BUSS164 Business for Society
경영과 사회
The Theory of the Firm
기업이론
March 2023
문정빈 (Jon J. Moon)
Korea University Business School
1
The Theory of the Firm
▪ Economic Approach
▪ Neoclassical theory: To explain economic principles governing
production, investment, and pricing decision of established firms
▪ Transaction cost theory: To explain why firms exist
▪ Stakeholder Approach
▪ To guide the structure and operations of established firms
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1. Economic Approach
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Economic Approach: Big Picture
▪ Fundamental assumption about human being in economics
▪ Efficiency of market
▪ Considering efficiency of market, why do firms exist?
▪ Where do we draw the boundaries of the firm and why?
▪ Why conduct some transactions within a firm, while others are
conducted across a market interface?
▪ What is the goal of the firm?
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Homo Economicus
▪ Rationality
▪ Homo Economicus chooses the best actions to achieve his/her goals
▪ Homo Economicus optimizes
▪ Ex) Consumers (firms) maximize utility (profit)
▪ Pursuit of Self-Interest
▪ Homo Economicus cares about only himself/herself
▪ Ex) People care about only their own utility
▪ Homo Economicus is like a robot which maximizes its own
utility
▪ Rationality and self-interest are two independent dimensions.
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Rationality and Self-interest
Self-interest
Homo Economicus
assumed in economics
100
Rationality
0 100
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Rationality and Self-interest
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Self-interest?
▪ Why do people exchange gifts or make donation?
▪ Why do people sometime behave in a moral way?
▪ Acting out of self-interest is not necessarily immoral.
▪ However, exclusively self-interested motivation is amoral
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Self-interest?
▪ Morality
▪ “If morality represents how we would like the
world to work, then economics represents how it
actually does work.”
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Self-interest?
▪ Adam Smith’s concept of “sympathy”
▪ Formal versus informal regulations of human behavior
▪ Formal: Carrot and Stick (law)
▪ Informal: Trust and Sympathy (education)
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Goals of Economic Systems
▪ To satisfy human needs and wants, every economic entity is
confronted with three basic issues:
• What to produce
• How to produce it
• Who gets it
▪ The answer depends on the allocation mechanisms
• Free markets
• Central planning
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Comparing Effectiveness of Economic Systems
▪ In free markets, economic decisions are decentralized to
individuals
▪ In centrally planned economies, government officials make
economic decisions
▪ Free market versus central planning?
▪ At least, history suggests that free market performs better than
central planning
▪ Economists conclude that free market can achieve more efficient
resource allocation than central planning
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Natural Experiment
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Property Rights and Exchange in a Market Economy
▪ A property right is a legally enforced right to select use of
an economic good
▪ Property right is private when it is assigned to a specific
person
▪ Two dimensions of property rights
• Alienable rights
• Use rights
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Supply and Demand in the PC Industry
When prices are high, the
quantity supplied is greater $
than quantity demanded and Supply
a surplus exists.
When prices are low, the Surplus
quantity demanded is greater PHI
Price (in dollars)
than quantity supplied and a
shortage exists. P*
Only the market-clearing
price avoids surpluses or PLO Shortage
shortages.
Demand
Q
Q*
Quantity of PCs
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Prices as Social Coordinators
▪ Coordinate consumption and production decisions (the
invisible hand)
• Prices give suppliers incentives to shift production to high priced
products
• Prices give consumers incentives to reduce quantity of high priced
products
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Efficient Exchange and Production
▪ At equilibrium prices, the quantity supplied equals the
quantity demanded for all goods and so there are no
shortages or surpluses
▪ Everyone who wants to make trades has done so, and all gains
from trade have been exhausted
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Measuring the Gains From Trade
▪ Consumer surplus - the difference between what consumers
are willing to pay (value) and what they actually pay (price)
▪ measured as the area below the demand curve and above the price
▪ Producer surplus - the difference between the price received
and willingness to produce (cost)
▪ measured as the area above the supply curve and below the price
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Consumer and Producer Surplus
P
$20
Consumer surplus Supply
(Triangle A)
$10 Producer surplus
(Triangle B)
B
Incremental production
costs (Triangle C)
C
Demand
Q
10
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Markets versus Central Planning
▪ General knowledge is freely transferable
▪ Specific knowledge is expensive to transfer
• Centrally planned economies fail because specific knowledge is
not used in the planning process
▪ Prices convey general knowledge
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Specific Knowledge
▪ Examples
• idiosyncratic knowledge of particular circumstances
• scientific knowledge
• assembled knowledge
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Friedrich Von Hayek
Nobel Prize Winner in Economics (1974)
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Specific Knowledge and Economic System
▪ Free markets make superior use of specific knowledge
dispersed among many participants
▪ “If we can agree that the economic problem of society is mainly
one of rapid adaptation to changes in the particular
circumstances of time and place, it would seem to follow that
the ultimate decisions must be left to the people who are
familiar with these circumstances, who know directly of the
relevant changes and of the resources immediately available to
meet them.”
