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What are we looking at

“One side of what? The other side of what?” thought Alice to herself.

It is a good question that needs to be answered before we can proceed, because often we investigate and analyze and change and improve and mess up without ever asking ourselves: what is that thing that we are looking at?

Most of us — and I include myself in this, at least a former me — carry around a picture of business organizations as machines — inputs in, outputs out, run by whoever holds the controls. That picture is logically, historically and legally wrong. And it’s worth a little of our time to look at this more closely, because what it gets wrong shapes everything else we do.

And where better to start than with Ronald H. Coase and his 1937 paper “The Nature of the Firm.” Now this is hardcore economics, but we’ll get other points of view later. For Coase the definition of a firm — as he calls it — is given by the reason it is formed. Using any kind of resources — labour, capital, knowledge, steel, microchips or anything else — in the market has a certain real cost: finding it, finding the price, negotiating, making contracts. These are called transaction costs. A firm now replaces a number of these contracts with one broad contract. Thus the transaction costs should be lower. Now, costs here are meant in a total sense. Because if you are like me you probably think, well, it’s not just about cost, it would also be incredibly complicated — to the point of impossibility — to make individual contracts for all different resources with all the different providers of these resources. But see, for an economist like Coase, complicated just means more costs, which of course is true, we are just not used to calling it that. So firms are lowering transaction costs. Point. Of course firms generate their own internal costs too — that is what sets their limits — but that is a different discussion.

Again we want to raise our voice and say, but what about coordination as a reason for firms? So many people, so many resources cannot just work without it being coordinated. Agreed, coordination is real, but it’s not what actually explains why firms exist. See, coordination would also be possible in a multiverse of contracts, it would just be so complicated that transaction costs would explode.

So it is still about lowering transaction costs primarily. I know, sort of flat, but hey, it’s true. Something else driving up transaction costs is one of these obvious facts of life. We already discussed that time and change are aspects that are always there. In the last essay we saw that we are constantly playing a game of catch. Reality changes the moment we look at it. And because of our changes in perception, even the past changes. Therefore the future is necessarily uncertain to a degree. Now most contracts are made for the future. Making detailed, individual contracts for the future exchange of resources is problematic — to be clear: costly, not impossible. It is kinda hard to contract for future microchips whose workings I don’t even know today. Then a better possibility is to hire the knowledge and the labour and get it developed thus again lowering transaction costs.

So firms come to be because of costs and — permit me to single that out although it is connected to costs — because of uncertainty. Or: they replace individual, specified contracts with broad contracts that are just directional within limits — I hire you as a microchip engineer, not to make a specific, predetermined future microchip.

But if I learned one thing in law school, then it is that there are always different approaches to interpretation or definition. Another would be the historical approach. Now we have done our homework and already discussed the history of the corporation in a past essay. Colin Mayer in his book “Prosperity: Better Business Makes the Greater Good” has a good summary too — the whole book is of course interesting. In essence the historical approach shows that business organizations were not meant to be a simple machine, but more of an independent entity or a persona — yeah, that’s why we call it legal person today. See the need arose for an entity that was independent of the individual people, that could take over and act continuously on its own. The idea was built gradually — a development — starting with the Roman collegium to canon law to English municipal charters to guilds. These organizations were meant to perform a public and/or institutional function — for example tax collection, ocean trade, standards for craftsmanship. The whole shebang with the raising of capital was added later, by merging the corporate organization — whose focus was on the performance and the governance — and the partnership, which was the traditional fund-raising form. So out of their historical development, business organizations as we experience them today still have these two aspects: raising of capital and public purpose.

The funny persona thing was also a historical development. And it connects to something I quoted Barnard stating: that an organization would destroy itself if it had only a fixed purpose in the sense of a goal line — we want to make running shoes. In the historical original form, that was the case for business organizations. But already the Romans saw that this limits the usefulness of these organizations. They needed to adapt to needs. In one year, provide provisions for armies; in the next, collect taxes. And that is the difference between a machine, which is built for one purpose, and a persona, which can change. Not a hammer — which can only hammer nails and fingers — but a handyman, who can fix all kinds of things.

Now if we also want to look at the question of what is a business organization from a societal perspective, we need to establish who contributes to these organizations. Because remember, Coase doesn’t go there. He just said there are a lot of interactions or contracts, and it’s cheaper if we make a bundle out of these instead of having a hundred different contractual agreements. So who provides this input, this investment? Because that’s what these contributions are, investments in the broadest sense. Margaret M. Blair and Lynn A. Stout describe this in a paper called “A Team Production Theory of Corporate Law.” Yeah, I know, corporate law is not the most thrilling of subjects, but they have some neat ideas. So it is generally accepted that besides financial investors there are other contributors, and that a lot of them are actually essential for a business to exist: managers, employees, community, and of course the capital providers. So all of their contributions are needed investments or resources in the organization. The act of incorporation — sorry, strange way of saying the forming of a business — is that some contributors form a team by giving up control rights over the input, process and output to a new, separate legal entity that “takes on a life of its own and could, potentially, act against their interests.” Why do they do this? Well, good question. One is that once working together in a business, their contributions become firm-specific, meaning they would have less value outside their collaboration. This is common to all the contributors, so it establishes their connection. Then there is the problem of control. All forms where only one or a small number of contributors would hold control result in a risky situation for the others. So control is given to that formed entity or more precisely, to its mediating body — the board, because no single contributor group can be trusted to hold it alone.

