrian theorists of the firm. Rothbard generalizesthe Mises's calculation argument by pointing out that if a part of economicactivity guided by central planning grows at the expense of market based-

transactions via prices, the overall economic efficiency diminishes that way:

"islands of non-calculable chaos swell to the proportions of masses and

continents. As the area of incalculability increases, the degrees of irrationality,misallocation, loss, impoverishment, etc., become greater" (Rothbard, 2004).

Therefore, as more and more of the economic activity falls under the firm's central

planning mode of coordination, "incalculability chaos" increases. If we accept thisRothbard's argument, it would follow that every firm by its own existence

hampers to some extent the overall economic performance of the economy. What

this Rothbardian logic does imply is that the firm is basically a problem and ananomaly. The shrinkage of the area covered by market price coordination, which

is replaced by the central planning commands, diminishes ipso facto thepossibility of entrepreneurs to calculate the real opportunity costs of resources and

their capacity to know what efficient production and investment is. The optimal

industrial structure according to this perspective would be the one without anyfirms altogether (without those "islands of incalculability"), and with a multitude

of individual entrepreneurs that are buying and selling products on the open

market. However, this is plainly wrong most advanced economies have a

myriad of firms, and in some cases very large or even monopolistic firms are themost efficient ones at the same time. So, the conventional Rothbardian analysis of

calculation is a brilliant (although non-intentional) critique of the Austrian theoryof the firm he and many other theorists have accepted. Obviously, the only way toreconcile the Mises/Rothbard's theory of the essential role of the entrepreneur

with their theory of the diminishing efficiency of a market system in which the

area of price coordination shrinks and the island of central planning expands, is to

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assume that the firm is not a central planning entity at all. That means that

''within'' it, a multitude of buying and selling operations is constantly taking place,

i.e. that firm is a part of the market itself. Only if that is somehow the case, the

existence of the firm can be seen as a contribution to the economic efficiency anda problem solving tool, rather than the source of wasting resources and economic

miscoordination. We shall show that exactly this is the case, i.e. that the firm is a

nexus of markets and not a central planning entity. Which is to say that the

Misesian definition of an entrepreneur as a speculator in the capital market is too

narrow, and that should be substantially broadened to include not only speculation

in labor markets (buying services of the people instead of products of otherpeople) but also every use of a superior capability or knowledge to improve the

financial condition of an actor, "within" or "outside" the firm.

The first significant problem we have to deal with here is to try to answerthe question: when an entrepreneur organizes the production within the firm what

does he really do? Does he engage in central planning? To begin with, anentrepreneur is just one individual. Every individual according to Mises'spraxeological axioms pursues his own ends by cooperating with other individuals.

The market is not (only) transactions via prices, the market is primarily a second

name for the peaceful cooperation of individuals within the system of private

property rights (the market prices are just a consequence of the existence of theprivate property rights). Every individual has his own interests, his own vision of

how to improve his condition. When an entrepreneur organizes the firm he

pursues in that way his own self interests, and his employees do the same, as well.However, an entrepreneur does not "supersede" the market when he organizes the

firm: he just operates in different markets than when he buys inputs from other

"firms". In a standard Coasian setting, an entrepreneur must decide whether tobuy the product on the open market or to organize its production within the firm.

However, and this is the crucial point, when he decides to make a product withinthe firm he only decides to achieve the same goal using a different market

instead of using the market for final or intermediate products, he uses the market

for labor and managerial services and does not abandon market coordinationaltogether. By buying services of various groups of people (in the firm), an

entrepreneur speculates that it is going to be a more profitable course of action

than buying the final or intermediate product. As Mathews nicely said: "...the

firm's make-or-buy decision is not a decision about whether to manage or to useinput markets; it is a managerial decision about which input markets to use"

(Mathews, 1998, 44). Potential labor and managerial services, assembled in a firmare just some of the possible input markets for the entrepreneurial speculation ofan individual, while products bought from another firm is another one. In that

regard, as it has been emphasized, the difference between the market and the

firm is only in the type of contract in the first case it is a selling contract,

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while in the other it is a wage contract. A person-entrepreneur is buying a set of

services rather than a final product.5 Does that mean that he somehow operates

"outside" the market when doing this?

