Introduction:
Why would a group of people coming together under the legal and commercial umbrella of a fictitious entity called the firm, achieve more towards the fulfillment of a certain need in society than individuals operating alone? Why has the acquisition of wealth been historically associated with Firms of various types?
The public would answer “Because I don’t want/can’t do that by myself” OR “I have other things to do”. But what they are really saying is that “I don’t have the ability or resources to do that effectively, and would probably pay somebody else to do it for me”.
Society began when humans acknowledged that they cannot live alone and still fulfill their basic needs (food, shelter, cloths etc) effectively. Communities began to emerge and a predisposition to basic division of labour lead to the emergence of craftsmen operating from their houses and later on from what was known as a market.
Perhaps not scientifically, but practically, society identified that it would be be cheaper for everyone to be geographically near each other and how proximity made the transacting better.
The very foundation of the market was to achieve better transaction economics, better coordination, better proximity to customers and better relationships with partner craftsmen. Coordination of economic activities became the hallmark of a successful firm.
Initially the firm was a one man firm, where the craftsman was manager, production supervisor, laborer and shareholder. This type of firm had excellent in-firm coordination where there were no problems associated with making decisions that could delay allocating resources towards achieving the firm's goals. This one man firm was limited by various factors such as production capacity, size of market and an information supply chain that was limited. In its initial setup, the one man firm only served to fulfill the day to day needs of putting food on the table of the craftsman.
As the hierarchy of needs of craftsman shifted more towards acquiring wealth than providing sustenance, the one man model of the firm ceased to be viable as more growth was needed to produce more goods and acquire more wealth. In other words, the one man firm began to discover it’s own boundaries and set about expanding them.
The first contract was probably drafted at this stage “perhaps verbally” in some form between craftsmen to join forces to produce more, barter, exchange and sell more to acquire wealth.
What incentivizes the creation and growth of a firm:
Adam Smith in the Wealth of Nations published in 1776 said “It is not from the benevolence of the Butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.” This regard to self interest, prompts the one man firm to provide at a profit to society something that it needs.
Why then has the one man firm evolved to become an entity that in some cases spans continents, employs thousands of people and in some cases generates more revenue than the GDP of various third world nations?
The firm, in it’s quest to accumulate wealth, began to slowly discover the vertical boundaries of it's existence and in the process what we now refer to as “transaction cost economics”. This understanding of growth inhibitors that prevents the firm from acquiring more wealth coupled with the firm's own self interest lead to the gradual decision to expand the boundaries of the firm by finding creative solutions to barriers to growth.
Powered by this understanding, a firm began to make rational decisions about what profit making activities it engages in, how to expand the scope of these activities using economies of scale and scope, utilizing division of labour at the strategic and non-strategic levels.
Once the understanding of transaction cost economics was in place, the firm engaged in a meticulous efforts to self-regulate and self-improve by monitoring and continuously improving transactions, thereby leading to a reduction in transaction times and costs and consequently more profits.
Decisions like “should I buy in bulk and store or buy on demand” began to be more important to the firm's survival. Decisions to make goods in house or use pre-existing components in the marketplace also began to shape. Suitable partnerships began to emerge around trust and mutual benefit and later on by contractual arrangements.
All this knowledge about transaction cost economics was acquired via experience, trial and error and sometime by the brilliance of entrepreneurs who engaged in the creative destruction of existing business models and replacing them with new more profitable ones.
Profit as the only goal of the firm:
The formula for wealth acquisition is simple, produce cheaply a product/service that is needed by society, sell that product/service dearly. If possible, do that as many times as you can, but never to the point where you generate negative feelings of mistrust in a society where you have competitors, and never to the point where production of more goods leads to reduction in profits.
In it’s quest to expand it’s boundaries, the firm began to identify all activities around it’s profit making processes that need improvement, the following section explains these boundaries.
The boundaries of the firm, re-explained:
Firms exist in a world bounded by laws, hence the firm itself is bounded by laws, most important of which is the law of supply and demand. A firm must identify “or create” a demand in society and then fulfill it by supplying a product/service that fulfills that need. Generally speaking, scaristy of Supply leads to a perceived increase in demand and hence potentially an increase in Price. Conversely, an increase in demand could lead to a perception of shortage of supply in the market leading again to an increase in price.
As the firm produces goods, it incurs costs associated with producing these goods, we identify Total Cost as the cost of producing X goods multiplied by the cost of producing one unit.
Ctotal=Cunit*X, where X is the number of good produced.
A firm will then sell these good at price P, generating a revenue of R.
Rtotal=Punit*X, where X is the number of goods produced.