— Friedrich A. Hayek, The Use of Knowledge in Society
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Warning: Market Failure
▪ Market fails when market does not generate an efficient
resource allocation
▪ Imperfect competition: Supplier can influence price with market power
▪ Externalities: The decisions of buyers and sellers sometimes affect
people who are not participants in the market at all
▪ Public goods: With non-excludability, non-rivalry in consumption, free-
riding becomes prevalent
▪ Asymmetric Information: Transaction seldom occurs
▪ Transaction costs: Learning and haggling costs over the terms of trade
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Economic Theories of the Firm
▪ Neoclassical Theory
▪ Firm as a set of feasible production plans
▪ Production function
Q = f ( x1 , x2 ,...xn )
▪ A manager maximizes profit
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Economic Theories of the Firm
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Economic Theories of the Firm
▪ Principal-Agent Theory
▪ Recognizes the conflicts of interest between different economic actors
▪ Still views the firm as a production set, but now a professional manager
makes production choices that the firm’s owners do not observe
▪ Shareholder is principal and CEO is agent
▪ Contracts can only partially align the interests of both shareholders and
CEO
▪ Important Assumption: Shareholder’s interests should have priority
over manager’s interests
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Ronald Coase
Nobel Prize Winner in Economics (1991)
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Economic Theories of the Firm
▪ Transaction Cost Economics (Ronald Coase)
▪ First introduced the concept of transaction cost as learning
(discovering prices) and haggling (contracting) cost in market
transaction
▪ Firm is characterized by the power to settle issues by authority
▪ The higher is the cost of transacting across markets, the greater
will be the comparative advantage of organizing resources within
the firm
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Why do Firms Exist?
The Role of Transaction Costs
▪ Transaction costs
▪ Costs incurred in making transaction in a market
▪ Costs of using the price mechanism
▪ Types of transaction (contracting) costs
• search and information costs
• bargaining and decision costs
• policing and enforcement costs
• Commodity versus non-commodity
▪ Optimal economic organization minimizes transaction costs
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Oliver Williamson
Nobel Prize Winner in Economics (2009)
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Economic Theories of the Firm
▪ Transaction Cost Economics (Oliver Williamson)
▪ Recognize the situation where transaction costs becomes
important
• When economic actors make relationship-specific investments
• Ex ante suboptimal investment incentives
• Ex post bargaining costs
▪ Ex) Car body supplier has to make relationship-specific
investment since each car body is unique
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Transaction Cost Economics
(Oliver Williamson)
▪ Assumptions
▪ Human factors
• Bounded rationality
• Opportunism: Self-interest with guile
▪ Environmental factors
• Uncertainty/complexity
• Small number bargaining (bilateral monopoly)
▪ Contracts are incomplete
▪ Hold-up problem
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Transaction Cost Economics
(Oliver Williamson)
▪ Hold-up problem
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GM and Fisher Body Case
▪ Transaction costs determine “boundaries” of the firm
▪ Hold-up problem
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Tales of Two Firms
Ford of 1930s with
more vertical
integration
Toyota today
relies more on
outside suppliers
based on trust
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Contracting Costs and Existence of Firms
▪ Advantages of firms over markets
• Fewer transactions
• Information specialization
• No transaction costs inside the firm
▪ Outsourcing versus insourcing (make or buy)
• Size of transaction costs is the key
• Make: Internal production costs
• Buy: Market price + Transaction costs
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Different Views on the firm
▪ Common Law countries such as the UK and the US view a
corporation as a piece of private property and through their
legal structure place exclusive emphasis on the shareholders
as the owners of the firm.
