8 - FIRMS AND HOUSEHOLDS AS SUBSTITUTES

Summary

Little attention was given to firms and households by economists until the middle part of the twentieth century, even though these institutions have a role to play in the theory of the economic system that emerged toward the end of the discipline's neoclassical period. The firm was not completely neglected, but discussions of it did not mature to the point at which the existence of the firm and its inner organization became important enough to integrate the firm into the theory of the economic system except in a very limited way. My purpose in this essay, however, is not to trace the rise of the firm as a topic of interest to economists but, rather, to discuss the current role of transaction cost in explaining the existence and organization of firms.

The first serious attempt to explain the firm's existence and organization was offered by F. H. Knight in his work Risk, Uncertainty, and Profit (1921), but this emerges as a byproduct of Knight's inquiry into the true source of profit (and loss). Contrary to then-popular views, which identified profit as the reward for risk taking, Knight identified uncertainty as the source. Uncertainty, to Knight, differs from risk. It is the outcome of conditions about which so little is known that there are no data on which to base probabilistic calculations that allow one to calculate risks of the sort against which firms offer insurance.