One thing that is obvious from the previous analysis (and from explicitstatements of Austrians led by Mises as well) is that the central role in economic

organization in Austrian economics does not belong to the "firm," but to theentrepreneur/individual (consistent with methodological individualism). Also,

whether the "firm" exists depends only upon an entrepreneur's decision regarding

which input market to use in the pursuit of profit market for goods or market for

services. The "firm" as a central planning island, and a key part of the theory ofindustrial organization developed the is clearly a praxeologically invalid concept.

The firm is a construct which refers to a certain number of people seeking their

self-interests via specific contractual arrangements. The analysis of the economicorganization must focus on an entrepreneur and the environment in which he

operates, and not only on the one specific market and one specific contractualform of market cooperation, called the "firm". An entrepreneur, on the basis ofexisting productive factors (being them capital, intermediate products, labor

services, knowledge...) speculates on what is the most profitable way of

improving his economic condition. The firm is only one usual specific case of

this endeavor, but by no means the only conceivable one.A fundamental weakness of the Misesian theory of the firm is confining

the entrepreneurial role to only financial speculation in the capital market. The

Misesian entrepreneur is a kind of Frankenstein-like creature he is a speculatorand investor who is guided by the price signal outside the firm. He is also a

central planner, almost a socialist commissar, within the firm. That way the scope

of entrepreneurship is very much narrowed, and ultimately reduced to thefinancial speculation. Mises makes a very strong distinction between the

entrepreneur and manager. "They (market socialists, IJ) fail to realize that the

operations of the corporate officers consist merely in the loyal execution of the

tasks entrusted to them by their bosses, the shareholders, and that in performingthe orders received they are forced to adjust themselves to the structure of the

market prices, ultimately determined by factors other than the various managerial

5 This kind of argument against distinguishing firms and markets should not be confused with

the arguments recently put forward by some neoclassical economists, according to which the new

technologies and the economy with a prevailing importance of outside sources of science and

knowledge make boundaries between the market and the firm somewhat more fuzzy, or flattenthe hierarchies within the firms (Cowen and Parker, 1997). On the contrary, our analysis does not

need this kind of redefinition, because it assumes that the basic distinction between markets andhierarchies is wrong and misleading to begin with, and that it does not apply even to the standard,

classical corporation. Our argument is not that the modern firm ceases to be so hierarchical as the

traditional corporation, but, following in the footsteps of Demsetz-Alchian and Jensen-Meckling's

early contributions that classical corporation was never hierarchical in the first place.

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operations." (Mises, 1949, 727) To underline even more strikingly the difference

between the inter-firm operations and market transactions Mises adds: "Those

who confuse entrepreneurship and management close their eyes to the economic

problem."(ibid 728). If the manager is only executing the tasks assigned to himby an entrepreneur / shareholder, then the firm itself is devoid of any kind of

entrepreneurship.Other Austrian authors offer a more sensible definition of entrepreneurship

that to a much higher degree can be reconciled with what we observe as

entrepreneurship in everyday life. Schumpeter considers entrepreneurship to be an

instrument of creative destruction by which capitalism permanently improvesthe technological and managerial ways of conducting business. Entrepreneurship

for him is a second name for the genuine creativity of the market process which

brings about the new and better products, managerial and technologicalinnovations, modes of branching or integration of capital, and so on.

Entrepreneurship is in the market, not in the firm, or solely between the marketand the firm (as in Mises's theory). It occurs at every level of economic life,although Schumpeter in the institutional sense most often identifies the

entrepreneur with an independent contractor (Klein and Foss, 2005). Unlike

Mises, who by and large, identifies the capitalist and the entrepreneur,

Schumpeter sharply, sometimes maybe too sharply, distinguishes between them,asserting that every entrepreneur when he creates a firm, ceases to be an

entrepreneur. Although this is probably an exaggerated formulation, it bears

significant elements of truth entrepreneurship cannot be identified with thespeculation with one's own capital.

