Theories of the firm arise from the motivations of their developers. They initially define a firm in a way that is compatible with their objectives and their worldview. This chapter shows how theories of the firm evolved in the disciplines of economics, finance, and management. In addition, this review places the pragmatic theory of the firm in historical context, highlights the main differences separating the pragmatic theory from alternative theories, and provides an initial assessment of its usefulness.

THE NUCLEUS OF THE PRAGMATIC THEORY OF THE FIRM

Any theory of the firm involves an answer to this question: What is a firm? The pragmatic theory defines a firm as a dynamic system of coordinated activities that evolves as management and employees build knowledge in order to efficiently create value for customers, and that knowledge-building proficiency, relative to competitors, determines a firm's life cycle and the extent of rewards to its stakeholders over time.

How should the usefulness of the pragmatic theory of the firm be gauged versus other theories of the firm? Six metrics can help.

1. Clarity about the firm's purpose. Any theory about the functioning of a firm needs to be clear about how the purpose of the firm provides guidelines for creating value for all of the firm's stakeholders. As the above quote by Bill George, former CEO of Medtronic, emphasizes, a firm's purpose is its bedrock foundation.
2. Source of competitive advantage. The pragmatic theory specifies that the source of long-term competitive advantage (disadvantage) is a firm's knowledge-building proficiency being greater (less) than competitors. This stake in the ground can help management prioritize performance improvement projects. How often do we hear that capability X is the key to a firm's competitive advantage? But, shouldn't the question of interest be: What is the source for improving capability X over time? And the answer circles back to a firm's knowledge-building proficiency.
3. Understanding the firm's market valuation. A strong suit of the pragmatic theory is how it connects a firm's core activities (e.g., work, innovation, and resource allocation) to its publicly traded market value (estimated for privately held firms). Currently, important issues tend to be analyzed without treating the firm as a dynamic, holistic system. For example, academic finance has a theory of asset pricing—the Capital Asset Pricing Model (CAPM) and its variations, which tie together risk and return. This equilibrium theory of asset pricing has been applied in accounting, management, and economic research because heretofore theories of the firm were incomplete due to ignoring key variables concerned with the market valuation of firms. However, the pragmatic theory of the firm provides new angles of thinking about important finance/management issues such as risk, cost of capital, intangible assets, competitive advantage, firm performance, resource allocation, and valuation. For many, this will be a transition that agrees with their business intuition by avoiding the constraint of firm risk being synonymous with the extent of co-movement (Beta) of a firm's stock price with the general market regardless of a firm's ability to be a viable competitor in an increasingly tough global business environment. The pragmatic theory leads to testable hypotheses about firm performance and shareholder returns (see Chapter 5).
4. Source of improved operating performance. The pragmatic theory predicts that performance of managerial tasks (e.g., strategy formulation, new product development, quality control, etc.) will improve as managers gain mastery in traversing the knowledge-building loop that is described in Chapter 2.
5. Source of improved managerial decisions. Management is well served by constructive skepticism as to what they think they know. The pragmatic theory views knowledge building as the foundation for value creation.
6. Analysis of firms. Not only managements, boards, and investors, but also academic researchers and business students can benefit from studying firms' long-term track records guided by the pragmatic theory of the firm. This promotes the study of value creation through deep understanding of the histories of firms, including a comprehension of what drives a firm's stock price over the long term—an especially important readout of long-term value creation. Moreover, economists tend to measure how value is created in a society via macroeconomic variables and industry analyses. The pragmatic theory of the firm equips economists (and their students) with a useful framework for evaluating the locus of value creation at the individual firm level, a highly beneficial microanalysis supplement.

The pragmatic theory of the firm addresses both the actual operations of a firm and a variety of practical needs for those relying on a theory of the firm—hence the label pragmatic. The next section presents a historical synopsis of how thinking about the theory of the firm has evolved. Keep in mind that theories have been tailor-made for certain academic disciplines and specific purposes and are not easily applied across disciplines. In contrast, the pragmatic theory of the firm should be useful across economics, finance, management, and other disciplines because it provides insights regarding each of the above six metrics.³

THE EVOLUTION OF THINKING ABOUT THE THEORY OF THE FIRM

If a theory of the firm is to be widely useful, it necessarily must deal with how a firm is managed. One of the earliest statements clearly acknowledging this need is found in an 1886 speech, “The Engineer as an Economist,” presented to the American Society of Mechanical Engineers by Henry R. Towne, cofounder of the Yale Lock Manufacturing Company.

