The Theory of the Firm: If Economics & Entrepreneurship Would Converse

Richard Stallman is largely considered the "founder" of open source software.

Richard Stallman is largely considered the “founder” of open source software. “Richard Matthew Stallman. Digital image. Wikipedia Foundation Inc., n.d. Web.”

Given my background, I very often tend to straddle the line between economics and entrepreneurial literature. Even if one had little to no background in either field however, it requires relatively little thought or observation to discover how married at the hip these two fields truly are. Indeed in entry level microeconomics courses  we are taught about the theory of the firm. Various definitions of this exist and it has certainly evolved overtime of course. Interpretations range from such austere neoclassical concepts as “that firms exist and make decisions purely to maximize profits (or shareholder wealth)” to more modern ideas which add to that concepts of long and short term aims, corporate responsibility, innovation, etc. though most of those are found in industrial organization or business oriented scholarship.

Why the neoclassical (read as ~ pre-WWI) ideas are rarely accepted in their unbridled form probably should come as no surprise. Few theories that old in any field of scholarship are still accepted in their pure form today. The story of how that came to be is largely attributed to the works of John Maynard Keynes (1883 – 1946) and his post WWI economic proposals. More to the point, observation of how firms’ behavior are beginning to evolve today (key word = evolve) often runs in stark contrast to many of today’s well-accepted theories of firm behavior let alone those of old.

While the definition of “entrepreneurship” is fairly contested even within the field of research, if we consider entrepreneurship in the context of scholarship as at least incorporating the study of how individuals and firms innovate and evolve in the marketplace, then it has the potential to offer key insights into the theory of the firm. What is missing from the conversation in economics, though it is beginning to foster more discussion in entrepreneurial fields, are the behavioral changes and corresponding firm/entrepreneur motivations which stand almost as a 4th dimension to the 3D world of neoclassical thought.

If we accept the traditional theories as a universal truth, then what on Earth causes any entrepreneur to form a Benefit Corporation or B-Corp? Who in their right mind would take the time to create Wikipedia, let alone Wikileaks? What interest does homo economicus or a wealth maximizing firm have to create Bitcoin?  How can open source software, which provides a crystal clear opportunity for profit generation, possibly exist in a free market? Speak with almost any entrepreneur in renewable energy and the words “profit” or “wealth” are rarely uttered while “climate change” and other socially oriented value concepts dominate the conversation. Why do so many local microbreweries and cafes which are axiomatically in competition with one-another,  assist each other in forming their businesses? Why do some business owners, with little to no market incentive to do so, purposefully locate their manufacturing to more costly, higher wage, countries? How do companies on Kickstarter generate such activity? Why would health clinics form in the developing world which charge affluent customers for medical services then turn around those profits to provide free health care to the poor? While some may find ways to argue their place in traditional economic theories, in truth these ideas mesh with neoclassical economics no more than Noah’s Ark meshes with Geology. As is seen time and time again throughout history, rather than simply observe these phenomena those that feel they challenge established theory instead very poorly try to explain them using conventional wisdom.

So what does this imply exactly? The answer to that, is probably the most exciting takeaway one can get from reading research literature or blog posts for that matter. We simply do not know yet. How cool is that!? These concepts continue to evolve into our modern economy and economists, entrepreneurial scholars, and other academics are yet to fully analyze and understand them, let alone model them. Keep an eye on the forefront of economic research because while most people today emphasize sovereign debt, China’s inward shift, oil prices, and automotive sales, in the coming decades, I believe this field of economic research will begin to change the way we view and operate within the economy altogether.

The True Purpose of “Paternalism”

What is “Paternalism”?

Words carry preconceived definitions. While the word “Paternalism” is often related to restrictions in freedom, though in economic discussions, paternalism generally synonymous with government policy. In a broad definition, it can also include any policy put into place by a choice architect or any individual or organization in an authoritarian or influential position. Phone companies offer a tremendous example here. It is in their power to determine what the default data sharing options are in customer contracts or how discouragingly complex to make a customer service process, in both instances, substantially influencing consumer behavior. For the purposes of this discussion however, we will narrow the scope to purely those policies which can be controlled by  a government entity or legislative body. Private companies are primarily profit driven and carry a variety  of additional relationship complexities which would themselves demand a doctoral dissertation let alone a blog post.