A firm’s generation of wealth or profit is then expressed as:
P=Rtotal-Ctotal;
As the firm identifies that it can generate more profits by producing more and selling more it encounters many boundaries, some of which are:
Production boundaries: The limit of the firm’s production capacity, effectively putting a cap on units produced at (Xmax). These production boundaries can only be overcome by increasing production capacity or changing the production process altogether. Furthermore, the cost of producing one unit may not be linear and may increase or decrease depending on the item produced. This variation in cost of production leads to the formation of the term marginal cost, or the cost of producing one more unit of the product.
Price Sensitivity boundaries: A firm notices a demand for a product, identifies a gap in the supply and fills it by charging a price for it’s in demand products. So long as there is a gap between demand and supply, the firm can set the price at the maximum point that the market will bear. As supply increases, the gap between supply and demand decreases and the market becomes more sensitive to the price and exercises the option to reduce demand for the product “by stopping to use it or switching to another product”. This forces the firm to reduce prices in an attempt to return demand to it’s previous state.
Rational Boundaries: Understanding the market can only be achieved by having information about the market being served. Information was relayed by first hand experience or a network of connections that was limited by geographical constraints. As information started to flow more freely due to the advances in the infrastructure, bounded rationality began to decrease. It must be noted that bounded rationality will never reach a perfect state of complete rationality. It is because of this fact, that all economic decision are almost always only accurate under certain condition. And hence there will always be economic risk
If Rationalitybounded=RationalityComplete Then Riskeconomic=0
Supply Boundaries: To produce a product or provide a service, components or materials are needed and in most cases, these materials are provided by other firms also in the business of fulfilling a need while making a profit. The firm must commerce with them in one of two ways:
1-To directly compete with these firms by getting into their business (This is known as Vertical Integration). A firm may acquire or grow to become a provider of a certain component in the vertical chain. This is refereed to as a “Make Decision”
2-To contract these firms to provide the goods needed in what is refereed to as a “Buy Decision”.
Contractual boundaries: The firm is often rightly referred to as a nexus of contracts, bounded by the ability to draft and execute the fulfillment of contracts pertaining to the delivery of it’s products. Contractual boundaries have traditionally prevented firms from growing properly until society reached a stage where legal frameworks existed to protect firms through what we know as “Contract Law”
Governance Boundaries: Firms typically grow organically at a very linear pace or by step-wise pace of “merging/acquiring” other firms at discrete points in time. Both types of growth can happen at the same time. Growth, however needs funds to fuel it and these funds irrespective of where they come from, are not provided without precondition. Therefore funding growth typically presented firms with various governance issues which lead to many observed types of management, namely: The Satificing model, The profit Maximizing Model and the Share holder value balanced with growth model.
The Satisfycing model proposed by Simon stated that firm’s management may sometimes prefer to achieve a certain level of satisfactory performance in a certain parameter such as sales. This is observed in firms that have just entered a market, the first priority of such firms is survival. Firms in this embryonic stage seek to gain market share without upsetting the incumbent player in the market. Therefore it plays “perhaps Subconsciously” a game embedded strategy of providing the goods at a price that ensures growth, but not to a degree that would signal to the incumbent firm that they are at risk from the new entrant firm. This game embedded strategy if implemented properly can assure the new firm of survival without forcing the competitors to price them out of the market.
Management for profit maximization can be seen in firms that have gone beyond the point of merely surviving in the market. They are no longer satisfied with survival and may seek to profit maximize. This Baomol Model proposed in 1967 proposes that maintaining growth can be done if a company chooses to maximize profits; “Although reducing costs is an option”; by expanding the sales footprint of a product that provides a decent but not spectacular profit margin, firms can hope to gain more market share and leverage brand recognition in the market and economies of scope and scale if possible.
The Marris management model spurred by governance issues related to funding growth and the preconditions attached to it, was proposed by Simon. His model applies to publicly traded companies where shareholders typically have an interest in seeing dividends from investments they made in the firm towards the firm's growth. Management in such firms have two goals that are not mutually exclusive. The Marriss model tries to balance growth by mergers & acquisitions to achieve growth with paying dividends. A compromise that achieves both goals: Growth and Share holder value.
Coordination, the firm’s ability to respond effectively to market conditions:
As the firm seeks to achieve it's goals, it needs to understand it's vertical boundaries, understand it’s market, work within or expand its vertical boundaries in order to achieve growth that leads to profit making. This effort requires coordination. Firms typically coordinate at the management level where supposedly information about all the boundaries exist. These coordination decisions are best seen in the Make/Buy scenarios that every firm has to make in it's quest for growth, profit maximization and wealth generation and accumulation.
