Firms have a history almost as long as human civilisation.
Sole traders, acting on their own behalf, and agents (people acting on behalf of traders) have been recorded since civilisation began. Roman law accepted legally-defined associations between two or more owners: societa, which were partnerships with unlimited liability, and commenda, partnerships with limited liability.
It took another 1,000 years for a different form of business organisation to emerge in Europe. In the 13th century, the English crown granted exclusive trading charters to regulated companies. The first was named the Merchants of Staple, which specialised in wool exports. It is argued that the modern company was born in 1561 in the form of a firm chartered by the king of France to trade in Africa. Queen Elizabeth I of England granted a royal charter that set up a company with exclusive rights to trade with Russia. The charter allowed the company to structure itself on a joint stock basis. This called for its ownership to be divided among several investors and the appointment of professional managers. That innovation was followed by a slaving corporation, licensed by Genoa in 1580; the English East India Company in 1599 and the Dutch East India Company in 1602. The shared characteristic of these three entities was that they had permanent existence, rather than a temporary one for the purposes of a single journey or mission. The East India Company allowed its shares to be transferred and for divisions of its profits, later to be name dividends, to be paid to shareholders. As was discussed in the previous capital, these documents are among the earliest forms of intangible capital.
The most dynamic corporations of the modern era originated in the US. The first significant industrial company, The Boston Manufacturing Company, was formed in 1813 by Thomas Lowell to manufacture cotton textiles. American companies grew to unprecedented size after the end of the Civil War in 1865. In 1882, the Standard Oil Trust was created to centralise the petroleum businesses. General Electric (GE), still America’s largest manufacturing firm, was formed in 1892. US Steel, the first American company worth more than $1 billion, was created by merging smaller steel companies in 1901. The Ford Motor Company was established in 1903. The rise of the giant corporation inspired the development of business education. In 1908, the Harvard Graduate School of Business Administration launched the first Masters of Business Administration (MBA) programme. The banking industry, despite recent setbacks, is still dominated by huge joint stock corporations. Similar developments have taken place in other advanced economies. With rare exceptions, corporations dominate tangible and intangible production in most advanced economies.
Neoclassical economists tend to view this trend benignly. Corporations exist because they have mastered the art of coping with the market-clearing price. They have grown big for the same reason. Some economists have declared the business corporation to be the unimprovable product of the market-clearing price system and both natural and good. One of its most enthusiastic supporters was Ludwig Von Mises. Here is an example of the terms that he applied to big corporations in a stinging repudiation of those that criticised them.
“Against all this fanatical propaganda there is need to emphasize again and again the truth that it is big business that brought about the unprecedented improvement of the masses’ standard of living. Luxury goods for a comparatively small number of well-to-do can be produced by small-size enterprises. But the fundamental principle of capitalism is to produce for the satisfaction of the wants of the many. The same people who are employed by the big corporations are the main consumers of the goods turned out. If you look around in the household of an average American wage-earner, you will see for whom the wheels of the machines are turning. It is big business that makes all the achievements of modern technology accessible to the common man. Everybody is benefited by the high productivity of big scale production.
It is silly to speak of the ‘power’ of big business. The very mark of capitalism is that supreme power in all economic matters is vested in the consumers. All big enterprises grew from modest beginnings into bigness because the patronage of the consumers made them grow. It would be impossible for small or medium-size firms to turn out those products which no present-day American would like to do without. The bigger a corporation is, the more does it depend on the consumers’ readiness to buy its wares. It was the wishes – or, as some say, the folly – of the consumers that drove the automobile industry into the production of ever bigger cars and force it today to manufacture smaller cars. Chain stores and department stores are under the necessity to adjust their operations daily anew to the satisfaction of the changing wants of their customers. The fundamental law of the market is: the customer is always right.
A man who criticizes the conduct of business affairs and pretends to know better methods for the provision of the consumers is just an idle babbler. If he thinks that his own designs are better, why does he not try them himself? There are in this country always capitalists in search of a profitable investment of their funds who are ready to provide the capital required for any reasonable innovations. The public is always eager to buy what is better or cheaper or better and cheaper. What counts in the market are not fantastic reveries, but doing. It was not talking that made the ‘tycoons’ rich, but service to the customers.“
The Economic Foundations of Freedom, by Ludwig Von Mises, published in The Freeman, April 1960
With some qualifications, and a lot less hyperbole, most academic economists would probably agree with the main points Von Mises made more than 50 years ago. Firms exist because they must be doing efficiently something useful.
Monopolies and oligopolies
The first challenge came from those that argued that the free market doesn’t work optimally and that, even if it did, its results were sub-optimal. This debate became particularly resonant with the rise of large-scale manufacturing. Were the giant corporations created by Andrew Carnegie1, John Pierpoint Morgan2 and John D Rockefeller3 natural and efficient or were they artificial and malign? Did their profit-seeking activities lead to higher production and welfare or the opposite? Were they monopolies and, in effect, conspiracies involving the wealthy few against the interests of the many?
Economists have for centuries been critical of monopolies. One of the definitive characteristics of classical economics was its rejection of the exclusive trade charters granted by the state that are associated with mercantilist thought. Adam Smith denounced business people that conspired to control production and raise prices. David Ricardo’s model, which showed profits falling and rents rising, was based on the idea that the limited supply of cultivatable land was monopolised by a particular class; the landlord. Karl Marx argued that the concentration of capital was an inevitable product of capitalists’ desire to increase profits. It was essentially malign, but necessary for economic and social progress.
