Extending the Pragmatic Theory of the Firm with Social Norms

Abstract

Recent research and public debates suggest that the economic theory of the firm is incomplete and in need of revision. For example, the theory fails to address fundamental issues of value creation and how that value creation is reflected in the financial statements and market price of the firm. Further, it has led to endless public debates regarding the purpose of the corporation, shareholder capitalism versus stakeholder capitalism, and whether corporations need to sacrifice their profit-making obligation to investors to serve the wider needs of society and the environment. We argue that these debates are due to the lack of a holistic, comprehensive theory of the firm. This paper addresses this weakness of current theory by describing the pragmatic theory of the firm (PTF) and showing how it can be extended by incorporating social norms. We begin by summarizing the potential benefits from a theory of the firm and the development of the economic theory of the firm in finance and accounting. This summary highlights the resistance of neoclassical economists to useful extensions of their economic theory and how that resistance reduced its usefulness. Next, we explain how the PTF provides important intuition by modeling the firm as a value-creating system and making explicit the connection between the firm’s life-cycle financial performance and its market valuation. Importantly, the theory positions maximizing shareholder value not as the firm’s purpose, but as the result of a firm successfully achieving its value-creating purpose. The rest of the paper describes how incorporating social norms increases the ability of the theory to explain value creation (and destruction) in the firm given the new economy. We conclude that social norms are not only essential for the effective management of the firm, they are also needed to achieve the value-creating purpose of the firm to the benefit of capitalist society.

Keywords: Theory of the Firm, Value Creation, Social Norms, Capitalism, Purpose of the Firm