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937] THE NATURE OF THE FIRM 387 the margin.Our definition must,of course,"relate to formal relations which are capable of being conceived exactly. I It is convenient if,in searching for a definition of a firm, we first consider the economic system as it is normally treated by the economist.Let us consider the description of the economic system given by Sir Arthur Salter."The normal economic system works itself.For its current operation it is under no central control,it needs no central survey.Over the whole range of human activity and human need,supply is adjusted to demand,and production to consumption,by a process that is automatic,elastic and responsive."An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organisation but an organism.The economic system "works itself."This does not mean that there is no planning by individuals.These exercise foresight and choose between alternatives.This is necessarily so if there is to be order in the system.But this theory assumes that the direction of resources is dependent directly on the price mechanism.Indeed,it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism.5.Sir Arthur Salter's description,however,gives a very incomplete picture of our economic system.Within a firm,the description does not fit at all.For instance,in economic theory we find that the allocation of factors of production between different uses is determined by the price.mechanism.The price of factor becomes higher in X than in r.As a result, 4 moves from r to X until the difference between the. prices in X and r,except in so far as it 'compensates for other differential advantages,disappears.Yet in the real world,we find that there are many areas where this does not apply.If a workman moves from department r to department X,he does not go because of a change in relative prices,but because he is ordered to do so.Those who 【了.M.Keynes,Essays in Biography,Pp.223-4 L.Robbins,Narure and Significance of Economie Science,p.63. a This description is quoted with approval by D.H.Robertson,Comrol of Indusiry, p.85,and by Professor Arnold Plant,"Trends in Business Administration,"Ecoxomte: Februaty,1932.It appears in Allied Shipping Control,pp.16-17. See 'A.Hayek,The Trend of Econamic Thinking,"EcoxoNCA,3fay:1933. s See F.A.Hayek op.cit

388 ECONOMICA [NOVEMBER object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning.The example given above is typical of a large sphere in our modern economic system. Of course,this fact has not been ignored by economists Marshall introduces organisation as a fourth factor of production;J.B.Clark gives the co-ordinating function to the entrepreneur;Professor Knight introduces managers who co-ordinate.As D.H.Robertson points out,we find "islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk."But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organisation necessary Why are there these "islands of conscious power"?Outside the firm,price movements direct production,which is co-ordinated through a series of exchange transactions on the market.Within a firm,these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur-co-ordinator, who directs production.?It is clear that these are alternative methods of co-ordinating production.Yet,having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all,well might we ask,why is there any organisation Of course,the degree to which the price mechanism is superseded varies greatly.In a department store,the allocation of the different sections to the various locations in the building may.be done by the controlling authority or it may be the result of competitive price bidding for space.In the Lancashire cotton industry,a weaver can rent power and shop-room and can obtain looms and yarn on credit.This co-ordination of the various factors of production is,however,normally carried out without the intervention of the price mechanism.As is evident,the amount of "vertical"integration,involving as it does 1 Op.cit..p.85. In che rest of this paper I shall use the temmi entrepreneur to refer to the person or persons who,in a competitive ystem,take the place of theprice mechanism in the direction af花ources线. Surey of Temtile Indusriet,p.26

1937] THE NATURE OF THE FIRM 389 the supersession of the price mechanism,varies greatly from industry to industry and from firm to firm. It can,I think,be assumed that the distinguishing mark of the firm is the supersession of the price mechanism. It is,of course,as Professor Robbins points out,"related to an outside network of relative prices and costs,"1 but it is important to discover the exact nature of this relation- ship.This distinction between the allocation of resources in a firm and the allocation in the economic system has been very vividly described by Mr.Maurice Dobb when discussing Adam Smith's conception of the capitalist: "It began to be seen that there was something more important than the relations inside each factory or unit captained by an undertaker;there were the relations of the undertaker with the rest of the economic world outside his immediate sphere ...the undertaker busies himself with the division of labour inside each firm and he plans and organises consciously,"but."he is related to the much larger economic specialisation,of which he himself is metely one specialised unit.Here,he plays his part as a single cell in a larger organism,mainly unconscious of the wider role he fills." In view of the fact that while economists treat the price mechanism as a co-ordinating instrument,they also admit the co-ordinating function of the "entrepreneur,"it is surely important to enquire why co-ordination is the work of the price mechanism in one case and of the entrepreneur in another.The purpose of this paper is to bridge what appears to be a gap in economic theory between the assump- tion (made for some purposes)that resources are allocated by means of the price mechanism and the assumption (made for other purposes)that this allocation is dependent on the entrepreneur-co-ordinator.We have to explain the basis on which,in practice,this choice between alternatives is effected. Op.cit p 1. Capitalist Enterprise and Social Progress p.C Henderon,Supply and Demand ethState takes over the direction of industrythatiaplami it it is doing samething which was previously done by the price mechanism.What is usually not realised is that any business man in organising the relations between his depart- mencs is also dqing someching which could be organised through the price mechanism.Thece is therefore point in Mr.Durhin's answer to those who emphasise the probiems invalved in econdmic planaing that the same problems have to be solved by business men in the competitive systemm.(See "Econamie Caleulus in a Planned Econamy,"Ecaramic December,1936.)The important difference between theie two cases is that economic planning is imposed on industry while firms arise voluntarily because they represent a more effcienc method of organising produetion,In a competitive ay性trm、t止here is an“optimum" amount of planning【