Early neoclassical theoreticians were more relaxed about the rise of large-scale units of production. Their original model was based on the idea of the existence of multiple suppliers and buyers where no one buyer or seller was capable of exercising a monopoly over a particular market over more than the short-term. Buyers always have alternatives and suppliers will compete to secure the purchasing power of buyers. The market-clearing price was all that was needed to ensure the outcome of was both efficient and fair.
Alfred Marshall distilled the idea that the market-clearing price was socially and technically efficient. Nevertheless, he turned his mind to the fact that monopolies existed in the real world in Economic Principles. He examined the situation where an industry was subject to declining long-turn average costs. This meant that a single producer would be able to make goods on average more cheaply than many producers. The theory showed that a profit-seeking monopoly would restrict production and consequently drive prices above the natural, market-clearing level. The theory of monopoly was the first coherently-presented explanation of why monopolies might occur and why their behaviour would be sub-optimal.
In the real world, pure monopolies are, however, rare. This shifted attention to the possibility that a small number of producers could collude and, effectively, behave in aggregate like a monopoly by raising prices above and depressing below the optimal level. Further theories were developed to cover instances where there was a single buyer (monopsony) or small number of buyers. Economics classifies them as theories of imperfect or monopolistic competition4.
The consensus was that monopolies and oligopolies, although potentially natural in theory, were technically and socially-inefficient. This theoretical work is the inspiration behind the existence of regulatory bodies in most advanced economies that act to control prices in industries deemed to be natural monopolies since they enjoy falling long-run average costs. Theories of monopoly and imperfect competition also laid the foundations for state ownership. Critics of monopolies and oligopolies argued that they were inefficient and the source of inequality and exploitation. Some concluded that only the state representing the interests of the community as a whole was able to address the problem and this could be done most effectively by taking monopolies and oligopolies into public ownership. The profit-maximising compulsion of private owners would be displaced and industries would be run solely in the national interest5.
Here was a clear example of a situation where conventional microeconomic logic showed that the “true” market-clearing price wouldn’t emerge naturally. The argument was neat but incomplete. The first criticism of the theory of monopoly is that it’s almost impossible for a single producer to secure 100 per cent of a market. Even if that were possible within a single economy, the monopoly producer would face competition at home and abroad from producers based in other economies.
A more realistic situation is where a small number of producers dominated markets and industries. Oligopolies, however, face intractable problems over time since they will be obliged constantly to negotiate and renegotiate production-restricting agreements. They also face the challenge of cheating among oligopolists and the philosophical problem named the prisoners’ dilemma. This means that a group that sticks together will be better off in aggregate than one that doesn’t. But the incentives for individual parties to break an agreement are strong and can be overwhelming. These observations have laid the foundations for the emergence of game theory as a way of explaining the behaviour of oligopolies in the real world. A rich and expanding body of theory has developed which increasingly influences competition policy in advanced economies.
The idea that the state should run industries enjoying declining long-run average costs has also been subject to the criticism that managers free from the improving influence of price completion are no more likely to deliver an optimal solution than private owners. Managers and employees of state-owned monopolies can become lazy and fail to innovate. The state itself is not a neutral agency and is subject to the self-serving behaviour of ministers, politicians and civil servants. The certainties inspired by the original theories of monopoly and imperfect competition have consequently given way to an appreciation that the real world does not correspond to the theories developed by economists. It is now accepted that a pure monopoly never exists in reality, that oligopolies are unsustainable and that situations where industries benefit from falling long-run average costs are best managed by independent regulators rather than through state ownership and control.
The permissive attitude that has developed towards industrial concentration has been supported by developments in all tangible industries in the past 100 years and the rise of corporations making intangibles. The decline and, in some instances, the disappearance of giant manufacturing industries are cited as evidence that monopolies and oligopolies are more apparent and real. Even if a single producer, or a group of producers, can control the production of a particular good, it’s impossible to prevent the emergence of new ways of producing the same good or for technology to make that good redundant. The IT industry is a prime example of the process. Forty years ago, the computing industry was dominated by IBM, which manufactured large systems based on mainframe computers. Its position was undercut by producers of desktop computers. They in turn lost out to makers of laptops which are now being challenged by makers of tablets and mobile devices. The balance of power in the industry has shifted away from manufacturers of equipment to developers of software. Monopolies or quasi-monopolies have developed in IT, but they haven’t lasted.
Contemporary economic theory therefore argues that the key factor determining whether a monopoly or an oligopoly can exist is the extent to which new producers and suppliers can enter a market. The barriers to entry in a specific market, and not the scale and dominance of existing producers, are the critical issue. These barriers can take many forms and can include technology, government regulations and market size. But their single most compelling expression is price. If a new entrant can sustainably undercut the price of an incumbent – whether it’s a monopoly, monopolistic or oligopolistic – it should prevail.
The theory of monopoly and imperfect competition, nevertheless, continues to form a core part of popular economics text books. Economics by Lipsey & Chrystal devotes two chapters and more than 40 pages to monopoly and imperfect competition. It encompasses important theoretical developments including the idea that monopolies and oligopolies are able to extract exceptional profits through a process named price discrimination. This depicts a monopolist/oligopolist pricing sales on an individual basis rather than setting a single price. It expresses itself in multiple ways. Airlines, probably the most sophisticated price discriminators, can sometimes charge each passenger in a single flight a different fare. This involves a transfer of wealth from buyers to sellers, but is it in principle a bad thing?
