Back to the Drawing Board: Is the Traditional Theory of the Firm Obsolete?

Now that so many companies work across continents in vast webs of partnership, some Wharton scholars are wondering whether the traditional idea of the firm is obsolete.

In the same way physicists have had to struggle with how to fit all those quarks and leptons they have discovered into the traditional idea of the atom, business thinkers are faced today with a need to reconcile the ways in which companies are actually doing business in the 21^st century with the classic idea of the firm.

That might sound like a fairly recondite problem, but professors who are organizing a meeting on the topic at Wharton’s SEI Center for Advanced Studies in Management on September 30 and October 1 insist that it matters. In economics, finance, marketing, operations, and accounting, the theory of the firm plays a central role, and Wharton faculty members are now questioning whether an idea of the firm that traces its lineage all the way back to Adam Smith is still a relevant model today.

Their answer is a resounding no. Like John Maynard Keynes, who once wrote that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” SEI Center director Yoram “Jerry” Wind, a professor of marketing and co-author of The Power of Impossible Thinking, argues that the classic conception of the firm may be preventing academics and executives alike from understanding the true nature of business today. Says Wind: “Our book argued that it is necessary to examine mental models to keep pace with changing realities, and that also applies to the theory of the firm.”

The original theory has had a good run. Its ideas about the firm were mulled first by Adam Smith in the 18^th century, and then more fully spelled out by Alfred Lord Marshall in the late 19^th century and Paul Samuelson of MIT in the 1930s and 1940s.  This traditional framework was further elaborated in the 1960s and 1970s by the Carnegie School, and exemplified in the works of Herbert Simon and Oliver Williamson, who brought important behavioral dimensions to the study of the firm.

A Whole New World
But those were ideas designed for a different world, says Paul Kleindorfer, a professor of operations at Wharton and co-director of the school’s Risk Management and Decision Processes Center. “It’s not surprising that with the changes that we’ve seen in the past decade or so, driven by communications technology and information technology more generally, and the huge changes that China and India have brought about…that there would be in some sense a need to revisit this fundamental building block, the theory of the firm, and to ask whether the old tried-and-true theory had all the necessary bells and whistles in it to deal with the new realities,” he says.

In the old days, most companies made products out of raw materials and then sent those goods on to their customers. “The traditional theory of the firm is about the unitary, rational actor that more or less controls all the pieces of the puzzle that it needs in order to produce its outputs,” says Kleindorfer. But today, he says, global companies like GM or Toyota don’t directly control most of their inputs. “Rather, these organizations are a part of a huge set of interlinked networks across the planet.

“All of that reflects fundamental changes not just in globalization but in the multi-party, diffused ownership of these new value chains,” Kleindorfer says.  “Whether it’s in credit, in logistics, in risk, in operations, in marketing, you name it, this is a different ballgame.” Yet although this is how the world works today, most intermediate economics textbooks still use the old definitions of the firm, according to Kleindorfer. “We haven’t caught up with the fact that the world is a different place now.”

Another participant at the SEI meeting, business theorist Kenichi Ohmae, argues in his forthcoming book, The Global Stage, that the root of the problem is ultimately that today’s most popular economic ideas were formed at a time when most countries’ economies weren’t intimately linked with the outside world.

“Economists specializing in macroeconomics, whether the high priests of economic theory like John Maynard Keynes or Milton Friedman, or their numerous disciples, are marooned in the old world of economics and business behavior,” Ohmae writes. “It is against the background of national economies that their theories have been developed and it is in this arena that they continue to work.”

Wharton professors say that the cracks in the theory have led to challenges for various disciplines. In accounting, for instance, a better theory of the firm might help lead to better ways to measure value. Such measures as customer retention, employee turnover, and environmental success aren’t included in traditional financial accounting, yet they can be essential aspects of a company’s value, and sometimes even serve as leading indicators to firm performance, says David Larcker, a professor of accounting who serves on the SEI Center’s advisory board.

“Eventually everything shows up in earnings and cash flow, but it shows up late,” he says. In accounting, theorists are now trying to find some measures of value, such as customer retention, that can be monitored earlier than the balance sheet, when an understanding would be more useful, according to Larcker – a kind of dashboard that would monitor the most important factors in creating value.

In operations, Kleindorfer sees a vast distance between the traditional theory and current practice. “If you look at the way in which outsourcing has driven the value chain recently, you would see [that the changes have been huge.] Even along a traditional value chain – from incoming logistics and manufacturing to outgoing, outbound logistics, to marketing, sales and after sales support – firms use contracting and strategic partnering rather than direct ownership to manage the value chain.”

In marketing, Wind notes that many of the traditional models and approaches are no longer working very well. Old models of consumer behavior are being increasingly overlooked in board rooms, he says. Turnover is higher among chief marketing officers. Part of the reason: The mass market is vanishing, in favor of customers who are both less loyal and more demanding. At the same time, he says, preconceptions about markets mean that companies today overlook 86% of the world’s population, citing the work of C.K. Prahalad in his new book, The Fortune at the Bottom of the Pyramid.

Wind quotes Jim Stengel, the global chief marketing officer of P&G, who said earlier this year that “Today’s marketing world is broken. I give us a `D’ because our mentalities have not changed. Our work processes have not changed enough. Our measurement has not evolved,” he says.