Similarly, Kirzner in his Hayekian theory of competitive process as a

discovery procedure, dramatically widens the scope of entrepreneurship, over andabove what the canonical Misesian definition assumes. According to Kirzner, the

defining feature of an entrepreneur is his alertness to profit opportunities missedby others (Kirzner, 1973). An entrepreneur is a person accidentally possessing

specific useful knowledge and knowing how to use that specific information in

order to reap a profit. Like Schumpeter, although in different theoretical language,Kirzner develops the theory that leaves no room for any privileged systematic link

between the entrepreneur and the firm. Entrepreneurship is a widespread mode of

economic behavior we can find in many different market settings, both within and

outside the firm.6 So, the economic, monetary entrepreneurship as a risk-taking

6 This is not to deny the merits of standard critique of the Kirznerian concept of entrepreneurship

by the Austrians such as Rothbard and Salerno, according to which Kirzner completely abolishedany systematic link between the physical capital and the entrepreneurship. But, when the Austrians

of the main current got it wrong in criticizing Kirzner is in emphasizing that entrepreneurship

necessarily must mean the ownership over the capital per definitionem; i.e. that the entrepreneurial

function must necessarily and always be performed by an owner of the physical asset, and never

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activity in conditions of uncertainty is a universal praxeological fact.

Entrepreneurship emerges because some individuals have information that is not

possessed by others. If person X buys a car not in A's shop but in B's shop, where

it is cheaper, it is because X knows that B sells cars at a certain price that happensto be lower than A's prices. However, a certain other individual, named Y, may be

completely ignorant about this, therefore buying in A's shop. We may describe thefeature of his behavior that has to do with the use of certain information present in

his "domain", as entrepreneurship. If he opens a factory, or invests in a company,

or manages a firm, the same principle is at work his behavior is also

entrepreneurial in the economic, i.e. financial sense. Person X in both cases hasmade a monetary gain (profit) on the basis of the superior use of a specific

knowledge of time and place (Hayek).7 It is not immediately apparent on what

basis we can exclude the first type of using or economizing scarce informationfrom the domain of entrepreneurship. Just like in the case of isolated individuals,

we can speak about the entrepreneurial behavior at many levels within the firm.Every person X having better information on, or knowledge of the specifics of hismanagerial or working or buying/selling situation, can perform better than person

Y lacking that knowledge, and thus provide higher monetary value added to the

firm and to himself.

It may be true that "market socialists" completely ignored the financialspeculation in the capital market as one of the crucial roles of entrepreneurship.

However, it also may be true that Mises himself made the completely opposite

mistake he removed entrepreneurship completely, not only from the firm, butalso from non-financial markets as well. A manager is, according to him, a mere

robotic machine carrying out the orders and plans of an entrepreneur, regardless

of the question of his capacity to do his job. Workers are also, by and large, therobots carrying out someone else's plans; in the same way the neoclassical theory

adopted by market socialists described the behaviour of the economic actors ingeneral. Different units of a firm are subjected to the central planning authority of

their center, carrying out the orders that are given to them, without any autonomy

or initiative. The only difference between Mises's description of the firm and thedescription of the firm given by market socialists, is that he adds, over and above

that central planning mechanistic entity a capital market with prices and the

vigorous financial speculator as some kind of liaison officerbetween the market

by the person entrusted by the owner to use it (ie. CEO).7

I used over this convenient example of buying a car from the internet site of the AustrianEconomics ForumThe usual example of an entrepreneur who is not risking real physical capital is a speculative

short-seller or arbitrageur on the stock market, but I thought it was much more interesting to

assign the entrepreneurial character to an "ordinary" behavior that has financial concequences as

well.

(http://www.austrianforum.com/index.php?showtopic=577&hl=Foss,and,Klein ).