The consensus among economists is that the capacity to discriminate among consumers is not necessarily evidence of a monopoly or an oligopoly and can in fact be both technically and socially-efficient. An airline that can ask more from wealthier customers is, in effect, subsidising the less wealthy. Price discrimination invariably involves a transfer, but it can promote the production of goods and services that otherwise might not be made by raising average margins and returns.
The concept of price discrimination also highlights the power of consumer choice and preferences, even in circumstances where a single producer is technically optimal. The profit-seeking single supplier will have an incentive to differentiate buyers to take into account their preferences and capacity to pay. The market-price therefore provides an incentive for a producer to increase outputs towards the level that would have occurred in perfect competition. The distributional implications might invite additional taxation, but that’s outside the scope of what most economists would consider to be their proper domain. From a technical point of view, a price-discrimination monopolist or oligopolist would be doing nothing more damaging than the market-clearing price delivers.
The journey the theory of the firm has made is fascinating and is continuing. The new models that have been developed provide the intellectual underpinnings for management education and training and are manifested in the structure and conduct of practically every significant corporation. But can these models be sustained in economies were services are dominant? This question will now be addressed.
The firm in the intangible era
The firm is probably the most distinctive institutional expression of the idea of the market-clearing price. Its capacity to survive and grow depends upon its ability to monitor and master the mass of price signals emerging from the dynamic interaction among buyers and suppliers in the markets for the inputs it uses and the goods it produced. The theory of the market-clearing price suggests that most of the information available to participants in those markets, including about likely future trends, is expressed in prices8.
But can the firm continue to master economies where relationships – the location of value-creation in service economies – are detaching from the process: the tangibles and the embodied technology that make value-creation possible? Will a single organisation be able effectively to develop and retain the competences necessary for effective relationships as well as the skills needed to produce and maintain processes? And will they be able to compete with companies that focus on just one of the two skills?
To address these questions, we shall again start by examining conventional theory. There are four main theories of the firm: basic neoclassical, transaction cost, managerial/behavioural and evolutionary. They will be briefly outlined and their relevance to the theory of value creation in services will then be investigated.
Basic neoclassical economic theory conceptualises the firm as an entity, motivated by the objective of maximising profits, which develops as a rational response to the challenge of producing goods and addressing the preferences of consumers. It assumes employees and owners of firms have complete information, including about all input and output prices. The theory perceives firms as being derived from aggregate demand and supply and a response to the resulting price signals. Critics of basic neoclassical theory say that this is no explanation of why a firm exists and what it does, and that it presents the firm as a “black box”.
Transaction cost theories emerged following a conceptual breakthrough by Ronald Coase, a British economist who was awarded the Nobel Memorial Prize for Economics in 1991. In a short paper published in 1937, Coase argued that firms exist to avoid transaction costs associated with dealing with the market: uncertainty, price discovery, and price negotiations, particularly involving employees7. Without a firm, all its internal relationships would have to be individually negotiated and renegotiated. Logically, a firm exists because it’s cheaper and easier for everyone to accept an overarching institutional arrangement.
“We may sum up…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 Nature of the Firm, by Ronald Coase, Section II.
Published in Economica in November 1937
Although apparently breaching the neoclassical ideal of markets being shaped by the choices of individuals as consumers and producers, the theory of the firm defined by Coase is in fact its logical derivative and product of the idea of the market-clearing price.
Managerial and behavioural theorists argue that firms exist and grow principally because of the actions of managers and employees as individuals or in groups who seek to maximise their own satisfaction rather than profit or returns to shareholders. This approach has been refined into principal-agent analysis which argues that shareholders (the principals) can only have an imperfect understanding of the activities of a company’s managers (the agents). This approach has been used to explain the behaviour of the management of banks before the 2007/08 financial crisis. An extension of the idea is that a firm’s behaviour is partly driven by internal conflicts – for example between the finance team which want to keep costs down and the marketing team that wants growth. A firm’s decisions are therefore the result of a compromise among and between the individuals and groups within a firm.
The fourth main theory views the firm as an organism, a living thing that responds to a multitude of factors, including uncertainty about the future. Human knowledge is a critical factor and is deemed to be somehow embedded in a semi-permanent form in a firms’ structure.
To what extent do these four theories address the issues that have emerged as a result of the rise of services in the global economy? Basic neoclassical microeconomic theory makes two assumptions. The first is that a firm is a single unit. The second is that it is profit-maximising. Profit is simply defined: it is the difference between total revenue and total costs. Revenue and costs are derivatives of price. Securing the right or best price for inputs and output is, therefore, a primary motive for firms in basic economic theory. Whether they use or produce intangibles is of no consequence for the theory.
