Neoclassical economic theory posits that the individual firm’s pursuit of profit maximisation will always ensure that they produce with technical efficiency with this notion proposing industries to be the aggregation of individual firms and an economy and the aggregation of industries. The process of production is concerned with issues of supply, a process often centred on optimisation of costs and profits, disembodied from the dynamics and reality of production. This is due to the often used ‘black-box’ approach to conceptualising this process using a presumably known technology function. Such theorising portrays a representative firm, assuming away the possibility of different technological constraints and different capabilities to produce, so therefore there is no need for greater investigation into firm dynamics and determinants. However, firms operate at different levels of efficiency since some knowledge or assets are tacit[1], unable to be acquired through markets and must be learned through experience, and an important source of increased labour productivity. Workers gain, firm-specific, idiosyncratic knowledge from being within a job for some time[2]. As well as due to firm-specific assets, relative inefficiencies across firms may persist due to motivational problems that arise from mutually conflicting objectives within the firm which often leads to non-maximising behaviours[3]. Other variations in firm performance can also be argued to be due to how the pursuit of interests of individuals within firms manifest at the aggregated level[4].

Valuing and empowering workers is central to the long-term success of firms so hence, the retention of workers is essential in order to create long-term commitments from workers instead of incentivising short-term rewards and performances for the purpose of supporting any subsequent attempts at movement within the job market[5]. Favouring internal recruitment for higher positions within the firm also re-instils an attitude towards long-term commitments to the firm, thus enabling firms to further make long term commitments to society and foster lasting and meaningful relationships with various stakeholders. Horizontal information flows and cooperation can greatly enhance the productivity and efficiency of workers, thus giving a competitive edge to firms where such is commonplace. Additionally there is evidence that paying a wage premium to workers instils great job value to the worker who will now be incentivised not to free-ride while in the job due to this wage premium[6]. Hence, despite the greater costs, in jobs where supervision is costly and prone to shirking, it is not only fair to pay such a wage but may increase labour productivity and efficiency.

BUSINESS & SOCIETY

Economic interaction between agents can be viewed as decisions when we conceptualise exchange as a voluntary interaction of mutually interested parties. Game Theory, which is commonly drawn upon for social analysis within multiple disciplines – including behavioural economics – is able to frame the continual interaction of consumers and firms as sequential rounds of a continuous ‘game’. Therefore a preliminary analysis using orthodox theory would indicate there is a common interest in cooperation between business and consumers with regards to the quality and safety of goods and services provided, and the prompt payment of what is due to firms[7]. Cooperation in most cases has been shown to produce the optimal welfare outcomes for all parties concerned over time, as opposed to where one party chooses to break any implicit agreement to cooperate for a personal, short-term gain[8]. Trust can very quickly break down between participants and can take a long time to regain. Additionally, the decision to punish the ‘cheater’, often through a loss to sales, can be made at relatively little cost to adversely affected participants. Though a rational response, it produces an outcome where both parties could be made better of through cooperation once more.

The financial and economic crisis before the turn of the decade embodies the waning of part of the business community’s commitment to this cooperation and responsibility to engage honestly with customers. This has resulted in the failure to maintain meaningful relationships between stakeholders that would ensure the prolonging of the welfare gains deriving from cooperation. Such a sub-optimal outcome is an example of markets alone failing to achieve the best outcome for society. Such can occur when individuals do not have sufficient control over commodities, transaction costs exceed the gains from trade, and when individuals cannot agree on how to share gains from an exchange with this latter point representing this breakdown in fair relationships. Agents may cautiously ‘under-transact’ in an environment of uncertainty, instability or where all available information is not shared, thus social welfare gains are not maximised as a result. Hence, by establishing strong mutual commitments to sustainable and honest business relationships and sharing information necessary to breed confidence and faith in one another, stakeholders can secure long-term cooperation to ensure the best social outcome for all parties.

Another reason for the breaking down of such cooperation between stakeholders is the misalignments of social costs with social benefits as a result of private exchanges and consequentially the mal-incentives produced for business. There are many negative externalities from business practices that business is not currently accountable for and therefore, the information that certain practices are potentially damaging to society is not effectively fed back to those making decisions within firms. Without a conscious effort by firms to consider all members of society affected by business activities and attempt to internalise these externalities, the social costs will continue to be over looked and the true costs of business will continue to be externalised.

The economic crisis was perhaps a reminder to those within business, fixated with short-term gains, that business is indeed a series of continual relationships and consecutive decisions and that a re-emphasis to a longer time horizon would benefit all stakeholders. Management theory can illuminate why such a strong focus on short-term, private gains prevailed pre-crisis and there were no meaningful attempts to inter-temporally optimise business practices. The professional manager has differing goals to the overall firm or its owners (often to expand market share or output to beyond what is aligned with profit-maximisation) and risk aversions[9]: If the majority of a firm is owned by outsiders managers will tend to feel a lower obligation to stewardship and the private costs and benefits will greatly differ from social costs and benefits[10]. Excess production and provision of some demerit goods and services may incur grave costs on the environment and the sustainability of business practices. The decentralised, equity ownership structure of FTSE100 companies perhaps invites the pursuit of riskier investments and practices by managers than perhaps debt holders want. Therefore, without a concerted effort towards considering all stakeholder and the externalities of business activities, these principle-agent problems of misaligned incentives are likely to persist under such ownership structures.