390 ECONOMICA NOVEMBER If Our task is to attempt to discover why a firm emerges at all in a specialised exchange economy.The price mechanism (considered purely from the side of the direction of resources)might be superseded if the relationship which replaced it was desired for its own sake.This would be the case,for example,if some people preferred to work under the direction of some other person.Such individuals would accept less in order to work under someone,and firms would arise naturally from this.But it would appear that this cannot be a very important reason,for it would rather seem that the opposite tendency is operating if one judges from the stress normally laid on the advantage of "being one's own master."1 Of course,if the desire was not to be controlled but to control,to exercise power over others,then people might be willing to give up something in order to direct others;that is,they would be willing to pay others more than they could get under the price mechanism in erder to be able to direct them.But this implies that those who direct pay in order to be able to do this and are not paid to direct,which is clearly not true in the majority of cases.?Firms might also exist if purchasers preferred commodities which are produced by firms to those not so produced;but even in spheres where one would expect such preferences(if they exist)to be of negligibie importance,firms are to be found in the real world. Therefore there must be other elements involved. The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.The most obvious cost of "organising" production through the price mechanism is that of discovering what the relevant prices are.4 This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information.The costs of negotiating and CL Harry Dawes,"Labour Mobility in the Steel Industry,Ecomowic feacrmal Marck hthe trkinad inrceo by the better paid of skilled unen due to the desire foften the main aim in lite of a vorker)ta he independent" (.85} None the less,this is not altogether fauciful.Some small shopkeepe are said to carn Jess than their assistanta. C.F.Shove,"The Imperfection of the Market:Further Note"Ecoauic March,93,p.1,note t,points out chat such preferences may exiat,altbaugh the exampl he gives is almost the reverse of che instance given in the text. According to N.Kaldor,"A Clasifctoty Nate of the Determinatenes of Equilibrium," Revie 4f Econaic Sedies,Februaty 1934,it is one of the assumptions o static tbeary thatAll the relevant prices are known to all individuats"But thi is cleady mot te aft小he real world

937] THE NATURE OF THE FIRM 39r concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account.Again,in certain markets,e.g.,produce exchanges, a technique is devised for minimising these contract costs but they are not eliminated.It is true that contracts are not eliminated when there is a firm but they are greatly reduced.A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm,as would be necessary,of course,if this co-operation were as a direct result of the working of the price mechanism.For this series of contracts is substituted one.At this stage,it is important to note the character of the contract into which a factor enters that is employed within a firm.The contract is one whereby the factor,for a certain remuneration (which may be fixed or fluctuating),agrees to obey the directions of an entrepreneur within cerlain limits.:The essence of the contract is that it should only state the limits to the powers of the entrepreneur.Within these limits,he can therefore direct the other factors of production. There are,however,other disadvantages-or costs- of using the price mechanism.It may be desired to make a long-term contract for the supply of some article or service. This may be due to the fact that if one contract is made for a longer period,instead of several shorter ones,then certain costs of making each contract will be avoided. Or,owing to the risk attitude of the people concerned, they may prefer to make a.long rather than a short-term contract. Now,owing to the difficulty of forecasting,the longer the period of the contract is for the supply of the commodity or service,the less possible,and indeed,the less desirable it is for the person purchasing to specify what the other contracting party is expected to do.It may well be a matter of indifference to the person supplying the service or commodity which of several courses of action is taken,but not to the purchaser of that service or com- modity.But the purchaser will not know which of these several courses he will want the supplier to take.Therefore, 1 This induenee was noted by Professor Usher when diecusing the development of capitalism. He "The tucceive buying and elling of partly finished produets werc sheer waste of cuetgy."(Introdetion to tbe Industrial History of EnglandB )But he does nat develop the idea nor consider why it is that buying and selling aperations still exist. Ie would be posible or n limits tothe power of the entrepreneur tobe fixed.This wauld be voluntary slavery.According to Profeisor Batt,The Lote of Mdasrer awd Soruant p.t such a contract would be void and unepforceable

