An Economic Theory of Managerial Firms

Strategic Delegation in Oligopoly

Luca Lambertini

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781317218258
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The separation between ownership and control has become common practice over the last century, in most medium and large firms across the world. Throughout the twentieth century, the theory of the firm and the theory of industrial organization developed parallel and complementary views on managerial firms. This book offers a comprehensive exposition of this debate.

In its survey of strategic delegation in oligopoly games, An Economic Theory of Managerial Firms is able to offer a reinterpretation of a range of standard results in the light of the fact that the control of firms is generally not in the hand of its owners. The theoretical models are supported by a wealth of real-world examples, in order to provide a study of strategic delegation that is far more in-depth than has previously been found in the literature on industrial organization. In this volume, analysis is extended in several directions to cover applications concerning the role of: managerial firms in mixed market; collusion and mergers; divisionalization and vertical relations; technical progress; product differentiation; international trade; environmental issues; and the intertemporal growth of firms.

This book is of great interest to those who study industrial economics, organizational studies and industrial studies.

1 The theory of managerial firms

Setting the stage

In the neoclassical theory of the firm (or production), the essence of a firm is its technological endowment: essentially, its production function or its cost function. At the (perfectly competitive) general equilibrium, things like firms’ size or internal organization do not matter and are not modelled. As stressed by Jensen and Meckling (1976), we encounter countless references to the theory of the firm, while one should more correctly talk about a theory of markets, in which firms adopt strategies usually aimed at profit maximization, their internal structure being blackboxed. That is, the first generation of models describing oligopolistic behaviour (and, in the opposite limits, monopoly or perfect competition), say, between the early 1970s and the mid-1980s, takes the assumption of pure profit maximization as given and investigates its consequences. This amounts to saying that firms are controlled by owners, although this aspect is not explicitly discussed.

All of this does not answer two fundamental questions. (i) What is a firm? And (ii) why firms rather than markets? These questions are intuitively relevant, as casual observation reveals that there are many firms around, whose size, in terms of employment, installed capital or revenues, is almost as large as that of the markets wherein they operate and, not rarely, larger than several countries around the globe.

The prevailing view about the nature of the firms is that they are a nexus of contracts rather than simply a container of technologies (see, once again, Jensen and Meckling, 1976). Consequently, the firm appears to be more easily understood in terms of the contractual and informational constraints it faces, rather then those of a technological nature described in neoclassical microeconomics.

This chapter offers a reconstruction of the debate about the nature of the firm as a set of contracts, from its early days when the matter was understanding the reasons for internalizing transactions into firms replacing portions of markets to its latest developments combining agency theory with oligopolistic interaction. As will become clear in the remainder, the evolution of this debate has a common flavour but is not linear, as the theory of the growth of the firm – initiated in the late 1950s and then abruptly abandoned twenty years later – illustrates.

1.1 Of firms and markets

Although a sense of the diversity, alterity and antagonism between firms and markets already existed (see, e.g., Berle and Means, 1932), the explicit departure from a theory of the firm based upon the efficient use of technology in competitive markets must be credited to Ronald Coase (1937). In Aghion et al. (2011, p. 181) words:

Ronald Coase raised a question that may at first appear naive but in fact turned out to be fundamental: if the market is an efficient method of resource allocation, then why do so many transactions take place within firms? Coase developed verbal arguments for the existence of firms, in particular emphasizing haggling problems in decentralized market transactions, which he thought authority within firms could partly overcome. In other words, firms exist because there are costs to using the price mechanism: prices must become known, bargains must be made, contracts must be written. In his famous essay, Coase (1937) quoted the description of D.H. Robertson (1928, p. 85) that firms are ‘islands of conscious power in oceans of unconsciousness like lumps of butter coagulating in buttermilk.’

Coase (1937) offered the first interpretation of the rise of firms as entities agglomerating actions previously carried out in markets. In a way, the story could be told as if ‘in the beginning there was the market’, an isotropic and perfectly competitive universe of atomistic activities including production and transactions. Then, there appeared clumps or clots altering that homogeneous market landscape. Those clumps where firms internalizing some activities and transactions into complex hierarchical organizations governed by internal rules (contracts) among groups of individuals (owners, managers, workers) with conflicting interests. These hierarchical structures started replacing increasingly larger portions of markets, and the question soon became whether gigantic structures could eventually replace entire markets. Coase’s (1937) answer, echoed by the subsequent literature, was that most probably this cannot happen, since the remedy to the transaction costs involved by the market mechanism has an endogenous limit: internalizing transactions entails organizational costs adding up to production ones and making governance more and more problematic as the size of a firm increases. In the end, this form of attrition generated by internalizing an expanding volume of transactions previously entrusted to the market prevents the visible hand of a firm from replacing Adam Smith’s (1776, 1976) invisible hand (Chandler, 1962, 1977).

In a nutshell, transaction costs cause market failures which, in turn, create room (and incentives) for the formation of firms, by removing transactions from the market and transferring them into organizations whose growth is then conditional upon their ability to control such transactions at least as efficiently as the market would do.

1.2 U-form vs M-form, and opportunistic behaviour

Williamson (1964, 1975, 1979, 1985, 1986) revisited Coase’s (1937) intuition, developing it into the New Institutional Economics. The connection with Coase’s (1937) transaction cost economics is made explicit on several occasions, for example:

it is not uncertainty or small numbers … that occasion market failure but it is rather the joining of these factors with bounded rationality on the one hand and opportunism on the other that gives rise to exchange difficulty.

(Williamson, 1975, p. 7)

As in Arrow (1974), the basic idea is that transactions flock into firms as the hierarchical structure of the latter eliminates the need for stipulating and enforcing a mass of contingent contracts. Williamson gives a full-fledged shape to the representation of this mechanism, on the following grounds:

• the market and the firm are alternative instruments that can be used to carry out economic transactions;

• the criterion for assigning a transaction to the market or to a firm is relative efficiency;

• human and environmental factors influencing markets also operate within firms’ boundaries.

Environmental factors are uncertainty and small numbers. Human factors are bounded rationality and opportunism.¹ Consider first the environmental factors....

Table of contents

• Cover
• Half Title
• Title Page
• Copyrigh Page
• Dedication
• Table of Contents
• List of figures
• Preface
• Acknowledgements
• 1 The theory of managerial firms: setting the stage
• 2 Strategic delegation in oligopoly
• 3 Mixed oligopolies
• 4 Collusive behaviour and horizontal mergers
• 5 Divisionalization and vertical relations
• 6 Innovation and technical progress
• 7 Endogenous product differentiation
• 8 Trade and the environment
• 9 Strategic delegation in differential games
• Index