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and the firm/socialist island. The entrepreneur is somehow inserted from

outside the firm provides an informational basis for decision-making within that

socialist island.

One additional way of seeing why this rigid Misesian concept ofentrepreneurship as a speculation in the capital markets is not a useful concept, is

to consider the modern corporation. Who is the entrepreneur, and who is "just amanager" in the modern corporation? Many of those essential activities of

entrepreneurs to "establish corporations and other firms, enlarge or reduce their

size, dissolve them or merge them with other enterprises; (to) buy and sell the

shares and bonds of already existing and of new corporations; grant, withdraw,and recover credits;"(Mises)are essentially in the modern corporation carried out

by the people whom Mises and his followers basically would describe as

managers people hired by the shareholders and capitalists to manage the firm.They make the decisions about the new emissions of stocks, about borrowing and

lending, about business strategies, about takeover bids, and about the whole rangeof the crucial entrepreneurial issues, with shareholders playing clearly a side rolein the whole process. From the orthodox Austrian perspective, this is complete

nonsense how can mere managers act as entrepreneurs? However, according to

nexus-of-contracts and nexus-of-markets theories, this development is quite

possible. Since the firm is just a fictional set of contracts among individuals, thereis nothing especially intriguing or scandalous in the fact that this nexus of

contracts can evolve in such a way to allow for different organization of

entrepreneurial speculation in capital markets. It is exactly the fact that acorporation is a nexus-of-markets that allows and requires such a redistribution of

roles between the owners and managers. Managers can successfully operate

with the firm's capital, dissolve and merge the firms, buy and sell shares,recover credits and all the rest, because they are in a wide network of different

markets that evaluate their services. Managers are exposed every day to thedisciplining force of the capital markets that value the quality of their investment

decisions by share price indicators; then they are exposed to the market for

corporate control (to the threats of hostile takeovers if they do not perform well)(Bittlingamyer, 1999), then to the market for managers both within and outside

the firm (Fama and Jensen, 1983) and so on. Without understanding the nexus-of-

markets nature of the corporation, we cannot satisfactorily account for the very

fact of its existence and survival, in spite of the complete separation between theownership and managing functions within it. Most of the modern corporations are

limited liability entities, which means that shareholders are responsible for thefirm's debt and obligations only to the extent of the dividends and other sources ofincome they received. If Klein (2010) is right when stating that the entrepreneur

is nearly always also a capitalist and the capitalist is also an entrepreneur, then

corporation must be an awfully inefficient form of business organization, since it

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produces a very strong moral hazard, by allowing to shareholders to reap the full

fruits of corporation's profitable activity while avoiding to bear the full cost of its

failure (socialization of costs). A capitalist-owner-entrepreneur with the

limited liability for his own business decisions is there anything morecontradictory to the Misesian notion of an entrepreneur? Still, the corporate form

of the firm is dominating today's business world. Does that mean that the financialand product markets are so inefficient that they bolster an inferior form of

business organization (corporation), while suppressing the superior forms

private firms and proprietorships, with their unlimited liability of an owner?

Obviously not. The corporations out-competed to a large extent the private firmsin the open market. The prevalence of the corporations in today's economic life is

not a sign of a market failure (as one would be tempted to think on the basis of the

Misesian theory of the entrepreneurship), but the clear sign that the Misesiantheory of entrepreneurship is flawed, or at least incomplete. Once we drop a too

restrictive assumption that capitalist=owner=entrepreneur, the paradox ofcorporation entirely disappears. CEO can become an entrepreneur, in spite of notowning the single share of the corporation.