There are many good mechanical engineers—there are also many good businessmen—but the two are rarely combined in one person. But this combination of qualities, together with at least some skill as an accountant, either in one person or more, is essential to the successful management of industrial works, and has its highest effectiveness if united in one person, who is thus qualified to supervise, either personally or through assistants, the operations of all departments of a business, and to subordinate each to the harmonious development of the whole [i.e., systems thinking].⁴

In 1911, Fredrick Taylor published Principles of Scientific Management, which focused in the extreme on quantitative measurement to develop “the one best way” to accomplish specific tasks. In short, management should develop the required knowledge and then command employees to follow the prescribed routines. Taylor's worldview did not embrace win-win partnerships that continually developed employees' problem-solving skills while simultaneously increasing job satisfaction.

Meanwhile, the economist Alfred Marshall's book, Principles of Economics, first published in 1890 and revised in eight subsequent editions, became the dominant economic textbook for decades. Marshall cemented the use of supply-and-demand curves, marginal cost, elasticity, and many other important concepts tied together as a system of partial equilibrium. His book became the foundation for neoclassical economics which is the guiding light for mainstream economics taught to students today.

Neoclassical economics exerts a heavy hand in how a theory of the firm is configured in economics textbooks. Market prices are a function of supply and demand, and given perfect competition, will generate an equilibrium in which resources are efficiently allocated. In this stylized world, a firm transforms labor and capital inputs by way of its production cost function to yield outputs. Equilibrium is attained and profit maximized when marginal cost equals marginal revenue. In a world of complete information and perfect competition, no excess profits are possible. Oftentimes, the neoclassical definition of the firm is referred to as a “black box” since the firm is a mechanism to maintain mathematical logic of an economic system in equilibrium. Peter Klein summarizes:

In neoclassical economic theory, the firm as such does not exist at all. The “firm” is a production function or production possibilities set, a means of transforming inputs into outputs. Given the available technology, a vector of input prices, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. That is all there is to it.… In short: the firm is a set of cost curves, and the “theory of the firm” is a calculus problem.⁵

The Nobel economist Ronald Coase remarked: “Economists have tended to neglect the main activity of the firm, running a business.”⁶ In his celebrated 1937 journal article, “The Nature of the Firm,” Coase asked a penetrating question: Why do firms exist? He explained that the alternative of individuals engaging in private transactions and employing contracts to duplicate a firm's activities can be excessively costly. Firms exist because they are more efficient at coordinating activities outside of the marketplace and within the boundaries of the firm.⁷ This way of thinking led to the transactions cost theory of the firm with the objective of explaining the different organizational forms for a business.⁸ The property rights approach extended the transaction cost perspective to address issues concerning the rights of control over assets.⁹ The pragmatic theory of the firm is not concerned with deep explanations of why firms exist other than to have the opportunity to earn above-cost-of-capital returns. The pragmatic theory deals with practical issues concerned with managing firms.

In the first edition of Capitalism, Socialism and Democracy published in 1942, the economist Joseph Schumpeter argued that the neoclassical view of economic equilibrium minimizes the role of the entrepreneur. Furthermore, an evolutionary process of continuous innovation and creative destruction offers a more illuminating view of economic progress in a capitalistic society.

As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position.…But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology … competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is … more effective than the other as a bombardment is in comparison with forcing a door.¹⁰

In 1959, Edith Penrose published The Theory of the Growth of the Firm in response to limitations of the neoclassical treatment of the firm. Her objective was to explain a firm's long-term growth. Penrose focused on the services obtainable from a firm's resources and laid the foundation for the resource-based view of the firm, which appeals to those dealing with a firm's strategy.

Richard Cyert and James March coauthored A Behavioral Theory of the Firm in 1963, and they questioned the usefulness of profit maximization and perfect knowledge used in neoclassical economics. They stressed multiple goals (sales, market share, etc.) and satisficing as opposed to maximization, that is, a bounded rationality view of decision-making. Cyert and March were interested in process explanations—actual behavior and learning versus assumed rational behavior—missing from standard economic explanations of firm behavior. Their seminal work continued the development of evolutionary economics, which is reviewed below.

