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Theories of the Firm

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Theories of the Firm
To understand firm heterogeneity within industries and its relations to competitive advantage, reviewing some of the most influential theories of the firm is important.

Starting with Coase (1937), academic research in economics and management has nurtured a long tradition of trying to unveil the “essence of the firm.” Some scholars believe that discovering the true nature of the firm permits understanding real- world firms.
Whether things or concepts have “essences” is questionable. From a practical standpoint, finding this essence is not essential, but having a practical definition of the firm may be needed. A good “theory of the firm” is one that helps managers identify and choose the best projects among all feasible ones. It must also provide a definition of “best.”
A brief review of three theories of the firm follows. The first theory views the firm as a nexus of contracts. Most valuation and project selection frameworks implicitly assume this view. The second one views the firm as an efficient solution to the problem of economizing on transaction costs. Such a view is particularly useful for understanding acquisitions and divestitures, especially in those cases involving vertical integration or outsourcing decisions. The third theory views the firm as the locus of crucial resources. This view is particularly helpful for understanding corporate strategy and value creation.
The Firm as a Nexus of Contracts
Some argue that the firm is nothing more than a nexus of contracts. Under this view, most stakeholders such as employees, bondholders, and suppliers are thought to be protected by bilateral contracts with the firms’ equity holders. Equity holders own the firm in the sense that they have residual cash flow rights: After all stakeholders are paid according to their contracts, equity holders are entitled to the residual profits...

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