Moreover, its even possible to hypothesize that the corporation is so

efficient a form of business organization compared with all the alternatives

because it encompasses so many different markets that intersect each other, or inour language, because the corporation is an extraordinarily complex and rich

nexus of various markets. In no other form of business organization do we have

so many price signals coordinating the activity of so many people who work insome kind of team. So, far from being a hierarchical island of central planning in

the sea of market coordination, the firm is actually an extraordinarily rich focal

point of so many markets, and of hundreds of different prices.This brings us back to the initial problem of entrepreneurship and the

nature of the firm in the Austrian economics. A standard Austrian explanation ofwhy the firm as a centrally planned entity can function is that entrepreneurs, via

profit and loss, obtain the necessary information about the relative efficiency of

their business decisions. It is not necessary for a market to exist within the firm aslong as it exists outside it (Rothbard, 2004; Klein, 1996). However, although an

outside market can provide a firm with the information as to whether it makes or

loses money, such a market, perceived as being outside the firm, cannot help the

entrepreneur to discover thesource of relative inefficiency within the firm, and tohelp himto improve its performance. He must have some kind of price signal for

most of the factor inputs he uses within the firm, in order to be able to knowwhich of those factors contributed to the overall under-performance of theenterprise. And in order to have the prices for factors, the market (actually,

myriad of markets) must permeate the firm. There is no other way to objectively

assess the reasons for business failure except to have an internal factor market; as

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we have seen, if the firm was to be conceived as a centrally planned entity, it

would have no reason to exist whatsoever, from the Austrian perspective at least.

From that perspective, the firm's existence would only create problems in

economic calculation, or in Rothbard's jargon, it would represent an island ofincalculability inside the market. In some way, this has been clearly recognized

even by the neoclassical theorists: Errors are bound to be less frequent when

price information guides every activity performed, says Stephen Cheung

(Cheung, 1983), referring to the firm. So, only insofar as the firm is able to use or

create the price mechanism in its internal operation we can speak about the firm's

efficiency or its ability to evolve or improve its performance. In other words,the firm can be a problem-solving tool, only insofar as it is NOT a centrally

planned or commanding entity. For example, in the Alchian/Demsetzs model,

the firm arises as a tool of minimizing the shirking within the team production.However, the real problem here is the existence of the positive cost of discovery

of the relevant market prices of individual contributions within the team, and notthe different, allegedly non-market nature of inter-firm relationships. The costs ofdiscovering individual contributions within the team are not different

praxeologically at all from transaction costs as the costs of discovering the

market prices, pertaining to enforcement and monitoring of the observance of

ordinary contracts among the market participants in the conventional Coasiananalysis. In both cases, the owner of a productive input makes a contract with

other market participant (Cheung, 1983) and is equally bound to solve the same

kind of problems of discovering the best prices and enforcing the contracts. Theonly difference between those two cases (firm and market) is an irrelevant

one inputs used in the first case are different from those used in the second

case. However, the costs of discovering the price of individual contributionswithin the team work or of enforcing and monitoring the wage contracts are

praxeologically indistinguishable from the conventional Coasean transaction costson the market.

8Both settings include the same concerns of the cost of

information, of making and maintaining contracts, insufficient and limited

knowledge and so on. Problems of information costs, monitoring contracts, andstructural uncertainty are with us, within the firm or outside it. Prices guide the

operations of management within the firm, just as they guide the operations of an

8 One of the Austrian authors who clearly understands this is Pascal Salin. He observes that theillusion of a firm as a hierarchy which is fundamentally different from the market, stems from

asymmetry in monitoring costs between managers and workers: Thus, the manager spends farmore time ensuring compliance of the workers than the workers spend ensuring compliance of the

manager. This differentiation of roles and monitoring tasks gives the impression that there is ahierarchy. Again, let us be clear, the manager is not a commander-in-chief of an army of workers.

A well-functioning capitalist firm incorporates monitoring procedures, but no hierarchicalrelations. It could even be said that the capitalist firm has been invented because it is not a

hierarchical system. (Salin, 2002, p.9)

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entrepreneur when he makes a contract on the open market. So the Coasian and

Austro-Coasian limiting of the scope of those problems to the firm is without a

basis. It is equally wrong to assert that from the fact that it is hard to determine the

price of individual contributions within the teamwork it follows that inter-firmcooperation is not guided by the prices at all, as well as to say that the presence of

positive transaction costs on the open market entails that cooperation on the openmarket is not guided by prices whatsoever. There are costs of discovering the

relevant market prices within the firm and outside it. The only difference is in the

type of goods and services the prices of which we need to discover.