KINDRED SPIRITS FOR THE PRAGMATIC THEORY OF THE FIRM

The pragmatic theory of the firm combines value-creating components (discussed later in this chapter) to comprise a holistic system; focuses on relationships among these components (especially connections to a firm's market valuation); and utilizes a more detailed process for knowledge building by individuals versus other theories of the firm that stress organizational learning. Yet the theory certainly uses ideas that others have advanced in their work. Consider Peter Drucker, often referred to as the man who invented management. It is hard to overstate his impact on management thinking contained in 39 books and countless articles and op-eds. Based on his experience with fascism, and influenced by Schumpeter, Drucker argued that effective and responsible institutions were needed for a functioning society. He noted: “The fact is that in modern society there is no other leadership but managers. If the managers of our major institutions, and especially of business, do not take responsibility for the common good, no one else can or will.”¹¹

Drucker's insightful way of analyzing complex phenomena enabled him to predict emerging trends at an early stage (e.g., Japan's rise as an economic power, the transition to knowledge work, etc.). Drucker was a kindred spirit to the pragmatic theory in two significant ways. First, he believed that profit was not the firm's singular purpose but an essential requirement for a firm to survive and prosper. Second, he emphasized the importance of developing employees' knowledge-building proficiencies and adapting firms' organizational structures to productively utilize these knowledge workers.

Alfred Chandler published Strategy and Structure: Chapters in the History of the American Industrial Enterprise in 1962, which analyzed the long-term histories of large American firms and focused on the evolution of organizational structures to effectively manage expanding businesses. Chandler's 1977 book, The Visible Hand: The Managerial Revolution in American Business, is a historical analysis of the replacement of market mechanisms by firms in coordinating economic activity and allocating resources, in other words, the replacement of Adam Smith's invisible hand of the market with the visible hand of management. These two books showcased the role of managerial decision-making pertaining to strategy and organizational structure while significantly influencing future research.

Chandler's Scale and Scope: The Dynamics of Industrial Capitalism was published in 1990 and analyzed the growth and competitiveness of the major firms in the United States, Britain, and Germany after 1880. The book showed the unique importance in modern times of how firms and markets coevolve. To understand markets, one must understand firms. He made a strong case that managements' strategic and organizational choices over time coupled to proficiency in production and distribution plus overall managerial skill were the key determinants of the industrial development of these three countries. Chandler forcefully put firms on center stage as a dominant source of economic growth—for sure, a kindred spirit with the pragmatic theory of the firm. Chandler had a strong opinion about the firm as the fundamental unit of analysis.

Just as I find the earlier growth of the industrial firm difficult to explain fully in terms of transactions, agency and other information costs, so I find it hard to explain the recent process of expansion and contraction with these same concepts.… I am convinced that the unit of analysis must be the firm, rather than the transactions or contractual relations entered into by the firm. Only by focusing on the firm can microeconomic theory explain why this legal, contracting, transacting entity has been the instrument in capitalist economies for carrying out the processes of production and distribution, for increasing productivity and for propelling economic growth and transformation.¹²

In 1982, Richard Nelson and Sidney Winter coauthored An Evolutionary Theory of Economic Change, which extends Schumpeter's view of continuous innovation and change as the path to progress in modern capitalistic economies. The intrinsic uncertainty of innovation, emphasized in their book, does not comport with the neoclassical assumption that firms “know” how best to maximize profits. Moreover, the wide range of observed performance of firms is consistent with an evolutionary perspective.

An evolutionary perspective on innovation and competition is closely aligned with a firm's competitive life-cycle framework, which is introduced in Chapter 4. Nelson summarizes:

While a successful innovator is able to hold control over its new ways of doing things and reap the returns from the advantage they give it over its competitors for a certain period of time, almost always, aspects of new productive ways of doing things sooner or later become widely known, and the ability of the innovator to hold off its competitors from using that know-how generally is limited. As a result, the whole industry moves ahead over time. Market competition turns out to be an effective vehicle for evolutionary learning.

This is a very different view of what markets do and how they work than articulated in today's standard economic texts. And yet, here too it would appear that many contemporary economists have a view of the advantages of market organization of economic activity, and competition, that is very much in line with the [evolutionary perspective]. It is the theory they espouse when presenting formal economics that ignores this. As we have argued, a major advantage of evolutionary economic theory is that it puts forth an abstract view of economic activity, and the role of markets and competition, that squares with what much of the profession actually believes.¹³ (italics added)

Evolutionary economists view institutions (i.e., the rules of the game) as playing a central role in economic growth and how we got to where we are.¹⁴ Nelson and Winter stress how a firm's effectiveness is tied to routines and organizational learning, which underpin a firm's capabilities. This line of thinking was further developed with the concept of dynamic capabilities (discussed below) that treats the firm as an evolving, dynamic system. The Journal of Evolutionary Economics began in 1991 to showcase interdisciplinary research attuned to disequilibrium and the dynamics of innovation and competition.