▪ Civil Law countries such as Germany and France view
corporations as “mini-societies” and place emphasis on the
responsibility of the firm to its employees as well as its
shareholders
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Milton Friedman
Nobel Prize Winner in Economics (1976)
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Corporate Social Responsibility from the perspective of
economics
▪ “There is one and only one social responsibility of business—to use
its resources and engage in activities designed to improve its profits
so long as it stays within the rules of the game, which is to say,
engages in open and free competition, without deception and fraud.”
—Milton Friedman, Capitalism and Freedom, 1962
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2. Stakeholder Approach
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Johnson & Johnson Stock Price, 1981-2021
Source: Google Finance (4/1/’21)
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Recap: Business Roundtable
▪ In August 2019, Business Roundtable, an association of CEO’s of
America’s leading companies, published a statement on the purpose of
a corporation. It clearly states their commitment to:
▪ Delivering value to our customers.
▪ Investing in our employees.
▪ Dealing fairly and ethically with our suppliers.
▪ Supporting the communities in which we work.
▪ Generating long-term value for shareholders.
▪ While reaffirming that the free-market system is the best means of
generating good jobs, a strong and sustainable economy, innovation, a
healthy environment and economic opportunity for all.
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Origin of the Word “Stakeholder”
▪ “Stake” = Potential Benefit
▪ Coined in an internal memorandum at the Stanford
Research Institute in 1963
▪ Refers to “ those groups without whose support the
organization would cease to exist.”
▪ Includes shareowners, employees, customers, suppliers,
lenders, and society
▪ There should be a clear distinction between stakeholders
and influencers
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Edward Freeman
An American philosopher
and professor of business
administration at the
Darden School of the
University of Virginia
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Stakeholder Approach
▪ What is the purpose of the firm?
▪ Concerned with the firm’s best interests
▪ But this perspective differs with shareholder perspective on the
most effective approach to realize the firm’s best interests
▪ Firms can best generate competitive advantage and wealth by
taking more than just their shareholders into account
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Stakeholder Approach
▪ By taking the interests of all the firm’s stakeholders into
account, the firm could do “better” (achieve greater
performance) than by simply focusing on shareholder
interests
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A Firm’s Stakeholders
▪ All those diverse individuals and groups who affect or are
affected by a firm’s actions
▪ Capital Market Stakeholders
• Financiers/shareholders
▪ Product Market Stakeholders
• Customers, suppliers, communities
▪ Organizational Stakeholders
• Employees
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A Firm’s Stakeholders
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Stakeholder Approach
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Stakeholder Approach
▪ Central Theses
1. Descriptive: Emergence of numerous stakeholder groups and
new strategic issues → It presents a new model describing
what the corporation is. It describes the corporation as a
constellation of cooperative and competitive interests possessing
intrinsic value. Managers are indeed practicing stakeholder
management.
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Stakeholder Approach
▪ Central Theses
2. Instrumental (hypothetical imperative): Corporations practicing
stakeholder management will, other things being equal, be
relatively successful in conventional performance terms
(profitability, stability, growth, etc.)
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Stakeholder Approach
▪ Central Theses
3. Normative (categorical imperative): Stakeholders are identified
by their interests in the corporation, whether the corporation has
any corresponding functional interest in them. The interests of
all stakeholders are of intrinsic value. That is, each group of
stakeholders merits consideration for its own sake and not
merely because of its ability to further the interests of some
other group, such as the shareholders.
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Stakeholder Approach
▪ Central Theses
4. Managerial: Stakeholder management requires, as its key
attribute, simultaneous attention to the legitimate interests of all
appropriate stakeholders, both in the establishment of
organizational structures and general policies and in case-by-
case decision making.
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FAQ about managing for stakeholders (MFS)
▪ Is managing for stakeholders opposed to maximizing value
for shareholders? Don’t the interests of shareholders and
stakeholders conflict?