Conventional economics textbooks, nevertheless, generally refer to firms that produce tangibles. Chapter 6 of Economics by Richard Lipsey and Alec Chrystal refers to a situation where the output occurs as homogenous units of output. This is a characteristic that can only be manifested by tangibles: cars, shoes, books etc. The conventional theory of the firm shows that choice made by firms about inputs and outputs depend upon tangibility, as the theory of consumer choice explored in Chapter 2 shows. As was explained in that chapter, the capacity to make those choices is undermined by intangibility and becomes impossible when output is wholly intangible. The law of diminishing returns, which is discussed on page 121-2 of economics, suffers the same fate the as concept of diminishing marginal returns when it is applied coherently to intangibles. In short, neoclassical and transaction theories of the firm, like conventional theories of consumer choice, founder and fail when applied to a situation where the firms’ inputs and outputs are intangible.
Managerial and behavioural theories, which focus attention on the “satisficing” behaviour of managers and their relationship with employees and customers, express an alternative insight. But the firm in these models remains driven by the profit-motive since a firm and its managers can only exist if what is earned is greater than what is spent. Price is not the sole determinant of company behaviour but it remains the most important factor governing its behaviour.
The idea of the company as an organism, which is the inspiration for evolutionary theories of the firm, constitutes a radical break with previous thinking which either, like neoclassical theory, viewed the firm as a machine with a mysterious internal mechanism, or as one owned and managed by human beings, whose behaviour could not always be explained by science. For the evolutionary theorist, human knowledge is embedded in the firm. The workings of the minds of those that manage and work for it are therefore inextricably connected with its structure. This approach opens up economic theory to ideas derived from biology, anthropology and, even, the study of non-human primates and other species. The idea of competition over scarce resources which prioritises the role of the individual firm as a consumer and producer consequently can give ground to insights derived from the fact that firms are capable of collaboration and predation.
Evolutionary theories deliver compelling insights. Why some firms survive and others become extinct can be explained in the same way as the rise and fall of dinosaurs. No single factor is at work. Firms are driven by many including parenting and inheritance, environment and the impact of more successful competitors. The ability to compete for scarce resources remains the most important characteristic of firms that survive and flourish, but not the only one. The supremacy of price, the market’s way of expressing scarcity, appears to lose its dominant role.
The deficiencies of this approach are similar to those that emerge from over-interpreting the evolutionary compulsion in nature and the application of vulgar Darwinism to contemporary human society. Firms that exist today can be seen not only to be natural but also inevitable. They might be improvable, but innovation will come as a result of necessity rather than reflection. Destructive conflict in the short-term may be bad, but essential over time.
A more serious issue is whether the firm is an organism at all. Isn’t it just be the combination of the people that create value through constructive interaction with colleagues and customers and the tangibles and processes they use? It may be useful to perceive the firm to be like a cockroach with a decentralised nervous system that allows it to function even when its head’s removed. But the foundations for such a line of argument are intellectually and ethically deficient. It is absurd to regard the association of people working with machines and equipment as an organism, even if it behaves as if it were one. And it is wrong to conclude that humanity’s essence can be permanently embedded in a non-human entity.
The main weakness of the evolutionary theory of the firm, however, is that it obscures the source of value creation. Evolutionary theories of the firm rightly reject the idea that a firm is a mechanistic combination of material and processes. But the critical role of constructive human interaction – logically deduced from the theoretical exploration of value-creation in services presented in previous chapters – is simply not addressed.
All four main theories of the firm, therefore, founder when applied to intangibles. A new theory of the firm is required that can more effectively address the implications of the theory of value creation in services this book expresses.
Towards a theory of a firm that produces intangibles
As the account of how value is created in intangibles shows, two factors of production are used to produce services.
The first is the relationship, which encompasses the value-creating activities of individuals interacting with each other in intuitively defined communities. The second is the process, which comprises the supporting tangibles and human activity needed for the operation and maintenance of those processes that can be automated.
A successful service firm will, therefore, need two characteristics. The first is the capacity to create an environment which maximises the value created by its employees as they interact with customers. The requisite corporate structure is one that allows employees a high degree of autonomy and has a permeable frontier between employees and customers.
The second, in contrast, is the capacity to measure, monitor and manage the output of supporting machines and buildings and the people needed to operate and maintain them. The effective operation and maintenance of a hospital can’t be left to chance or the spontaneous behaviour of the people who work in it or use it. Information about the performance of its structure and equipment will have to be captured and processed to allow managers, the representatives of the hospital’s owners, to control electricity and water use and maintain the levels of hygiene that patients require. The performance of those wholly or essentially involved with operating and maintaining the hospital’s buildings and equipment also requires similar management.
The theoretically-ideal service firm will therefore have two master two competences. One liberates – and allows maximum subjective discretion – to its value-creating employees. The other is the capacity to measure, monitor and control the processes. The question must, therefore, be asked. Can a single organisation or group of people master such contrasting skills sets?
The transaction theory of the firm helps provide an answer. Firms exist because of their capacity efficiently to capture and process information about prices. This is then used by managers to decide whether a particular activity should be internalised or contracted out. That requires a company constantly to monitor the price of internal resources and how they compare with the market prices for the same resources; the price of externally-purchased inputs including finance, and the price of the goods and services they supply to the market. Companies also need the capacity to monitor and capture information about the relative cost of the finance used in production and whether an expansion should be financed through internally-generated resources or by going to the market for equity or debt or both.
This theory of the firm, however, founders when it’s applied to the purchase and production of intangibles. As has been argued, constructive interaction involving employees and customers is the sole source of intangible value and price fails to capture effectively information about the value these relationships create. Managers relying on price and opportunity cost data will always be misled and are likely consistently to make bad decisions when it comes to value-creation in services.