The importance of management's strategic decisions led to the resource-based view of the firm that emphasized difficult-to-copy resources presumed to be the source of competitive advantage. These resources include “all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc., controlled by a firm that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness.”¹⁵

A logical step from the resource-based view is to focus on a uniquely important resource—knowledge. Generating, sharing, and utilizing knowledge within the firm is a palpable means to improve the firm's effectiveness and potentially gain competitive advantage if the firm's knowledge process is difficult for others to reproduce. The knowledge-based view and a pragmatic theory of the firm concur that knowledge is the primary resource underlying value creation.¹⁶ Researchers applying a knowledge-based view often select for analysis the group, the business unit, or most frequently the overall firm (similar to the evolutionary perspective); in contrast, a critical component of the pragmatic theory of the firm is the process whereby individuals improve their knowledge base.¹⁷ Robert Grant, an early supporter of the knowledge-based view, agrees with the emphasis on individuals as the foundational unit of analysis for knowledge building.

The emphasis upon the role of the individual as the primary actor in knowledge creation and the principle repository of knowledge, I believe, is essential to piercing the veil of organizational knowledge and clarifying the role of organizations in the creation and application of knowledge.¹⁸

Keep in mind that ways of thinking about the firm tend to focus on how value is created. However, important issues concern how value is distributed. There is a fundamental tension between the owners (principals) of the firm who have delegated decision-making to the managers (agents). Managers have superior information and may be motivated to serve their own personal interests instead, or as an integral part, of meeting the owners' objectives. On the one hand, principal–agent research is concerned with the design of optimal incentive contracts between principals and agents. On the other hand, researchers have been working on a better understanding of financial structure, governance, and shareholder activism. Consistent with these research objectives, the firm is defined as a legal entity serving as a nexus for contracts (formal and informal) between those working for, or interacting with, the firm.¹⁹

With his 1979 article, “How Competitive Forces Shape Strategy,” Michael Porter began a highly influential body of work focused on formulating strategy.²⁰ He popularized the concept of five forces that shape industry competition: rivalry among existing competitors, threat of new entrants, bargaining power of buyers, bargaining power of suppliers, and the threat of substitute products or services. The usefulness of the five forces was due to setting the firm in the context of a specified industry. Stable industries were a hallmark of the Old Economy with its reliance on tangible assets to create value. The New Economy changes the context so that the five forces perspective is less useful as a thinking template. The New Economy with access to global transportation and information flows brings both hypercompetition and expanded collaboration that blurs the boundaries of industries. Intangible assets keyed to knowledge building have come to dominate as a source of competitive advantage.

In our fast-paced New Economy, it is even more imperative to develop an intellectual structure that enables a fundamental understanding of how (and why) firms succeed and fail. To meet this need, the dynamic capabilities theory of the firm has evolved, principally through the work of David Teece. It integrates the work of Penrose, Chandler, and Schumpeter, each interested in the dynamic link between knowledge and innovation.²¹ In a nutshell, this theory ties into the knowledge-building primacy promoted in this book as follows:

Effective organizational learning—a continuous process in most industries—requires dynamic capabilities. These capabilities are activities that can usefully be thought of in three clusters: sensing opportunities (building new knowledge), seizing those opportunities to capture value, and transforming the organization as needed to adapt to the requirements of new business models and the competitive environment.²²

Sensing, seizing, and transforming capture succinctly and comprehensively the critical responsibilities facing top management.

Whereas ordinary capabilities focus on doing things right, dynamic capabilities focus on doing the right things in an uncertain, rapidly changing environment. Dynamic capabilities are built (a learning process), not bought. Through the lens of dynamic capabilities, decision-makers see the firm as a system that poses continual challenges to realign the firm's tangible and intangible assets in hopes of achieving sustained superior performance. This sharply differs from competitive advantage being secured in the Old Economy by leveraging tangible assets which had a long productive life in a relatively stable environment. Both the dynamic capabilities theory of the firm and the pragmatic theory of the firm help explain the performance of firms and offer guideposts for practical decision-making.

