Is the firm really a “black box”?
Ioannis Ioannou (iioannou@hbs.edu)
PhD Candidate, Business Economics
Harvard Econ Dept & Business School
The theory of the firm, a well-known branch of traditional neo-classical economic theory,
has always assumed that a firm acts as a profit maximizer. It is claimed that this
behavioral assumption is a relatively good and acceptable approximation for the hundreds
of decisions that are made daily within the boundaries of the smallest to the largest of
corporations. In other words, such an assumption implies that complex organizational
structures, a large set of daily interconnected activities and routines, coupled with
personnel dynamics, and a path dependent organizational history, could all crudely be
aggregated into a theory that treats the firm as a “black box”. Such a theory is based on
the belief about the firm’s ability to almost instantaneously adjust its control variables to
better fit its exogenously (or endogenously) changing environmental context.
Since then, a number of theories followed within economics. One prominent view, for
example, claims that the firm could be seen as a nexus of binding contracts and
contracting agents. The Coasian view proposes that the boundaries of a firm are
effectively defined by the comparison between internal and external transaction costs.
However, these theories subscribe to a conceptual foundation which regards firms as
continuously moving along an equilibrium path. That is to say, each and every decision
that a firm takes is in accordance with some optimality (or efficiency) rule specified
within the model.
Surely to their credit, these theories, together with game theory, have revealed very
important insights and have helped economists unravel puzzles that appeared before them
in the daily business life. On the other hand, given the actual decision making processes
in the business world and the evolution of real organizations, such theories might have
reached a bottleneck. Thus, it is high time that economists looked more broadly outside
their discipline for answers, especially towards business academia.
This is not to say, however, that attempts haven’t been made within the field. For
instance, the rapidly growing field of “behavioral economics” tries to incorporate theories
from the psychology literature about individual choice. Behavioral economists propose
bold new theories that help us understand better the economic decision making process of
individuals, thus ameliorating significant drawbacks of the more traditional consumer
choice theory. In a similar way, finance theory has expanded through research on
“behavioral finance”. In addition, economists have gone into the lab. Experimental
economists conduct (computer) lab experiments with human participants in order to
evaluate the applicability of a range of new and old theories. Overall, however, it seems
that economics as a discipline is struggling with the issue of choice at the level of the
individual agent, not at the level of the organization.
A number of business academics have developed theories that aim to address reality more
closely. At the same time, they add an important prescriptive element that is often absent
from the economics literature. Strategy, Organizational Behavior, Technology,
Operations Management and Entrepreneurial Management, are only some of the
academic departments within business schools that have set forth new theories. The
questions that business researchers are trying to answer are, of course, different from the
ones that economists are asking, but that does not mean that there is no common ground
for cross-fertilization across fields.
For example, in the field of “Strategy” frameworks that were proposed relatively recently
deal with the difference between industry and business unit effects on long term firm
profitability. The notion of sustainable competitive advantage differentiates the firms into
essentially, winners and losers, whereas the decision making heuristics of the general
manager and/or the leadership of the senior executive are moved into center stage. But,
what is the point of all these theories, one could ask, if profit maximization is a good
enough approximation to reality? Well, in fact, it probably isn’t. The concept that firms
continuously optimize over their whole range of choices is highly unrealistic (despite its
tractability). Although it is accompanied by a high complexity cost, the business literature
tries to understand non-equilibrium path behavior - behavior that allows for mistakes,
heuristics and rules of thumb.
Some of the work actually originates from a well known economist, Joseph Schumpeter.
He proposed the process of “creative destruction” in the 1930s. The next step came from
Nelson and Winter who proposed an evolutionary theory of the firm. They incorporated
into their theories organizational routines that can act as an organization’s memory, an
accumulation of knowledge, as well as a balancing force for intra-organizational politics.
In other words, organizations may become rigid or develop a life of their own, as
contemporary organizational ecology would claim. The issue of organizational change,
which parallels the decision making process of economics, is one of the most
fundamental questions yet to be answered. There is a long and indeed rugged time path
until a decision is reached and even then, there is a further path towards implementation.
These temporal (and not only) considerations also lead us to think about issues of
organizational inertia i.e. resistance to change. The literature has identified several kinds,
such as cognitional, action or structural inertia vis-à-vis the role of the manager/decision
maker.
More recently, other scholars proposed the view that the firm is simply a set of resources
and that competitive advantage results from the uniqueness of these resources and the
inability of the competitors to replicate them. This came to be called “the resource based
view” of the firm. Combining this view with evolutionary theory, the framework of
“dynamic capabilities” proposed around 1997, acknowledges the path dependencies that
a firm faces. The theory claims that over time, firms accumulate a certain wealth of
knowledge and capabilities that could potentially generate a sustainable competitive
advantage through organizational capability building, learning and adaptability. If one
zooms in on the most important factor of economic growth, namely, technology, one will
find again theories that originate from business scholars. At a very basic level, theories on
product research and development, the modularity of the technology and the kind of the
technological advancement, attempt to explain the link between the micro-technological
foundations of the organization and the links to the market place, both in spatial as well
as temporal terms.
The above list is by no means exhaustive. More fascinating research is taking place in a
number of other fields. For example, work in organizational behavior units examines the
role of teams within firms. Within leadership and entrepreneurial management, the role
and the kinds of leadership in organizations are examined in depth. One should note
however, that the notion of “optimality” and/or “efficiency”, that is so often used in
economics is really not a necessary condition in most of these theories. In fact, most of
them drop this assumption and allow the system to provide answers endogenously.
Given all the above, at a conceptual level, it is intellectually unsatisfying to regard the
firm simply as a unitary actor and, in addition, to impose a “black box” structure.
Opening the black box, and seeing what is inside might prove to be a much more
challenging but also rewarding experience. An experience that would further our
understanding of the world of business and will offer concrete theories and prescriptive
advice on competitive strategies. Therefore, economists should pay attention to at least
two things: first, when it comes to choice, the unit of analysis should be elevated at the
level of the organization / business unit rather than the individual, when explaining firm
behavior. Secondly, the strong equilibrium path/optimality/continuous efficiency
assumption should be relaxed. The business school scholars have enriched our
understanding of the firm greatly. Now, the task remains for both business scholars and
economists to join forces in building a fascinating and, as complete as possible, theory of
the firm.