The firm, money, and economic calculation: considering the institutional nexus of market production - Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 2: Trust and Money

American Journal of Economics and Sociology, The, Oct, 1998 by Peter Lewin

I

Introduction: Firms and Calculation

Recent discussions on the rationale and nature of the firm (drawing on the pioneering work of Coase (1937) and sometimes called the New Institutionalist Economics) suggest that firms derive their rationale from the fact that the organization of production matters for its results.(1) By the same token, as the economy changes, and the production structure changes along with it, the advantages of different types of organization also changes (see for example Langlois & Robertson, 1995; Williamson & Winter 1991). Still, with all the far-reaching economic changes that have occurred, the firm as a category (the modern business corporation) has remained a dominant form of economic organization. It is an institution that is unique to a market, that is, capitalist, economy. In an important way the market economy owes its success to the business firm.

In his discussion on the feasibility of central planning under state Socialism, Ludwig von Mises pointed to the ability of private owners (investors) to calculate profitability as being the indispensable ingredient of a decentralized system, the absence of which accounted for the inevitable failure of a centrally planned one (von Mises, 1920, 1966, 1981).(2) This was part of the famous Socialist Calculation debate (Hayek, 1935a, Hoff, 1981, Lavoie, 1985a, Ramsey-Steele 1992), which has recently showed signs of resurfacing (Horwitz, 1996, Ramsey-Steele, 1992). According to von Mises, in a centrally planned economy (in which the means of production are collectively owned) the planners lack any basis on which to price the means of production. Without private ownership, alternative outputs would not have prices, nor would the inputs required to produce them. Without this the value of alternative uses would not be discernible. The scope of the debate was considerably broadened by Hayek (in the 1930s) in his consideration of what information would be necessary for calculation of prospective profits by private owners, and the observation that much of this information was not available to be collected, but emerged from the market process itself. Abolishing private ownership abolished the source of this crucial information, much of it reflected in prices, necessary for basic economic calculation (Hayek, 1935, 210-11).

Horwitz (1996) recently pointed to the connection between these insights and the role of money. In a market economy the existence of money, together with the institution of private property, facilitate the emergence of money prices which form the basis of the necessary economic calculation that drives the market process. In light of the discussion about business organizations, how does the firm, a dominant market institution, fit in with this?

According to the modern theories of the firm, the advantages of corporate organization derive from incentive, control, and information issues. By combining resources within the orbit of a single firm, it is sometimes possible to reduce the costs of monitoring and controlling production teams. This helps avoid the need to monitor and enforce the fulfillment of specific arms-length contracts between independent parties, acquiring knowledge about team member contributions and capabilities as they exist and change over time. Instead, the firm provides the necessary relative predictability and stability of long-term, open-ended contractual obligations with employees.(3) The boundaries of the firm are balanced dynamically and experimentally by these advantages weighed against using specialists from the market. Juxtaposing this line of thinking with the von Mises/Hayek rejection of the feasibility of socialist planning and production raises interesting questions:

1. On the one hand, if socialism is indeed irrational, in the sense of precluding the ability to perform the necessary calculations, how is it that the firm is not similarly encumbered? After all, is not a state socialist system simply one large firm? And are firms not islands of socialism in a market sea? If so, how does calculation proceed inside the firm?

2. On the other hand, if the market is necessary because it provides prices for productive calculation, why are firms necessary at all? Why not simply conduct all transactions through market spot and forward contracts?

We have already answered the second question. The answer given in the New Institutionalist Economics is that there are costs to using the market that are avoided by using the institution of the corporate firm. These transaction costs are related ultimately to the presence of certain types of irreducible uncertainty. The answer often given to question one is more interesting. It is a nonsequitur to conclude that if state socialism is impossible then anything resembling central planning, such as a firm, should also be impossible. In fact, they are not the same things. Planning within firms proceeds against the necessary backdrop of the market. Planning within firms can occur precisely because the market furnishes it with the necessary prices for the factor inputs that would be absent in a full-blown state ownership situation.(4)