In summary, most theories of the firm were constructed to fit specific disciplines and consequently are narrow in scope. In contrast, the pragmatic theory of the firm is broadly based and explicitly connects to firm valuation. It should be useful for those working in economics, finance, management, and accounting. The pragmatic theory treats the firm as a holistic system with a well-defined purpose. Its application should help management and all of the firm's stakeholders better achieve the firm's purpose.

INNOVATION AND ECONOMIC GROWTH

Economic growth is about being better off at the end of a time period compared to the beginning. Consider the early 1900s when transportation in cities was mainly via horse-drawn carriages. People continually inhaled pulverized manure courtesy of the many horses. Would city folks be materially better off with 3% growth in the “capital stock” of horse-drawn carriages? The innovation of the automobile made people decidedly better off versus merely incrementally expanding the existing means for providing transportation with its adverse effects and limitations. Henry Ford's ideas about manufacturing a low-cost automobile became reality through the Ford Motor Company. On one hand, consumer acceptance of the early electric/battery-powered automobiles would have benefited from an especially farsighted perspective of carbon emissions from the internal combustion engine. On the other hand, the cost of Ford's Model T was a fraction of the cost of the electric automobiles in production and enabled a mass market to develop. A multitude of ancillary businesses and large-scale employment gains were spawned from the birth of the automobile industry.

A strong case can be made that the critical role of firms in the innovation process has long been neglected by neoclassical (mainstream) economists primarily because it does not fit into their mathematical models. The issue is not just quibbling about the content of economic textbooks. Rather, one result is that the critical role of firms in economic growth is neglected in economic policy-making.

This section reviews how mainstream economics has dealt with innovation and highlights different perspectives for explaining economic growth. There is a ripe opportunity for a bottom-up, firm-based approach to economic growth. The pragmatic theory of the firm should contribute to that direction.

In the 1950s, Robert Solow noted the importance of technological change that spurs economic growth without adding more labor and capital. Solow's neoclassical growth model did not address the source of technological change. He labeled it as exogenous (i.e., outside of his model). Empirical studies identified the unexplained “residual” component of economic growth as remarkably big, implying that technological change has a genuinely big impact on economic growth.²³ As to technological change, think of the introduction of electricity versus the status quo of increased growth using more candles. In 1990, Paul Romer published a refined model that explained in mathematical terms (necessary in order to convince his peers) how technological change was endogenous, that is, an integral part of how his model generated economic growth.²⁴ In some ways, Romer's approach was a mathematical abstraction of the economic growth theme developed in the evolutionary economics approach.

For Romer, ideas are recipes to rearrange physical things in order to create value. Physical things are finite, but there is an infinite number of recipes to be discovered. Ideas do not suffer from diminishing returns that are characteristic of physical things; for example, over time it costs more to discover the next barrel of oil, to mine the next ton of copper, and so on. He is an optimist about the potential for significant future economic growth.

Romer's new growth theory involves three key principles. First, ideas are treated as goods which are “nonrival,” meaning everyone can use them at the same time. Second, commercialization of ideas can lead to increasing returns, which contravenes the deeply entrenched economic concept of decreasing returns. For example, while initially expensive to produce, copies of Microsoft's operating system for personal computers are almost costless to reproduce. And third, incentives that make ideas partially excludable (e.g., patents) are needed in order for some ideas to be initially produced. In Romer's words:

New growth theorists … start by dividing the world into two fundamentally different types of productive inputs that can be called “ideas” and “things.” Ideas are nonrival goods that could be stored in a bit string. Things are rival goods with mass (or energy). With ideas and things, one can explain how economic growth works. Nonrival ideas can be used to rearrange things, for example, when one follows a recipe and transforms noxious olives into tasty and healthful olive oil. Economic growth arises from the discovery of new recipes and the transformation of things from low to high value configurations … a nonrival idea can be copied and communicated, so its value increases in proportion to the size of the market in which it can be used.²⁵

Romer's insightful work improved the language of growth for economists, although still missing was the explicit role of firms. Consider Richard Nelson's critique of new growth theory.

I would like to propose that the attempt to probe more deeply leads inevitably to three topics that continue to be repressed, or misspecified, in standard growth theory, including the new neoclassical growth models. These are, first, technology as a body of understanding and practice, and the processes involved in mastering and advancing technology. Second, the nature of the organizations, principally business firms, that employ technology and produce output. And, third, the nature and role of a wide variety of economic institutions that establish the environment within which firms operate.²⁶

Many economists and historians have explained the historical sources of growth, providing reasons that ostensibly fit the data and were deemed plausible. Such explanations often undergird forecasts about future growth and policy proposals to boost economic growth. Three recent books summarize the core ideas of recognized leaders in this field.

