2.2.1 Rise of the modern firm

The theoretical framework of the underlying study concerns the concepts of corporate governance and the comply or explain principle, both centred around the existence of the firm (see I in figure 2.1a). Various reasons for the existence and definitions of 'firm' or 'company' have been published over the years. Coase defined the term 'firm' as the system of relationships which comes into existence when the direction of resources is dependent on a specific entrepreneur (Coase 1937, p. 40). A number of reasons can be indicated for the existence of such systems of relationships. Markets are not costless in use and each new contract entails marketing costs (also named transaction costs). The people involved in such transactions desire as much certainty as possible. Hence, long-term contracts for the supply of goods or services are desirable. In case of long-term contracts the costs for making several contracts will be avoided and the entrepreneur has less risk: for instance less risk that a supplier will not deliver on time because in doing so he puts his contract at stake. By bringing those contracts into a firm, even more costs will be avoided, less risk is involved and the production process becomes more efficient. A system of relationships with series of long-term and short-term contracts comes into existence. Williamson defined in 1981 the modern corporation as the product of a series of organisational innovations that had the purpose and effect of economising on transaction costs. The costs of those transactions and innovations are dependent on (i) the frequency of those transactions, (ii) as stated above the uncertainty to which the transactions are subject, and (iii) the degree to which those transactions have to be supported by durable transaction-specific investments (Williamson 1981, p. 1537 and 1546).

Alchian and Demsetz state that a firm is more than Coase's series of short-term and long-term contracts within a system of relations (Alchian and Demsetz 1972, p. 784). The production level of the team is also an important motive for starting a firm. Team production creates synergy; two people can do more than one, and even more than one plus one. Nevertheless, this desire for synergy creates a new problem in establishing a firm. The performance of the separate team members is not directly and separately observable, and the observance itself is costly. Because of possible absence or a lack of observance due to high costs, the team members have an incentive to shirk (e.g. more relaxation than allowed) (Alchian and Demsetz 1972, p. 780). Alchian and Demsetz indicate that a method of reducing this shirking is that someone specialises as a monitor to check the input performance of the separate team members (Alchian and Demsetz 1972, p. 781), as will be discussed in more detail below.

As this is a multidisciplinary study, the definition of a firm must also be seen from a judicial point of view and integrated afterwards with the economical view. Before doing so in section 2.2.6, more economical theory needs to be added to come to a comprehensive overview. In section 2.2.2 the development of the earliest limited liability company is described to show that this firm was established for the reasons given above (synergy, security and efficiency) and encountered problems still current today.