4. Firms, cartels and vertical integration

In this section we shall try to further elucidate why not only in the neoclassical,but also in the Austrian setting, there is no way to provide any meaningful and

non-tautological definition of the firm. This will be shown by analyzing cartelsand vertical integrations.

Nicolai Foss (2001), relying upon the Mises's contribution, objects to

those who try to understand the firm in categories of market analysis: "In his

critique of market socialism Mises (1949) pointed to the folly of "playing

markets" and I draw on his overall argument that bringing coordination

mechanisms characteristic of market organization into a planned organization isinherently problematic." So, according to Foss, any attempt to question a standard

Coasean notion of the firm as a commanding hierarchy with the clear outsideboundaries toward the market means just repeating mistakes of the market

socialists who wanted to play the market.

However, Mises himself also "played the market" in the same way, tobegin with. In the following passage he explains, contrary to his general theory

about the strong difference between the entrepreneur and the manger/firm, thatmarket very well exists also within the firm: "Operation of the market does not

stop at the doors of big concern...It permeates all its departments andbranches...It joins together utmost centralization of the whole concern with

almost complete autonomy of the parts, it brings into full agreement responsibility

of the central management with a high degree of interest and incentive of thesubordinated managers" (Mises, 1945, p. 47). So, an almost complete autonomy

of the parts of the "firm" exists, the market "permeates" all branches and divisionsof the firm, and combines centralization with the highest degree of competition.

The profit centers within the firm not only have a substantial autonomy inconducting business, but their profitability is independently evaluated on themarket via the transfer prices (Rothbard, ibid).

This description of the firm is similar to some descriptions of the cartel we

are accustomed to; firms in cartels unite competition and cooperation, price

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transactions and joint coordination of business. They cooperate in one area, e. g.,

through price-fixing or quality standardization, while competing in the other, e. g.,

services (Salin, 1991, Richardson, 1986) providing that way a productive service

to the society, that needs a combination of homogenization and differentiation ofproducts. Moreover, strictly speaking, we have no praxeological way of

distinguishing between the highly sophisticated and decentralized Misesian bigfirms or "concerns" and classical "cartels". What do a firm's independent profit

centers do that independent firms within cartels do not? Both "join together

utmost centralization of the whole concern with almost complete autonomy of the

parts". Praxeologically, the firm and the cartel are very hard to distinguish. PascalSalin points out that the most productive way of describing the cartel is that it is a

firm, which is in the process of splitting into separate profit centers, with different

owners.Instead of viewingthe cartel as a set of firms which are about to merge, itmay be both more realistic and more efficient to consider it as the ultimate stage

at which a big firm has been decentralized into various decision centers and,ultimately, split into independent profit centers with different owners." (Salin,1991, 46). Therefore, the question of where to set the boundary between the firm

and the cartel is quite an artificial issue without the theoretical ramifications

whatsoever, and probably has much more to do with the tax laws and government

regulations rather than with some a priori theoretical considerations. Therefore,the horizontal integration and disintegration function in the way that effectively

abolishes praxeological differences between the firm and the cartel.

However, the problem is even more far-reaching than that, and it can beobserved in vertical integration as well. Steven Cheung shows that many

contractual arrangements can be seen both as a "firm" and as a "market",

depending only upon how tax authorities and laws define some particulareconomic activity. He cites two very interesting examples. The first one is where

the owner of an apple orchard contracts with a beekeeper, to pollinate his fruits.The question that Cheung posed to Coase was do we have here one or two

firms? According to Cheung, this contractual arrangement at the same time could

be a hive-rental contract, a wage contract, contract sharing of the apple yield, or acombination of these. Economics cannot help us decide. Or even better, consider

the second of Cheung's examples, which even more casts doubt on the thesis that

the firm can be separated from the market, and conceived as a commanding entity.