In the 768 pages of The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War, Robert Gordon, a professor at Northwestern University, takes issue with how various versions of neoclassical growth theory imply “steady state” growth consistent with their mathematical construction. Gordon documents in considerable detail how actual economic growth, measured as the standard of living, began to accelerate after 1870; was very rapid between 1920 and 1970; slowed thereafter although temporarily increasing from 1996 to 2004; and was followed by slower growth to this day. In addition to economic analysis, his book provides significant insights about technology developments and their impact on how people work and live.

Context matters. Gordon emphasizes that the information technology revolution of recent decades pales in comparison to the impact of inventions that powered economic growth from 1870 to 1970, which include electricity, urban sanitation, pharmaceuticals and chemicals, the internal combustion engine, and modern communications. And the magnitude of the improvement brought by these inventions, according to Gordon, will not be repeated (e.g., “hoof and sail” to modern planes, polluting flames to electric lights, etc.).²⁷

In Gordon's analysis, the 1970 to 1995 phase of the information technology revolution replaced mechanical calculators and typewriters with electronic calculators and memory typewriters, brought personal computers with word processing and spreadsheets, and in general enhanced the productivity of business firms. The 1995–2005 phase brought the Internet, search engines, electronic commerce, and broadband advancements. Gordon's point is that these business-firm-oriented productivity gains are about done. His view is that robots and artificial intelligence are evolutionary innovations, not revolutionary on the scale of the great inventions noted earlier. Consequently, he forecasts a continuation of low economic growth in the future.

Joel Mokyr, also a professor at Northwestern University, has a much more optimistic view of future economic growth. His latest book, A Culture of Growth: The Origins of the Modern Economy, explains what ignited the Industrial Revolution and rising living standards after nearly zero economic growth for thousands of years. Mokyr stresses the importance of cultural beliefs among the educated people in Europe between Columbus and the death of Isaac Newton in 1729. Contrary to the past, the new culture was about blending scientific research with practical know-how in order to better humankind. The notion that life should be about making progress was a radical departure from the past. This cultural transition involved breaking the chains of paralyzing reverence for “knowledge” developed in the past (e.g., Aristotle) and taking control of the knowledge-building process.

Although Europe transitioned, China did not with its imperial bureaucracy that maintained a strict allegiance to centuries-old “knowledge.” Because Europe was fragmented, it spurred a competition for ideas between nations (not firms) to develop improved ships, navigation techniques, weaponry, and much more. In Europe, letters and books served as a network for exchanging ideas very quickly. The incentive to compete in knowledge building was the recognition (and opportunity for patronage jobs) accorded pioneers who solved important problems or made scientific discoveries. Mokyr believes that competition between nations, as long as it doesn't result in armed conflicts, is needed to maintain a pro-growth culture.²⁸ He looks at scientific knowledge building as the ultimate source of economic growth.²⁹

Keep in mind that many support Gordon's analysis and also agree with Tyler Cowen's point that the low-hanging fruit of transformative innovation has been picked.³⁰ Mokyr's response is that the scientific process, which includes advancements in tools, continues at a strong pace today and will enable taller ladders to reach higher hanging fruit. Who forecasted that the development of the microscope would lead to the discovery of the germ theory of disease? Who can forecast the discoveries that will follow from today's expanding scientific toolbox (gene editing, nanotechnology, etc.) coupled to Internet-enabled locating and sharing of information?

Edmund Phelps is a Nobel economist who currently directs the Center on Capitalism and Society at Columbia University and is Dean of China's New Huadu business school, which makes sense given the remarkable success of the Chinese translation of his capstone book, Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change. Phelps makes the case that the bedrock foundation that enables nations to prosper is society's embrace of what he terms modern values—desire to create, explore, and meet challenges.

Flourishing is the heart of prospering—engagement, meeting challenges, self-expression, and personal growth.… A person's flourishing comes from the experience of the new: new situations, new problems, new insights, and new ideas to develop and share. Similarly, prosperity on a national scale—mass flourishing—comes from broad involvement of people in the processes of innovation: the conception, development, and spread of new methods and products—indigenous innovation down to the grassroots. This dynamism may be narrowed or weakened by institutions.… But institutions alone cannot create it. Broad dynamism must be fueled by the right values.³¹

Phelps does not deny the benefits of scientific advancements. However, he gives top priority to regaining the modern values that were the hallmark of high-economic-growth times enabling “intellectual growth that comes from actively engaging the world and moral growth that comes from creating and exploring in the face of great uncertainty.” This flourishing goes beyond wages earned and is unfortunately absent from standard economic models.