The Need: Externalities

Many  economists will state that the need for any form of paternalism stems from the fact free markets carry innate inefficiencies at satisfying individuals needs. While there is an absolute cornucopia of research which attempts to substantiate this claim, one can also argue this effect is secondary to an often disregarded primary concern.

Although it is likely impossible to comprehensively define what a “good” individual choice is, it is frequently possible within a specific context, to establish a reasonable argument for what is a “good” choice for society. In other words, an individual’s preference is inherently idiosyncratic and not up for much if any debate, while in general, it is easier, though often still difficult, to discern what the best choice for society is. For instance, one can generally say it is better for society if people chose healthier food options, though what an individual determines to be their personal food choice is entirely subjective.

This juxtaposition of individual and social value is a topic of discussion which traces its roots within economics back to Adam Smith or even earlier. Theoretically, in a free market system needs are defined by individuals and the motivations of firms are directed at solving those needs to derive profit. As such, it is well documented that the needs of the whole do not necessarily equal to the sum of the needs of it’s parts. Value as defined by individuals and value as defined for society, are two often overlapping but not necessarily entirely equal constructs. There are many illegal products which would otherwise be available for sale to individuals through the free market had they not dire consequences for society at large. Narcotics, or military grade weapons for example. It is the existence of these types of discrepancies between individual and social value that I argue is really the primary driving need for paternalism.

“Externalities” is the key word of this discussion. The unavoidable consequential effects of one party’s actions on another. Second hand smoke or an accident due to drunk driving are particularly salient examples for those unfamiliar with the term. While these examples represent individual externalities, (the effect of one individual’s actions on another), social externalities (the effect of one individual or a group of individuals actions on society) are far less conducive to traditional forms of government regulation.

A Real World Example

So why is this so important to discuss? Well so far in order to preserve a more comprehensive scope, the discussion has been largely abstract in nature. To answer that question and bring us into a more everyday tangible context, let us explore how social externalities take place at a high level within the food industry.

As anyone will notice when they grocery shop today, attempting to consume a truly healthy and beneficial diet can be extremely difficult. The structure of the food industry in the US makes it inherently expensive and difficult to know which foods are truly healthy and further, to actually find and then choose those foods at the store.  As a result, two major social externalities are created:

  1. It becomes difficult to locate and expensive to buy healthy food options. What is healthy, becomes secondary to what profitable foods can be marketed as “healthy” by food producers, creating an intense veil of confusion and deception for consumers.  If you have doubts, according to the FDA’s vague definition, even food containing MSG can be labeled “natural”. Supply feeds demand and demand drives supply, crowding out and otherwise making it difficult for healthy food options to achieve the economies of scale and market competitiveness necessary for most consumers to regularly adopt.
  2. As is inherent to any healthcare system, public or private, single payer or free-market based, those that are healthy, heavily subsidize the costs of those that are less so. In areas where individual choice has played little to no role, this is not of relevance to our current discussion on externalities. However, if one individual choses to to consume a heavy cheeseburger diet for 40 years then develops obesity linked illnesses, it is ultimately those who have chosen not to consume that food who subsidize the long-term healthcare costs of doing so through insurance policy payments, disability claims, etc.

Why is Paternalism the Solution?

While this concept is itself highly politicized and controversial, I would argue this largely stems not from an ideological opposition to paternalism as a concept, but from either a misunderstanding or misuse of how the powers paternalism grants are to be employed. Irrespective of one’s political viewpoint, the fact remains that paternalism is uniquely positioned in our society to play the role of check and balance against the free market. The polarizing political consequence this concept creates could be far more neutral if the ideas of paternalism were focused on areas where individual and social externalities exist, and subsequently framed as such. Motorcycle helmet laws for instance might be far better accepted if the regulations and incentives were focused on protecting younger passengers or others motorists against the externalities rather than on the motorcyclists themselves. In a free market and free society, choices that affect the individual and only the individual, are theirs to make. Choices that begin to create externalities however, are subject to debate.

Why argue for parternalism here? Because it is precisely in those instances where paternalism is most effective. Externalities create an implicit competition between an individual’s needs and society’s needs, especially in areas where those needs are diametrically opposed. Freedom is good but externalities demonstrate areas where freedom can be abused to the individual benefit but to the detriment of the public. Paternalism is not a tool to be used to dictate how we think others should behave but to be used as a check on externalities caused by that behavior which may have adverse effects on others in the society.