“Discovering the Role of the Firm: The Separation Criterion and Corporate Law,” D. Spulber (2009)

(Note: After a Francophilic August hiatus, I’m back from the mountains and will be posting again roughly on a daily basis.)

There are a surprising number of very basic questions about the economic world for which the average undergraduate economic student will never encounter an explanation. For instance, why do businesses in the West sell goods with fixed prices, rather than souq-style bargaining? Despite the Nobel-driven popularity of Oliver Williamson, I imagine that few students are given an explanation for the problem Daniel Spulber considers in this paper: Why do firms exist?

Spulber’s “separation criterion” incorporates aspects of the neoclassical explanation (firms are the “owners” of a production technology, though here there is no reason why firms are entities, rather than informal groupings of individuals), the transaction cost explanation (firms, through repeated games, lower the transaction costs of producing goods; Williamson focuses particularly on the problem of hold-up when contracts cannot specify every possible contingency), and the contracts explanation (firms are a “nexus of contracts” for overcoming moral hazard and other informational problems when undertaking risky ventures). To Spulber, a firm is defined by the complete separation of owner goals and corporation goals. When this separation exists, firms will maximize profits, and owners will unilaterally agree with that objective. For example, if an owner has the goal of eradicating malaria, he will, in theory, prefer the firm he owns to maximize profits, then will spend his residual claim on the firm’s profits supporting charities in line with his public health consumption goal. Many organizations are not firms. Government-run firms generally pursue goals other than profit maximization (that is, they may pursue social policy objectives which are “consumption goods” for the government, thus violating Fisher’s separation theorem). Equal share partnerships are not firms: the owner/managers will each only take actions if their share of the firm profits makes it worthwhile.

This article is published in a law and econ journal, so there is a short discussion of the legal implications of this theory of firms. In particular, policies that destroy the separation of owner and firm maximands can destroy useful efficiency properties. One such policy would be restrictions on selling shares of a firm by the owners. One final caveat: since this is a law journal, the style is very different from what we economists are used to: there is no mathematical model, many seemingly important claims are supported only through references to other papers, and there is extensive interpretive discussion.

http://works.bepress.com/cgi/viewcontent.cgi?article=1000 (Working Paper – Final version in Berkeley Business Law Journal 6.1-2 (2009), which was actually published in 2010 despite the officially listed year)

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