These models miss indigenous innovation—a nation's home-grown, bottom-up innovating which can pervade the workplace and lead to well-earned satisfaction with the value of one's work. Earned success for employees of firms who may not be R&D superstars but who nonetheless creatively solve problems and seek out opportunities to create value is itself sufficient reward. While scientific discoveries are highly visible and newsworthy, business discoveries (knowledge building) are much less visible and rarely publicized even though they can be more important than scientific discoveries to the process of efficiently delivering high value to customers, says Phelps.³² Indigenous innovation manifested in a nation's workforce directly ties into the overriding importance given to a firm's knowledge-building proficiency in the pragmatic theory of the firm.

In summary, the three books highlighted above show that Gordon, Mokyr, and Phelps take different approaches to better understand the causes of economic growth while not being constrained by the mathematical formalism of mainstream economics. How can we coalesce these insights into something more illuminating and useful for today's economy?

A deep understanding of the role of firms, however, takes a back seat in these books and other major works in economics. This is because the type of research needed differs from how economists typically work; in addition, the analysis of centuries of economic growth includes times when the modern firm did not exist. The economics literature has been concerned with why firms exist and how they are established, but little has been done on the contribution of firms to economic growth. Research about firms in the finance literature has focused on capital structure, governance, and especially, empirical studies about shareholder returns, risk, and market efficiency. Less work has been conducted that connects firm performance to overall economic growth. In the management literature, priority is given to different theories of the firm to serve as a thinking template to analyze the impact of strategy and other managerial levers on firm performance, but once again, little work has been done that connects firms to overall economic growth (i.e., a bottom-up approach to macroeconomics).

This state of affairs is one reason for this book. For example, in Chapter 3 I review three high-impact approaches to improving firm performance that illustrate the process of bottom-up economic growth. One approach, Lean Thinking, originated with Toyota's revolutionary Toyota Production System (a major business discovery) for producing high-quality cars at lower prices while engaging employees in improving their problem-solving skills. Is this not a significant example of the type of dynamism that Phelps says we need? Perhaps the ongoing worldwide adoption of Lean Thinking is an underappreciated boost to future economic growth.

What is needed is an improved language to analyze and discuss firm performance consistent with a bottom-up approach to economic growth. To this end, the pragmatic theory of the firm involves the firm's competitive life cycle and related life-cycle track records for individual firms, which are introduced in Chapter 4. These life-cycle track records facilitate the analysis of firm performance over long time periods, including insights as to how firm performance links to stock prices.

Let's now consider the purpose of the firm.

THE PURPOSE OF THE FIRM

The pragmatic theory of the firm necessarily is rooted in the purpose of the firm. At the present time, the firm's purpose, including its social role and responsibilities, is at the center of a worldwide debate about capitalism. There are no shortages of proposed ways to move forward. This includes the CSR (corporate social responsibility) movement; Michael Porter's shared value concept; conscious capitalism led by John Mackey of Whole Foods; ESG (environmental, social, and governance) scorecards; a corporate commitment to purge short-termism and focus on building long-term value, which is promoted by FCLT (Focusing Capitalism on the Long Term) among others; and the Center for Capitalism and Society at Columbia University, which focuses on fundamental analysis of what determines a country's dynamism.³³ Larry Fink, CEO of BlackRock, the largest worldwide investment management firm, emphasizes the foundational role of a firm's purpose.

Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to investors who depend on it to finance their retirement, home purchases, or higher education.³⁴

For those engaged in the capitalism debate, and in order to improve how capitalism operates worldwide, it is first necessary to gain genuine clarity about the purpose of the firm. Many of those with a background in economics or finance assume that, whether privately held or publicly traded, the firm's purpose is simple and straightforward—maximize shareholder value (long-term profitability). As a pure, conceptual objective, this is sensible. The idea is to avoid investments that dissipate value while directing resources to investments that create value. But, stakeholder proponents contend that a singular purpose to maximize shareholder value will fail to generate commitment and support from the firm's stakeholders and will incentivize management to make decisions that most always shortchange nonshareholder stakeholders.³⁵ Stakeholder proponents say that, in practice, maximizing shareholder value results in an extreme focus by management on quarterly performance to the detriment of building long-term value. But there is a way out of this dilemma.

