On the occasion of the 100th birthday of Ronald Coase (actually, December 29th–and he’s alive and more than kicking, about to publish a new book early next year, How China Became Capitalist), the Economist has published Why Do Firms Exist?, which opens wonderfully with:
FOR philosophers the great existential question is: “Why is there something rather than nothing?” For management theorists the more mundane equivalent is: “Why do firms exist? Why isn’t everything done by the market?”
This is essentially the question Coase was among the first to pose, and to which he gave the most insightful, and still compelling, answer. Alas, Adam Smith was merely the first of many to not even ask the question:
Classical economics had little to say about this question. Adam Smith opened “The Wealth of Nations” with a wonderful description of the division of labour in a pin factory, but he said nothing about the bosses who hired the pin-makers or the managers who organised them. Smith’s successors said even less, either ignoring the pin factory entirely or treating it as a tedious black box. They preferred to focus on the sea rather than the islands.
The man who restored the pin factory to its rightful place at the heart of economic theory celebrates his 100th birthday on December 29th. The economics profession was slow to recognise Ronald Coase’s genius. He first expounded his thinking about the firm in a lecture in Dundee in 1932, when he was just 21 years old. Nobody much listened. He published “The Nature of the Firm” five years later. It went largely unread.
Now, we’ve written about Coase before here on Adam Smith, Esq.–both on his Nature of the Firm and on his equally original and paradigm-shifting The Problem of Social Cost–but it’s worth a quick revisit to the first in light of all the gallons of ink being spilled over outsourcing. Here’s the core of his theory:
His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.
As applied to law firm land, we see this play out every single day, don’t we? Boutiques spin off from BigLaw citing difficulties over conflicts and billing rates. US and UK firms merge in an attempt to gain global scale. (Sorry, I shouldn’t have said “merge;” at least not if they use the au courant Swiss verein structure.) And, yes, firms all up and down the food chain start outsourcing certain work in a serious way.
And actually that’s something that Coase anticipated: The balance between which activities should be inside, and which outside, a firm is constantly subject to refinement, adjustment, and if I may use a potentially treacherous analogy, might be thought of as lungs contracting and expanding. The evolving boundaries of the firm are, by their nature, growing and shrinking as technology (particularly telecommunications) advances. It’s what they do in the same sense that lungs breathe.
Lately a school of thought often referred to as “neo-Coasian” has arisen to challenge the comprehensiveness of Coase’s insights. Personally, I think the moniker “neo-Coasian” is overcooked. What these new thinkers have to offer is not to my mind a critique of Coase, but a supplement.
But Mr Coase’s narrow focus on transaction costs nevertheless provides only a partial explanation of the power of firms. The rise of the neo-Coasian school of economists has led to a fierce backlash among management theorists who champion the “resource-based theory” of the firm. They argue that activities are conducted within firms not only because markets fail, but also because firms succeed: they can marshal a wide range of resources–particularly nebulous ones such as “corporate culture” and “collective knowledge”–that markets cannot access. Companies can organise production and create knowledge in unique ways. They can also make long-term bets on innovations that will redefine markets rather than merely satisfy demand. Mr Coase’s theory of “market failure” needs to be complemented by a theory of “organisational advantages”.
In other words, there are both positive and negative reasons why firms’ boundaries fall where they do. One of the resources inhibiting the indefinite expansion of firms–or rather, a resource whose scarcity inhibits that expansion–is management talent.
This brings me to the question: Just how good is management at law firms?
Adopting the heroic assumption that such a broad question can even be posed or answered in a meaningful way, I think the common wisdom is that law firm management is subpar, at least compared with enterprises of comparable scope and sophistication in the general-business sphere. But should we be so quick to accede to this indictment?
Alex Novarese, editor of LegalWeek, wrote about six months ago that “management at law firms is better than many assume,” and posited these reasons for his opinion:
- Many of the failings of general-business management (to which Alex has had ample exposure in nearly 15 years as a business journalist) can be laid at the doorstep of the separation of ownership and control. This is of course not the reality for law firm partners with managerial roles.
- At least when it comes to lawyers (and not non-legal staff), law firms devote an inordinate, and arguably justified, level of resources towards acquiring the best talent. In a professional service firm, this has to be correct.
That’s the good news. Here’s the bad:
- When it does come to “non-legal staff” (an insulting and crabbed formulation in itself), we do not remotely place the value on them that we should, which means that we:
- Select from an insular and often poor talent pool (“I see that you haven’t worked for a law firm before…..”);
- Aren’t willing to pay them what they’re worth on the free market;
- Tend to ignore or downplay or second-guess their advice once they’re on-board.
- Our focus on continually honing and improving our existing model has many virtues, but one great vice: Genuinely new or ground-breaking initiatives arrive shouldering a tremendous burden of proof against them.
So where does this leave us?
The limiting constraint on the size to which law firms can grow, and the variety of activities they can house within their tent, is probably senior management talent.
Nothing else that we might need is in such short–constrained–supply. Legal talent is available; certainly at the entry level, it’s very much a buyer’s market today. Lateral partners can be hired, wisely or imprudently, but a disciplined, long-run, balanced-portfolio approach to hiring laterals would go far to countering the chasing-the-stars mentality.
Professional staff, at a caliber we’re not used to hiring, is also widely available (and the firms that get serious about hiring truly professional-caliber staff, across the board, will steal a serious march on the competition).
Finally, back to Coase: He pointed out the role of transactions costs in defining the boundaries of a firm. The “neo-Coasians” have added to his insight the specific benefits and strengths of being inside a firm. The challenge of the next decade, as the dueling centrifugal forces of outsourcing (lower transactions costs) and the centripetal forces of greater access to talent and capital (the Legal Services Act), play themselves out, will be to find the talented individuals who can envision and lead these global enterprises.