The firm can be viewed as a junction of not necessarily contractual relationships. Neoclassical economic theory views firms within disembodied markets as having arms-length relationships with other agents in the pursuit of profit maximisation – these relationships able to be terminated at any time. Meanwhile, other productive-efficiency theories of the firm claim that, through market interactions alone, firms can promote marked gains since such gains are produced from the self-motivated gains of major stakeholders of the firm. Technical theories deem the concentration of productive activities into the firm as a rational response due to the associated gains from scale and scope. Similarly, by internalising interacting processes within one entity, much of the uncertainty arising from a lack of contractual obligation and decentralisation, in addition to the expenses of enforcing any contracts in existence can be overcome by vertically integration of individual components interacting[11]. The ‘team production’ view also sees cooperation as beneficial to each individual but the firm here performs the purpose of metering the performance of team members in order to minimise free-riding[12]. Though the supervision implicit in such a hierarchical structure is likely to lead to increased profits, it is inefficient due to the wasted labour power used through supervision. Workers can be motivated through alternative forms of firm organisation, like in democratic firms, to produce more efficiently[13]. Hence, by creating an attitude of good will and cooperation, rather than a competitive and calculated atmosphere, firms may be able to produce more efficiently and reduce internal conflicts, both especially in the long-run.

Society should strive towards income stability, so hard working people are not out of work for no fault of their own, and income equity, so those who contribute towards prosperity get their fair share of economic growth – hence there needs to be an account of where value is created. Orthodox economic theory provides a market-centric theoretical basis for policy prescriptions that undermine income stability and inequity. At the root of the problem is the failure to acknowledge the distinction between value creation (output) and value extraction (income), and the dynamics that link them[14]. Individuals create value within organisations and not markets so the collective resource allocation decisions of organisations have a key role in the value creation and extraction processes within society. The career income of an employee is career-determined and not market-determined as is believed within orthodox economic theory, with firms rewarding those who engage in collective learning.

Value creation that results in higher quality, low cost products is innovation. Innovation is a collective, cumulative and uncertain process: it takes the application of skills and functions of multiple individuals within hierarchical and functional structures to contribute to organisational learning, it is a process of learning occurring over a period of time, and, tax payers and workers make investments in value creating capabilities that enable businesses to innovate without a guarantee of a return. Empowering the individuals within this process can be indispensable to innovation’s success. Therefore, to ensure that adequate efforts towards value creation are propelled, fair rewards for workers and investors are essential and can contribute to the long-term success of any business. Therefore, there is a need to create a set of social norms that regulate the relationship between value creation and excessive and predatory value extraction while encouraging participation in the economy to invest productive resources, and efforts, into the value creating process.

Written by Narottama Bowden


[1] Polanyi, M. (1958). Personal Knowledge: Towards a Post-Critical Philosophy, Chicago: University of Chicago Press.

[2] Williamson, O.E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press; Williamson, O.E. (1989). “Transaction cost economics”, pp. 135-182 in Schmalensee, R. and Willig, R.D. (eds.),

Handbook of Industrial Organization, Elsevier Science Publishers B.V.

[3] Leibenstein, H. (1966). “Allocative efficiency and X-efficiency”, American Economic Review, Vol. 56: No. 3: pp. 392-415; Leibenstein, H. (1978). “X-inefficiency Xists – reply to an Xorcist”, American Economic Review, Vol. 68, No. 1: pp. 203-211.

[4] Stigler, G. (1976). “The Xistence of x-efficiency”, American Economic Review, Vol. 66, No. 1: pp.213-216.

[5] Aoki, M. (1990). “Toward an economic model of the Japanese firm”, Journal of Economic Literature, Vol. 28, No. 1: pp. 1-27.

[6] Shapiro, C. & Stiglitz, J.E. (1984). “Equilibrium unemployment as a worker discipline device”,

American Economic Review, Vol. 74, No. 3: pp. 433-444.

[7] Olson, M. (1965). The Logic of Collective Action; Public Goods and the Theory of Groups, Cambridge, MA: Harvard University Press

[8] Nash, J. (1951). “Non-Cooperative Games”, The Annals of Mathematics, Vol. 54, No. 2: pp. 286-295

[9] Baumol, W. (1982). “Contestable markets: an uprising in the theory of industry structure”, American

Economic Review, Vol. 72, No.1: pp. 1-15.

[10]Jensen, M.C. & Meckling, W.H. (1976). “Theory of the firm: Managerial behavior, agency costs and ownership structure”, Journal of Financial Economics, Vol. 3, No. 4: pp. 305-360.

[11] Coase, R. (1937). “The Nature of the Firm”, Econometrica, Vol. 4, No. 16: pp. 386-405

[12] Alchian, A.A. & Demsetz, H. (1972). “Production, Information Costs, and Economic Organization”, American Economic Review, Vol. 62, No. 5: pp. 777-795.

[13] Bowles. S. (1985). “The production process in a competitive economy: Walrasian, Neo-Hobbesian,

and Marxian models”, American Economic Review, Vol. 75, No. 1: pp. 16-36.

[14] Lazonick, W. & Mazzucato, M. (2012). “The Risk-Reward Nexus; Innovation, Finance and Inclusive Growth”, A Policy Network Discussion Paper, Available at: http://www.policy-network.net/publications/4295/The-Risk-Reward-Nexus    Accessed on: 28/08/2014