Effective decision-making about buying and selling intangibles require managers to engage with each transaction in order to evaluate the value it creates and facilitate the maximisation of value-creation. In most firms, this would involve managers double-checking every detail of every interaction an employee has with a customer as well as every interaction among employees. But even if that were feasible, there would be subjective differences between the managers of a single firm about the value created in intra-company and company-customer interactions. Managers they will have to recognise that they themselves are a potential source of value-creation (or value-destruction) in interactions with their teams and with their customers.
To illustrate the challenge, let us consider how a hypothetical business producing tangibles makes an investment decision. Imagine it is a company that manufactures hair care products. It will track trends in demand for its products using qualitative and quantitative research. The qualitative research involves a specialist firm setting up interviews with people about their shampoo choices. They will be asked questions about their attitudes to the product, how they use them and the alternatives they reject and why. A more difficult challenge is discovering why people don’t buy a particular shampoo. Often it’s out of simple lack of knowledge or disinterest; any old shampoo will do.
The main objective of the qualitative research is to classify what was previously an undifferentiated mass of buyers into targetable groups defined by, for example, gender, age and income. Once the qualitative findings have been compiled, quantitative research can begin. Hundreds, even thousands, of present and potential customers, categorised according to types identified in the qualitative research, are asked specific and answerable questions. How often do you wash your hair? How many bottles of shampoo do you buy and so on? The findings are summarised into a report that is presented to chief executive who will then devise a business plan to support investment in production capacity. This might require new machinery or even a new factory for which finance will need to be secured from internal or external sources. The investment is done, the product launched and the results carefully measured. If the prior research has been done well, the chances of success will increase.
Most firms producing tangibles interact with their indirectly. They normally work through one or more intermediaries. For shampoo makers, there are the wholesalers that buy production from the factory and the retailers. Many tangibles are produced at great distances from their final markets. It’s a constant struggle to keep in touch with attitudes and feelings among final consumers.
A similar sequence of actions occur in production. Information about the volume and cost of inputs is digitally-captured and processed to facilitate senior management’s tactical and strategic decision-making. The result is that senior managers can sometimes been seen as pilots in an aircraft studying dashboards with digital displays showing speed, height, air-speed, engine performance and the host of other performance characteristics of a journey by air. Throughout industry, and particularly in tangible production, key performance indicators (KPIs), digitalised expressions of production and sales, have become a universal language.
That is why tangible good manufactures require permanent, centralised bureaucracies to measure markets and monitor production. They use information about expected future prices of what they are making to mobilise long-term finance from individuals and institutions in the form of equity and loans from banks, which in turn have prices. The consequence is that most tangible era firms were dominated by the finance function. Those who headed finance departments always had a seat on the board of directors. Finance directors often became chief executives. Most chief executives have at least some form of evidence of competence in the finance field. An MBA, essentially a qualification in corporate finance, is now regarded as essential for anyone aspiring to senior management positions. The vital role of the finance function has increased with the application of advanced IT systems designed to capture and analyse information about corporate performance. The ability of senior management to understand the operations of businesses generating billions of dollars of revenue in transactions that can be numbered by the million has been made possible by digitalisation which has played to the strengths of managers with an aptitude for, or training in, quantitative methods.
But how can this methodology be applied in the service economy? As The End of the Market argues, there is no such thing as a mass market in service interactions. Each is unique and leads, when repeated, to a value-creating relationship. For a service company, this takes place between an employee and the customer. The full value of the relationship is only realised when trust is established between the parties involved in the interactive relationship. It is shared among the parties to the interaction and only partly expressed by payments, or, the use the language of this book, the exchange of gifts. The potential of the relationship is intuitively obvious to those directly involved in the interaction but cannot be captured in a way that can be converted into digital forms. A detached, third party observer, no matter how skilled, will probably fail to comprehend all the subtleties of an established, value-creating relationship. The process costs supporting a successful value-creating relationship will also reflect the subjective requirements of the parties involved in the relationship.
A further and critical characteristic of relationship activity is that it requires little or no capital since value creation is purely the result of constructive human interaction. Processes, such as equipment and buildings, can be hired rather than owned and paid for out of current income rather than through financed through borrowing. The pure service firm need have no financial obligations of any kind. Any external financial obligations will simply raise the cost of producing the service and add nothing to value-creation. This suggests that the optimal service firm will be employee-owned without debt or equity. Since one of the reasons why firm exists is to monitor markets for finance, the transaction cost validation for the existence of the firm founders when it’s applied to services.
The transaction theory of the firm therefore suggests that owners and managers would retain that part of the business where transaction cost issues are the most pressing. The relationship component of the business, which requires minimal supervision and depends upon the value-creating competencies of employees interacting with colleagues and customers, gains nothing from being part of a transaction-cost based institution managed by managers with process control skills. Logic suggests that a firm motivated by minimising transaction costs would either exit the market that part of the business serves or contract it out.
Managerial and behavioural approaches which pay greater attention to the discretionary behaviour of managers and employees appear to be more applicable to a process-relationship hybrid. It could be the managers are good a managing costs but subjectively prefer to be involved in relationship work. This might be due to the status derived from being associated with creative businesses. For example, an accountant working at the BBC might derive personal satisfaction from being connected with the corporation’s news, documentary and artistic output. He or she might therefore be prepared to accept lower pay than would be available in a pure process firm. A process worker might even enjoy higher pay in a firm where the service component is well-remunerated, as might be the case in, for example, a premiership football club. Whether this arrangement is efficient, however, is open to question. And why should relationship workers accept the transfer of income that such arrangements entail?