▪ MFS is not anti-shareholder
▪ However, maximizing value for shareholder trades off the interests
of other stakeholders against the group maximized
▪ MFS is about using entrepreneurship and innovation to make all
key stakeholders better off
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FAQ about managing for stakeholders (MFS)
▪ Can we really make “all” of the stakeholders happy all of
the time?
▪ Absolutely not
▪ Need to get the interests of primary stakeholders, at least
customers, suppliers, employees, communities, and financiers
(for most companies), going in the same direction, most of the
time
▪ Can’t ignore the other stakeholders such as media, critics,
governments, NGOs, and so on, but you can’t always satisfy all
of their interest
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FAQ about managing for stakeholders (MFS)
▪ Is managing for stakeholders just another way to say
‘‘corporate social responsibility,’’ ‘‘triple bottom line,’’ or
‘‘sustainable business?’’ What is the connection among
these ideas?
▪ Common in that these ideas and MFS are used to
understand business and capitalism better
▪ The problem with these ideas, however, is that they
make a distinction between the economic or business
effects of an action and its social effects
▪ Within the current model of business it is too easy to
relegate social effects to corporate philanthropy or
public relations, or some other second-rate status
▪ By starting with stakeholders we can see how economic
and social and other effects go together
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FAQ about managing for stakeholders (MFS)
▪ What is the connection between managing for stakeholders
and ethics in business?
▪ MFS requires that we see stakeholders as fully human
▪ Capitalism works because of this humanity
▪ It is our way of cooperating to achieve common purposes
▪ Ethics is inseparable from this endeavor, as it is about how we are
going to live together and thrive
▪ The idea that business and ethics are not connected or that
business ethics is a joke is a dehumanizing idea
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FAQ about managing for stakeholders (MFS)
▪ How do you identify stakeholders? Isn’t everybody a stakeholder
in large multinational companies? Why are companies in the
center of the stakeholder map?
▪ The best way to identify stakeholders is to convene a diverse group of
people from an organization and ask them who is affected by the
organization and who can affect the organization
▪ Stakeholders can be stratified by what part of the business they affect
▪ See stakeholders as concrete groups and individuals rather than large
amorphous groups like ‘‘the public’’ or “society” which have so little in
common
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Alex Edmans
Professor of Finance at
London Business School
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Grow the Pie
▪ Pie-growing mentality instead of pie-splitting mentality
▪ Companies can serve both shareholders and society
▪ Businesses should focus on creating social value rather than just
profit
▪ Shareholder wealth vs. shareholder welfare
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Stakeholder Capitalism: Grow the Pie
▪ Assume that companies should be run in the
interests of shareholders
▪ Stakeholder capitalism
▪ “Stakeholder capitalism seeks to create shareholder
welfare only through creating stakeholder welfare”
▪ Stakeholder welfare is the end goal, pursued intrinsically;
profits are a by-product
▪ In a world of uncertainty, stakeholder capitalism is
practically more useful
▪ Shareholder capitalism
▪ Profits are the end goal; stakeholder value is an
instrumental way to create profits
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Stakeholder Capitalism: Grow the Pie
▪ Evidence that the stock market misvalues intangibles
▪ Employee satisfaction, customer satisfaction, best companies to
work for, materiality of sustainability investment
▪ Still needs a decision rule, but one based on principles
▪ Principle of multiplication: social benefit > private cost
▪ Principle of comparative advantage
▪ Principle of materiality: business materiality and intrinsic
materiality
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Stakeholder Capitalism: Grow the Pie
▪ Stakeholder capitalism is not
▪ Anti-shareholder capitalism
▪ Managerial capitalism
▪ Stakeholder capitalism, correctly defined:
▪ Has practical value in increasing shareholder wealth
▪ Allows companies to increase shareholder welfare
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Materiality Analysis: Inditex (2020)
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Materiality
Analysis Items
(Inditex 2020)
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International Scholar Invitation Forum held with Professor
Alex Edmans
▪ ESG Management: Theory and Practice
▪ Hosted by KUBS Asian Institute of Corporate Governance (AICG)
(2021. 07.06)
▪ LINK:
https://www.youtube.com/watch?v=1w6hPfTFRlk&t=3s
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Got Questions?
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