Review of Cowen (2019)

Note: This is the first of several blog posts reviewing Tyler Cowen’s book “Big Business: A Love Letter to an American Anti-Hero” (Picador, 2019).

Since Tyler Cowen has written a contrarian defense of big business, let’s begin my extended review of Professor Cowen’s excellent book in contrarian fashion as well. Let’s begin with the short appendix at the end of the book (pp. 207-211). Why am I starting at the end of the book? Because it was my favorite part of the entire book! Why was it my favorite part? Because Cowen addresses an important theoretical and practical question there: What is a business firm?

Believe it or not, economists still don’t have a good working definition of business firms! As Professor Cowen explains in his appendix, one popular theory in economics is that business firms exist in order to reduce “transaction costs,” i.e. the costs of carrying out a decision. Put in the simplest terms, every commercial activity can be carried out in one of two ways: “make” or “buy.” That is, when a business firm needs something, it can either make that something in house, or it can purchase it from an external supplier. Both of these methods are expensive to carry out, so firms will generally choose that method that is more efficient or cheaper …

Professor Cowen, however, calls bullshit on the transaction cost theory of the firm (p. 208): “Ask yourself a simple question. Let’s say you want to buy a work computer for your desk. Which method involves lower transaction costs: going online with Amazon … or trying to get an order for a new computer through your company’s purchasing department?” By way of example, I teach at a large southeastern university. Before the pandemic, I would travel frequently to attend academic conferences to present my research projects, but getting reimbursed for my travel expenses was an administrative quagmire of Napoleonic proportions. It was such a hassle that I completely gave up trying to get reimbursed for attending conferences and the like. If firms were really about reducing transactions costs, my home institution would find a way of making it easier for me to get reimbursed for my travel expenses, right?

So, in place of the transaction cost theory, Professor Cowen offers an alternative and more realistic theory of business firms. Specifically, he defines business firms in reputational and legal terms. Here, I will focus on the legal liability side of business firms, or in Cowen’s own words, a business firm is “a carrier of contractual and legal responsibility” (p. 210). As a business law professor, Cowen’s definition is music to my ears. Corporations (and now LLCs) exist, first and foremost, to shield their owners from legal liability. Yes, courts may pierce the corporate veil under certain conditions, but the general rule is that it is the corporate entity (not the owners of the entity) that is legally liable for the acts and omissions of the corporation’s officers, employees, and agents.

But, aside from my own personal background in business law, why is Professor Cowen’s legal-centric definition of business firms superior to the transaction cost theory? First off, because both market transactions (“buy”) and in house transactions (“make”) both involve transaction costs, and it is not always obvious which type of activity involves lower transaction costs. But, more importantly, because a firm is supposed to be legally accountable for the actions taken on its behalf. As the late great Thomas Schelling himself pointed out in his classic work on “The Strategy of Conflict,” without this ultimate burden of legal liability, firms would not be able to make credible commitments–either in house or through market transactions. We will proceed to Chapter 1 of “Big Business” in my next blog post …

PPT - Game Theory PowerPoint Presentation, free download - ID:6413799

Image credit: Lance Bruce

About F. E. Guerra-Pujol

When I’m not blogging, I am a business law professor at the University of Central Florida.
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