The idea that the skills of relationship workers are permanently or semi-permanently embedded in the structure of a firm as evolutionary theories of the firm suggest is false, as the theory of value creation in services demonstrates. Relationship value is exclusively associated with the activities of people. These can depart at any moment for higher pay or other reasons. A firm conforming to the evolutionary model may successfully arrange itself to retain relationship workers. But this is not an organic issue. It’s simply the result of rational management of a firm which recognises where value is created.
The theory of value creation in services therefore raises profound questions about the optimal structure of a firm wholly or largely involved with the production of intangibles, as most large firms in most advanced economies now are. It is unclear in theory and in practice why the process and the relationship should be tackled by a single organisation. The theory of value creation in intangibles suggests that a firm would be more efficient focussing on just one of those two competences. And there is plenty of evidence that suggests that conventional firms shaped by the idea they are producing tangibles will struggle with the challenge of optimally producing intangibles.
The grounds for economists to focus more attention to the implications for the theory and practice of the firm have been laid in this chapter. And the need for a coherent intellectual response is growing more intense. In view of the logical deconstruction of conventional microeconomic theory, economists need to focus attention on the legitimacy, application and implications of the concept of intangibles in general and of intangible capital in particular. Yet, corporations producing intangibles and constructed on intangible capital are taking control of the global economy. And, despite the setbacks they’ve suffered since 2007, banks continue to be their most influential incarnation.
Banking and the service era
Until the summer of 2008, the finance would have been viewed as the location of the most successful service firms. And yet, the largest financial service firms have at their hearts processes that in many ways outstripped those of manufacturing firms.
The biggest banks have networks of branch offices, many looking the same; employ people who operate according to rules and operate digitalised systems for recording information about their customers’ income, spending and saving. Decision-making about lending is invariably governed by processes not relationships. Borrowers are classified generically rather than individually and their borrowing applications processed digitally.
Only a minority of most banks’ activities have the attributes of a true service firm. And only a minority of its customers are regarded as parties to long-term, value-creating relationships. These tend to be the rich, who can be given special treatment for a price, and heavy borrowers, mainly corporations.
The average customer, who deposits money with banks and borrows occasionally, is often seen of little value, contributing fractionally to bank profitability. This encouraged banks to develop new products, such as credit cards and insurance, that would lift the revenue each of their customers generated. For most banks, the process drove the relationship rather than the other way round, which is the key to the long-term success of a pure service firm.
Over the past decade, nevertheless, banks enjoyed very high levels of profitability, evidence, or so it appeared, of their capacity to master process and relationship. This happy view of the banking industry suffered an enormous blow during the financial crisis of 2007/08. A high proportion of its recent earnings is now attributed to misleading accounting methods. Promises to repay housing loans made by many small borrowers were aggregated and iteratively mediated through regional, national and international capital markets. The relationships expressed in the loan agreements that were aggregated, discounted and traded through sub-prime markets proved to be friable and, effectively worthless.
From the perspective being developed by this book, the problem with the banking industry in the past decade has been this. It has tried to treat relationships like a process and make a process a relationship and succeeded in managing neither process nor relationship well. Loans, which are essentially promises or a documented form of relationship, were converted into homogenised and digitalised processes that made no reference to the original relationship. Digitalisation, which is a technical process, was presented as the best way of extracting value from relationships.
The effects were doubly negative:
- Turning loan relationships into processes eliminated the inter-personal obligations necessary to make relationships work.
- Trying to make processes mimic a relationship asked more than digitalised trading systems and techniques of analysing tangible asset classes were designed to do.
It is said that derivatives were at the heart of the crisis. This suggests that there was no human agency at work. But there was. A derivative is an intangible expression of an underlying tangible transaction. For example, I buy a car and, at the moment the transaction is paid, transfer the full price of the car to the seller. That is a tangible transaction.
If I promise to pay for the car in instalments, or later, that is a derivative. It’s an intangible. The promise to pay is only as good as the honesty of the person that made that promise. If I have no intention of paying for the car in full or in part, the promise is largely worthless, no matter how comprehensive the legal documentation may be. A person who with deliberation makes a promise he or she has no intention of keeping is also likely to be the kind of person who is confident they can escape the legal consequences of that broken promise. A further distortion to the transaction is introduced if the person accepting that promise knows that the promise won’t be kept.
This, in a simplified form, was the problem at the heart of the sub-prime crisis. Borrowers – who either had no intention of repaying loans or were unable to recognise that they would be unable to repay the loans – secured credit from banks that knew the borrowers weren’t going to repay or would be unlikely to do so. The borrowers got the money and the banks got a fee. These loans were then aggregated and sold at a discount into a secondary market where buyers took out insurance against default from insurance companies that were outside the regulatory framework covering the behaviour of the banks and markets for aggregated debt instruments. This pattern, although it made sense from a process point of view, conflicted with value-creation at every point.
There was minimal personal interaction, there was no requirement for honesty and interpersonal obligations were stripped from the transaction. On top of that, the fact that the loans were going to be iteratively mediated through the market dealt a further blow to whatever remaining relationship value was embedded in the instruments being traded.