The price signal in this example is transmitted from the "market" via severalintermediate steps toward the final consumer in a way that strongly resembles the

firm's operation, but at the end of the day we cannot be sure whether the wholeenterprise is a firm or not. A landlord wants to build a house; he makes a contractwith a building contractor. The contractor subcontracts with a hardwood floor

contractor for that part of the job, on the basis of the price per square foot. This

subcontractor imports wood material and makes a sub-subcontract with a vendor

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for a price per square foot. Finally, the sub-subcontractor employs workers to

provide wood for a wage (Cheung, 1983). The question is how many firms do

we have in this case one, two, three or four? Cheung notices that e.g. Hong

Kong laws consider every party to be responsible for paying taxes, and hence asseparate "firms", but economic analysis also shows that all four stages are

vertically integrated via transfer prices, and thus fulfill all the necessaryconditions to be treated as the parts of a single firm. The only way to decide how

many firms we have here is to draw the line somewhere arbitrarily, using the

regulation or tax laws as the benchmark. "The truth is that according to one's view

a "firm" may be as small as a contractual relationship between two input owners,or, if the chain of contracts is allowed to spread, as big as whole economy".

(Cheung, 1983)

A different way of emphasizing the same point is to say that both thefirm and the market are always combinations of competition through prices

and cooperation, or, as Cheung puts it delegations of right to use andtransmission of prices informationare matters of degree (emphasis added). So,price coordination of economic activity, or Misesian entrepreneurship, very well

exists "within" the "firm", as well as coordination by delegating the right to use

exist "outside" it (in cartels for example, but also in joint ventures, franchising

contracts and so on). It does not make much sense to try and explain what the firmis and what its boundaries are, by referring to the "non-market" forms of

coordination as its distinctive feature. The difference between the firm and the

market is the difference in some details of contracts, not in the type of relationshipbetween the individuals.

9As Demsetz pointed out, we have no way of sharply

distinguishing between an open market purchase and internal managerial decision,

because a firm that buys the factors on the open market from other firms also paysthe managerial costs of these other firms; on the other hand, a firm that produces

something in-house out of inputs bought on the market also buys the transactioncosts of those other firms (Demsetz, 1988;145) . Using the Austrian arguments

Mathews echoes the Demsetzs analysis of the problem. It is, according to him,

pointless to draw a precise distinction between managing and buying: Buying an

input involves a whole series of decisions that amounts to managing; making an

input requires the firm to use the market for managers. In other words, the firmsmake-or-buy decision is not a decision about whether to manage or use input

markets; it is a managerial decision about which input market to use (Mathews,1998, 43). As an illustration, let's imagine an entrepreneur who buys the

components for a machine on the open market, assembles them and then sells thefinal product (the machine) on the market again. What is going to change if he

9 For this, see Cowen and Parker, e.g. "Rather than difference between the firm and the market as a

resource allocator involves what might be more usefully viewed as subtle difference relating to the

form of contracting" (Cowen and Parker 1997, p.15)

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decides, instead of buying the components, to hire five people (create a firm) to

produce the same components out of raw materials bought on the market?

Would his enterprise of producing and selling this machine suddenly become a

non-market in nature? In what sense buying the physical product from otherpeople is a market transaction, while buying the services of other people is

engaging in central planning or exerting the commanding authority?Mises and Rothbard, as well as their followers in Austrian orthodox theory

of the firm were contradictory in explaining the basic relationship between the

firm and the market; on the one hand, all of them use or implicitly assume the

Coasean notion of a firm as a planned island (island of incalculability) in thecompetitive sea, and occasionally even ridicule the attempts to play the market

within the firm. However, at the same time, starting with Mises and Rothbard

themselves, they often emphasize the importance of transfer prices incoordinating the inter-firm operations. All of them, again led by Mises and