392 ECONOMICA NOVEMBER the service which is being provided is expressed in general terms,the exact details being left until a later date.All that is stated in the contract is the limits to what the persons supplying the commodity or service is expected to do. The details of what the supplier is expected to do is not stated in the contract but is decided later by the purchaser. When the direction of resources (within the limits of the contract)becomes dependent on the buyer in this way, that relationship which I term a "firm"may be obtained. A firm is likely therefore to emerge in those cases where a very short term contract would be unsatisfactory.It is obviously of more importance in the case of services- labour-than it is in the case of the buying of commodities. In the case of commodities,the main items can be stated in advance and the details which will be decided later will be of minor significance. We may sum up this section of the argument by saying that the operation of a market costs something and by forming an organisation and allowing some authority (an "entrepreneur")to direct the resources,certain marketing costs are saved.The entrepreneur has to carry out his function at less cost,taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes,because it is always possible to revert to the open market if he fails to do this. The question of uncertainty is one which is often considered to be very relevant to the study of the equilibrium of the firm.It seems improbable that a firm would emerge without the existence of uncertainty.But those,for instance, Professor Knight,who make the mode of payment the distinguishing mark of the firm-fixed incomes being guaranteed to some of those engaged in production by a person who takes the residual,and fluctuating,income- would appear to be introducing a point which is irrelevant to the problem we are considering.One entrepreneur may sell his services to another for a certain sum of money, while the payment to his employees may be mainly or wholly a share in profits.3 The significant question would Of course,it is not passible to deaw a hard and fast line which determines whether there is a firin or not There may be more or less direetion.It is similat ta the legal questfwheche there is the reiationship of master and seranor principal and agent. See the discussion of this problem helow. The vievrs of Professor Knight are examined below in more detail

1937] THE NATURE OF THE FIRM 393 appear to be why the allocation of resources is not done directly by the price mechanism. Another factor that should be noted is that exchange transactions on a market and the same transactions organised within a firm are often treated differently by Governments or other bodies with regulatory powers.If we consider the operation of a sales tax,it is clear that it is a tax on market transactions and not on the same transactions organised within the firm.Now since these are alternative methods of "organisation"by the price mechanism or by the entrepreneur-such a regulation would bring into existence firms which otherwise would have no raison d'atre.It would furnish a reason for the emergence of a firm in a specialised exchange economy.Of course,to the extent that firms already exist,such a measure as a sales tax would merely tend to make them larger than they would otherwise be. Similarly,quota schemes,and methods of price control which imply that there is rationing,and which do not apply to firms producing such products for themselves,by allowing advantages to those who organise within the firm and not through the market,necessarily encourage the growth of firms.But it is difficult to believe that it is measures such as have been mentioned in this paragraph which have brought firms into existence.Such measures would,however, tend to have this result if they did not exist for other reasons. These,then,are the reasons why organisations such as firms exist in a specialised exchange economy in which it is generally assumed that the distribution of resources is "organised"by the price mechanism.A firm,therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur. The approach which has just been sketched would appear to offer an advantage in that it is possible to give a scientific meaning to what is meant by saying that a firm gets larger or smaller.A firm becomes larger as additional transactions (which could be exchange transactions co-ordinated through the price mechanism)are organised by the entrepreneur and becomes smaller as he abandons the organisation of such transactions.The question which arises is whether it is possible to study the forces which determine the size of the firm.Why does the entrepreneur not organise one

394 ECONOMICA NOVEMBER less transaction or one more It is interesting to note that Professor Knight considers that "the relation between efficiency.and size is one of the most serious problems of theory,being,in contrast with the relation for a plant,largely a matter of personality and historical accident rather than of intelligible general principles.But the question is peculiarly vital because the possibility of monopoly gain offers a powerful incentive to continuous and unlimited expansion of the firm,which force must be offset by some equally powerful one making for decreased efficiency (in the production of money income)with growth in size,if even boundary competition is to exist." Professor Knight would appear to consider that it is impossible to treat scientifically the determinants of the size of the firm.On the basis of the concept of the firm developed above,this task will now be attempted. It was suggested that the introduction of the firm was due primarily to the existence of marketing costs.A pertinent question to ask would appear to be (quite apart from the monopoly considerations raised by Professor Knight),why,if by organising one can eliminate certain costs and in fact reduce the cost of production,are there any market transactions at all Why is not all production carried on by one big firm There would appear to be certain possible explanations. First,as a firm gets larger,there may be decreasing returns to the entrepreneur function,that is,the costs of organising additional transactions within the firm may rise.Naturally,a point must be reached where the costs of organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market,or,to the costs of organising by another entrepreneur.Secondly,it may be that as the transactions which are organised increase,the entrepreneur fails to place the factors of production in the uses where their value Ritk Uncertainty and Profit Preface to the Re-issue:1.ondon Schoal af Ecqucmmics Series of Reprints Na.16,1933. There are certin marketing costs which could on be cfiminatod by the abolition of consumers'choice"and these are the costs of retailitg.It is canceivsble that these costs might be so high that people would be willing to accepr ratious beeause the extra produet abeained waa worth the loss of their choice 3 This argument assumes that exchange transactinus on a markee can be consideted as hamogenenus:which is clearly unttue in fact This cninplicarinn is taken into account below