To understand what happened, apply the principles applied in the sub-prime mortgage market to Catholic marriage. One party promises to love and support the other until death. The other partner accepts that obligation and makes a matching one. There is an exchange of gifts in the form of shared wealth and income and a host of services provided one to the other over time. The relationship is also normally legally-binding and claims can be made through the courts to assert rights, as if marriage was a tangible. But the value-creation in marriage depends upon spontaneous and intuitive human interaction driven by a sense of obligation, not law or the threat of punishment, or the promise of tangible rewards.
Now consider what would happen to the underlying transaction – the relationship between two people – if it is turned into a financial derivative. Someone works out the net present value of the tangibles that will be produced and shared in the marriage. He or she then offers to buy the rights to this stream of tangibles. The couple would be instantly tangibly richer. The financier then sells the contract that legally establishes the claim to all the tangibles to be exchanged and shared in the marriage in question to a third party who aggregates it with other such contracts into a single large asset which can be sold on a collateralised marriage obligation (CMO) market, the collateral being the shared marital tangibles.
The rating agencies evaluate the creditworthiness of these contracts, allocating a higher classification to marriages involving people likely to live longer. The CMOs are then traded in regional, local and international markets. At each point, fees are paid and commissions earned.
But these processes are not neutral.
If the parties to the marriage conclude that the promises made are not to someone with whom he or she has a relationship and consequent obligations, the likelihood that those obligations will be discharged will decline. It would involve a complete lack of understanding of human nature and compulsions if it didn’t. In fact, it is unlikely that either party would be prepared to make the promises honestly in the first place. The incentive would be to lie about the promises, sell the CMO and disappear.
Of course, a huge system of regulation and enforcement could be put in place to ensure that the CMO contracts are properly drafted and enforceable. CMO financial advisors would have to pass exams demonstrating their understanding of the nature of marriage. In extremis, the government would be ready and willing to intervene in the CMO market as a buyer of last resort. But wouldn’t it just be simpler and more efficient for people to go back to the original relationship and try to make it work?
This metaphor may appear to be a trivialisation of the sub-prime mortgage crisis. But it has been used to make a serious point. The value of any financial promise is only as good as the commitment of the original parties to discharge the obligations they have accepted.
The value of the loan made to someone to buy a home is not the discounted value of the home in question. It’s the credibility, not the creditworthiness, of the individual or individuals living in that home and taking the loan. The home’s worth nothing if the people living in it aren’t able or willing to pay back what they borrow. Mediation through the market, insurance wraps and the best efforts of rating agencies are pointless without it. If those accepting the financial promise do so in the knowledge that the promise is insincere or impractical, the agreement is also worthless. And as a growing proportion of the output of advanced economies is taking the form of intangibles that only exist in the minds of the parties to a service transaction, and therefore require the honest acceptance and discharge of obligations, this issue is going to become more important for the efficient operation of modern economies.
The response to the shocks of 2008 is yet to be fully formed. What has happened so far is a substantial enhancement to the system of financial regulation which will make it more difficult for individuals to borrow from banks; harder for banks to lend to them anyway and possibly impossible for many types of loan agreements to be aggregated and collectively mediated through secondary markets. This may reduce the riskiness of bank methodologies; the financial industry’s attempt to turn a relationship business into a process. But the price could be a decline in the capacity of people to acquire the processes necessary for their own value-creating relationships: a home that they can regard as their own, for instance.
The analysis in The End of the Market suggests an alternative approach which would involve separating process from relationship in banking. The process – or the industrial-scale capacity to capture information about the patterns of income, spending and saving of hundreds of millions of people – would then be run by process specialists; essentially IT firms with the capacity to run network computer systems efficiently and securely. Such firms could provide a direct interface for their customers to the entire system, rather like Google does for the web. Individuals could then monitor their income, spending and saving, make decisions and directly input instructions into the system. Payments to the process firm would be to finance the necessary improvements in the security and efficiency of the system. Some of the costs might be defrayed, or even covered, by selling advertising, as Google does. Since the system would establish no relationship with the individuals using it, there would be a greatly reduced need for regulation. It is possible, therefore, to conclude that the processes in the financial system could be remodeled as a single, on-line IT network.
The financial process could then support many financial advisory firms that would form value-creating relationships with people wanting to lend or borrow money. Their task would be to give impartial, long-term advice to help their customers achieve their goals. Acting on such advice, individuals would directly enter information into the computerised bank network which would involve making deposits, investing in various forms of digitalised financial instruments or acquiring digital debts. The financial advisory firms, employing value-creating relationship specialists, would charge fees in instalments to customers based on the perceived long-term value of their relationship; an exchange of gifts in another form.
Regulation of the financial advisory system would be relatively uncomplicated. Any financial advisor would have to pass regular tests of competence and honesty. No financial advisor would be allowed to act as an agent for a financial process firm. They would compete with each other freely. It is probable that individual financial advisors would group together to service specific target communities, charging fees according to the nature of the relationships established and the value created.
Corporate finance would require a different structure. Corporate advisory firms would function like personal financial advisors; living off fees from providing advice to customers. They would also not be allowed to act as an agent for financial process firms. This reconceptualisation of the financial service industries to separate process from relationship might eventually lead to the elimination of separate securities markets. Buying and selling shares through computers programmed to deliver the lowest cost service to customers could be incorporated into the larger financial process network using the same principles.