Rothbard, believe that it is essential for the firm that transfer prices are based onthe real market prices. In other words, they themselves are playing the marketwithin the firm. Even more strikingly, Mises emphasizes that ...whatever people

do in the market economy, is the execution of their own plans. In this sense everyhuman action means planning. What those calling themselves planners advocate

is not the substitution of planned action for letting things go. It is the substitutionof the planner's own plan for the plans of his fellow-men. (Mises, 1981). In what

sense then the entrepreneur as a leader of the firm is planning, while the worker

or manager are not planning? If the individual planning on the basis of marketprices is a universal praxeological fact (as Mises seems to suggest in the quoted

passage), how then the same individual planning on the basis of market prices can

be a differentia specifica of an entrepreneur's activity exclusively?To conclude, even within the Austrian camp it is not clear what the firm is;

when trying to emphasize the role of entrepreneurs, the Austrians derogate thefirm to a centrally planned puppet of the money-market speculator. However,

when explaining the calculation problems of socialism they point to transfer

prices and othermarketmechanisms as part and parcel of every successful firmand sharply contrast the individual and collective or central planning, which

(contrast) undercuts the basis for the theory of the firm as a central planned entity.

In the prevailing Austrian theoretical experience, just like in the neoclassical

Coasean one, a firm is in praxeological sense indistinguishable from a cartel,joint venture, franchising business or any other set of contracts which in some

way combinepricecompetition and delegation of rights to use an asset.Our conclusion from the previous analysis is that the firm should be seen

in the Austrian context as a specific contractual arrangement between the

entrepreneur and the outside economic environment, or entrepreneurial

speculation in various input markets, not as some kind of central-planning

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instrument of the entrepreneur. All people are owners of some productive factor,

capital, land or at least their labor. They seek to contract with other people in

order to improve their economic condition. If we would like to speak in terms of

planning instrumentalization, we could equally say that an entrepreneur is aplanning instrument of a worker, as well that a worker is an entrepreneur's

instrument. As we already emphasized, when market arrangements take the shapeof labor contracts, i.e. when an entrepreneur decides that his most profitable

course of action is to speculate in the labor market, i.e. to employ labor inputs or

services instead of making a contract for a final product, we often speak about the

firm. However, often we do not know exactly how to distinguish between firmand non-firm contracting in labor and services markets. As Steven Cheung says:

"...it is futile to press the issue what is or what is not a firm. If each individual is

private input owner of his own labor, if nothing else then almost allindividuals in the society are bound by contracts when they compete and interact"

(Cheung, 1983, 18).The most fundamental thing in this connection is that an entrepreneurhas

the price signals, irrespective of whether he speculates by hiring labor or by

buying an intermediate product on the market. He is always in some market. A

firm is efficient to the extent it allows to the entrepreneur to speculate based on

the market prices of inputs. Rothbard's warning that the widening of the area ofeconomy coordinated by central planning brings about the increased costs of

coordination is quite appropriate, and it is clear that the firm cannot be viewed as

a centrally planned entity exactly for that reason. If it were a central planning unit,then it wouldn't have any reason to exist. It is impossible to reconcile the idea that

central planning diminishes the economic efficiency (and that the firm is a

centrally planned entity in the same time), with the basic assumption that the firmis a problem-solving tool of the market, which exists to satisfy the real demands

of the market economy. The "firm" cannot be the problem and the solution at thesame time.

Conclusion

Both the classical Coasean theory of the firm and a Misesian update with

entrepreneurship as an appendix to the centrally planned firm are wrong. There is

no island of central planning, surrounded by a sea of market transactions; there isonly a multitude of contractual arrangements. The three part Austrian theory of

the firm (firm, market and the entrepreneur as a connection between the two)developed as a synthesis of Coase's, Mises's and Rothbard's contributions shouldbe in my view abandoned and replaced by a program of integrating the

contractual tradition (Demsetz, Alchian, Jensen/Meckling, Cheung) with the

Misesian praxeology. In this endeavor, the theory of economic organization

24



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should have two basic pillars, entrepreneurship and contract arrangements through

a wide range of different markets (capital, managerial, labor, inputs...). A firm is a

nexus of those markets, legal fiction for various types of contracts of free

individuals seeking to improve their economic condition.

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