Theories of the Firm: What They are Good For and What They are Really Bad At
Posted: 9 Oct 2019
Date Written: September 30, 2019
In spite of the growing awareness of the unsustainability of business as usual, discussion has tended to concentrate on the theme of corporate social responsibility (CSR) or more modern variations of that concept, drawing on stakeholder theoretical contributions juxtaposed to shareholder (primacy) theories. This paper takes a different approach, interrogating the theoretical roots of corporate governance and its influence on corporate law debates, identifying two fundamental flaws: significant theories have not kept up with the development of real-life business, and these still dominant theories present significant barriers to securing the contribution of business to sustainability.
Throughout the history of the corporation, we have very broadly speaking had two significant streams of theories: economic theories of the firm, which have tended to be concentrated on the corporation, and legal theories of the corporation. Influence has shifted, and although there is not a clear-cut distinction between economic and legal theories, we can determine that the economic theories have gained dominance since the 1970s and still have a pervasive influence. This paper accordingly concentrates on the economic theories, and canvasses and analyses the most influential of these theories.
Throughout the analysis, the two main and interlinked questions of the paper are firstly, to what extent does the theory explain the corporation? Secondly, to what extent is the theory useful in understanding the relationship between the corporation and society, including whether, to what extent and how the corporation should be regulated?
After the introduction, Section 2 sets out the backdrop for the analysis: what the corporation is today, i.e. its role in the complex and opaque systems of business, and the significance of the corporation for humanity’s possibility of meeting the grand challenge of our time, of securing the social foundation for humanity now and in the future within planetary boundaries.
Section 3 begins with a brief overview of the dominant theories underpinning corporate governance (with knock-on effects also on the basis for policy-making in corporate and securities law), before turning to the analysis. While recognizing the contribution of the selected theories to understanding some aspects of business and finance, the section identifies problematic aspects of these theories. The analysis concentrates on the mainstream version of principal-agent theory as a case in point, based on the interconnection of agency theory with other influential theories.
Section 4 summarises and concludes with reflections on the elements that a more comprehensive and systemic, and thereby more adequate, theory should encompass.
Keywords: law and economics, agency theory, efficient market hypothesis, market for corporate control, nexus of contracts, corporate governance, shareholder primacy, sustainability, planetary boundaries, social foundation
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