The idea of a single, centralised process supporting many relationship service providers could be applied to other parts of the economy. Electricity generation for instance already operates along similar lines. Several connected power generating firms would seek to make profit by operating their systems as efficiently as possible. They would then supply a regional or national electricity transmission scheme that would also prioritise cost reductions. Switching through substations to provide power that can be sold to companies would probably benefit from competition to get costs down.
Finally, service providers with no tangible assets – companies dealing directly with households and companies – would generate value by developing solutions that delivered value to final users. This might involve advice in energy-saving, the adoption of new technologies and through phasing consumption. Like the financial system, the national power industry could be reconceptualised as a process which focuses on converting energy into electricity as efficiently as possible and delivering it as cheaply as possible to relationship businesses interacting with customers to help them use energy efficiently in return for payment, or the exchange of gifts.
Readers are invited to use the process relationship model to reconceptualise their own industry and their own firms.
This would not be the end of the company, however. It should be a new beginning.
One of the peculiarities of companies is their brevity. Most close or are taken over within a decade of being created. Only handfuls have survived more than a human generation. None are more than two centuries old. But those that can master the art of operating in the service era, however challenging that might be to the conventional wisdom of tangible era business thinking, may live indefinitely. For companies in the service era, longevity demands that they learn how to recognise the new value-creating communities that technology is helping to sustain. That requires intuitive competences at the level of the individual employee, not the capacity to capture digital data in increasing volumes.
This is a challenge for the state as well, as the following chapter will explain.
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Notes to Chapter 6
1 Andrew Carnegie (1835-1919) was born in Scotland and migrated with his family to Pennsylvania in 1848. His initial fortune was made in the railway industry before and during the American Civil War. Carnegie was one of the first investors in the Pennsylvanian oil industry in 1864. After the war, Carnegie concentrated on iron and steel manufacture, helping make Pittsburgh the centre of the new industry. In 1901, he sold his interests in steel to John Pierpoint Morgan. They were integrated into US Steel, the first company with a market capitalisation of more than $1bn. In retirement, Carnegie concentrated on philanthropy and established charitable agencies that exist to this day. Carnegie’s reputation is based on his use of modern management methods and new technology to increase production and efficiency.
2 John Pierpoint Morgan (1837-1913) was born in Hartford Connecticut. He started work in the London Branch of his father’s investment banking firm in 1857. Morgan returned to the US the following year and continued working in banking. JP Morgan & Company was established in 1893. Morgan was a dominant figure in US finance until his death. His bank, now named JP Morgan, is now the world’s America’s largest investment bank.
3 John D Rockefeller (1839-1937) was born in New York state. His first job aged 16 involved working as an accounts clerk in an agricultural commodity firm. In 1863, Rockefeller co-financed the construction of a rudimentary refinery in Cleveland, Ohio to serve the booming Pennsylvania oil industry. He took control of the refinery in 1865 and used it as the basis for the construction of national oil production and transportation business. Standard Oil of Ohio was formed in 1870. The Standard Oil Trust was created in 1882. The subject of critical press coverage and vilified by populists, Standard Oil was divided into multiple units under the 1890 Sherman Anti-Trust Act. The descendants of these units include Exxon and Chevron.
4 The most complete distillation of imperfect and monopolistic competition can be found in Theory of Monopolistic Competition by Edward Chamberlin (1933) and Economics of Imperfect Competition by Joan Robinson (1933).
5 The idea that the state is better at running some businesses has a long pedigree but it attained special significance in the First World War when governments in combatant nations took control of economies to maximise the production of goods needed for the conflict. It was accepted by practically all of them that robust government intervention was required for effective reconstruction after the war. Further government intervention developed following the start of the Great Depression in 1929 and it expressed itself in different ways in the Soviet Union, Nazi Germany and Fascist Italy. Government again took a leading role in reconstruction in Europe and Japan after 1945.
6 The Efficient Market Hypothesis (EMH) emerged from studies of financial markets. In its initial form, it was known as the random walk theory which argued that stock market prices adjusted suddenly as new information emerged and was acted on by market participants. The conclusion was that investors that tried to beat the market by using forecasting models were likely to fail. The EMH was developed by Eugene Fama at the University of Chicago Booth School of Business as in the early 1960s. Fama was joint winner of the 2013 Nobel Memorial Prize in the Economic Sciences. The theory has been heavily criticised by empiricists who argue that stock market prices can reflect forecastable factors. Investors and researchers have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral economists argue that stock market trends reflect overconfidence, the impact of crowd behaviour and other human errors that can be identified and adjusted to. The EMH is consequently out of favour and is normally now presented in a weak, semi-strong and strong-form.
7 Ronald Coase (1910-2013) was born in London and graduated from the London School of Economics in 1932. A comprehensive summary of the development of transaction cost theories of the firm can be found in Transaction Cost Economics: The Natural Progression, the Nobel Memorial Prize in Economic Sciences acceptance speech delivered by Oliver Williamson (1932-) in Stockholm on 8 December 2009. A professor at the University of California Los Angeles, Williamson was a student of Coase.
8 More information about the history of the firm can be found in Corporation or Limited Liability Company, Charles Hickson & John Turner, contained in The Encyclopedia of World Trade since 1450, published in 2005.