Ok, we had the economic view, the historical and the societal one. We briefly mentioned purpose but we still need to discuss that in more detail. Purpose is actually philosophical, but don’t be scared, it’s going to stay rather practical.

But what does purpose have to do with definition? Well, even without building too much of a thought construct, we can all agree that knowing the purpose of something gives us a good idea of what that thing is. Specifically regarding business organizations, Mayer found that the purpose determines the inner workings — he calls it structure and conduct — which determine performance measured against purpose — in ocean trade you need ships not a server farm or a chemical lab. The first part here is interesting for us, because it means once we know the purpose, we know how a business organization is truly structured.

Now let’s go back to Blair and Stout, or better, their recounting of Alchian and Demsetz’s definition of team production. It is actually quite simple and consists of three parts: there are multiple resource types involved in production — the usual suspects: labour, materials, knowledge, things like that. The finished product cannot be split meaningfully into separate outputs — yes, you can take a smartphone apart, but usually the individual parts are then not very useful anymore. That’s also why there is no single owner of all these resources — no one contributor can claim the result for themselves, which is why it falls to the new entity to hold and administer it. 

Now let’s take that idea from Blair and Stout and add that the whole product actually becomes bigger than the sum of the parts. Think of it. Tiny speakers, a good touch-based GUI and microchips and batteries that you can recharge thousands of times, and all the other components of a smartphone are quite cool, but only when you put them together do they become something really useful. Or, to take their example, that by writing a paper together the two authors could come up with a lot nerdier ideas than either of them could have alone — meaning of course that collectively they hold more knowledge than individually.

Something we need to clear up now and here is why money is not the perfect answer to the purpose of a business organization. Profit — right? — is what is most important in business. The whole discussion of profit is detailed and we need to be very precise. So open up your reading ears wide. Profit is really important in any business activity. No author writing about economics or management would disagree. At least I haven’t found one. But what about the more critical ones? Authors like Mayer or Porter or Freeman and Mintzberg, also the epic D&D — Drucker and Deming — still think that profit is important. And they all basically agree that profit is important mainly because it is a requirement for the survival of the organization. It is a necessity, an economic condition of survival. Mayer goes as far as calling it actually an input in the process, not an output. But these more nuanced thinkers also agree that profit is not the purpose of a business organization. Making money is cool and needed, but you need to do something to make it. That something is your purpose. Even top managers built their businesses around something other than profit: Paul Polman (Unilever), Konosuke Matsushita (Panasonic), Akio Morita (Sony) and Steve Jobs for example. We can describe this something as value and the process is called value creation — and yeah, we will discuss it in a future essay.

Now, let me add one bonus point, because it comes out of this discussion. And that is how structurally value is created in a business organization. We saw that teams create value, the bundled effort, out of the many needed resources. This is nothing new. The team in Blair and Stout created something that was more than the sum of all inputs. It added value. Now the truly interesting part is that these value-adding processes work mostly horizontally in businesses. We know that from processes in our daily experience. Most process flows that add value are horizontal. One person or team adds to what the last added. My colleague in procurement buys the material. Somebody in R&D designs the speakers. I put together the microchip, then another team puts the microchip into the smartphone — sorry, remember I shorted a hard disk once — somebody develops and loads the software. It’s generally speaking all a horizontal process, or let’s call it a horizontally oriented flow. What is vertical structure — or hierarchy — supposed to do then? It’s needed too, because it coordinates, since otherwise processes would constantly run into problems. You can say that hierarchy is a cost of coordination, but not a source of value. The value comes from what happens between people at the same level, it is based on horizontal cooperation. So hierarchy is problem-driven and cooperation is value-driven. Did this just blow your mind? Mine certainly did when I first found this.

And since we found that value adding is at the heart of what business is, so must cooperation be too. We found a bundling of relationships as a reason for firms, the need for a flexible, persona-like organization, the team forming, and value creation as the purpose of business organizations. Now we can also add that they are about cooperation.

Which means we have to discuss cooperation next, and we will. But for now, we certainly have a good picture of what we are looking at.

Don’t just take it from me, here is some good stuff to read:

Carroll, Lewis. “Alice’s Adventures in Wonderland”. 1865.

Coase, Ronald H. “The Nature of the Firm.” Economica, vol. 4, no. 16, November 1937, pp. 386–405.

Mayer, Colin. “Prosperity: Better Business Makes the Greater Good”. Oxford University Press, 2018.

Blair, Margaret M., and Lynn A. Stout. “A Team Production Theory of Corporate Law.” Virginia Law Review, vol. 85, no. 2, March 1999, pp. 247–328.

Drucker, Peter F. “The Practice of Management”. Harper & Row, 1954.