The four-part purpose detailed below resolves this dilemma and should be acceptable to both proponents of maximizing shareholder value and stakeholder proponents. A key insight is that maximizing shareholder value is best positioned not as the purpose of the firm, but as the result of a firm successfully achieving its purpose.³⁶ The following four mutually reinforcing goals constitute a firm's purpose and should be supported by all the firm's stakeholders, including its most knowledgeable institutional owners.

1. Communicate a vision that can inspire and motivate employees to work for a firm committed to behaving ethically and making the world a better place. The large, diversified firm 3M has a vision of collaborative innovation “advancing every company,” “enhancing every home,” and “improving every life.” Managements of firms that provide commodities and basic services can craft a vision based on the value received by their customers.
2. Survive and prosper through continual gains in efficiency and sustained innovation, which depend upon a firm's knowledge-building proficiency.³⁷ Managements and boards typically embrace a “grow the business” mindset which is suitable for firms in a stage of their life cycle wherein profitability exceeds the cost of capital consumed and genuine value is being created for customers. But this “business-as-usual” mindset causes problems as firms mature and what worked well in the past can easily become out-of-step with a changed environment. Orchestrating feedback about change is key to early adaptation. Otherwise, management eventually is faced with downsizing business units that are uncompetitive at their current size while helping employees who lose their jobs to transition to more viable job opportunities. To be sure, nothing works long term if a firm consistently fails to earn its cost of capital.
3. Work continuously to sustain win-win relationships with all of the firm's stakeholders. The brokerage and financial advisory firm Charles Schwab delivers products and services that “put clients first.” Some of its competitors, as a practical matter, put the generation of sales commissions first. The firm has a well-deserved reputation of management decision-making that gives priority to: “What's this going to look like through the eyes of the customers?” Over the long term, Schwab shareholders have been significantly rewarded.
4. Take care of future generations. What is needed is a genuine commitment by management and the board to ensure the sustainability of the environment. The early stage of the design of products and manufacturing processes should be focused on minimizing waste and pollution. We return full circle to the importance of a firm's knowledge-building proficiency. Smart design can reduce total product costs (and increase profits) while simultaneously reducing harm to the environment.³⁸ In addition, the application of a lean mindset across all of the firm's activities can reduce waste throughout the entire value stream of a product, including raw material procurement and end-of-life recycling. Knowledge-building proficiency tied to the four-part purpose is a viable route to taking care of future generations.

A firm that is successful in achieving its four-part purpose benefits society and the firm's stakeholders. For example, Intuitive Surgical has a vision that people needing medical intervention should recover as quickly and completely as possible. Intuitive Surgical is the global leader in robotic-assisted minimally invasive surgery. As illustrated in Chapter 6, its stock price has significantly appreciated as high profits were earned due to the exceptionally high value delivered to customers (surgeons and their patients). Surely, Intuitive Surgical's scientists, engineers, and other employees have been motivated, not by maximizing shareholder value, but by the opportunity to make the world a better (healthier) place through the products they design and manufacture.³⁹

In summary, the four-part purpose addresses the foundational needs of all stakeholders. It answers the question of why employees should show up for work. It provides a solid base to deal with tough issues that involve not just capital expenditures on R&D or new manufacturing capabilities but decisions to fund new employee health benefits and expand local community programs. Management, in fact, needs a cost-of-capital guidepost to make logically sound decisions even though it can be exceedingly difficult at times to execute. In this manner, the firm and, by extension, society can get the most out of its limited resources.

The firm's purpose underscores that it is a complex system of interrelated components. With complex systems, analysis of a single component isolated from its relationships with other system components will yield insufficient understanding and, at times, lead to decisions that degrade rather than improve performance. Of utmost importance is how a firm's knowledge-building proficiency touches so many of the firm's activities and is intimately tied to the firm's purpose. Consider this summary by Brad Smith, CEO of Intuit, which has a stellar long-term track record of financial performance:

The culture you create lays the foundation that enables every other part of the company to grow and succeed … job one in creating a culture is building a purpose-driven culture.… What is the bigger idea that we are all part of?… At Intuit, our mission is to improve our customers' financial lives so profoundly they can't imagine going back to the old way.… One way leaders can create an action-oriented environment is to match inspiration with rigor, adopting a rapid experimentation culture … [that] cuts through hierarchy (especially if leaders hold their own ideas to the same scrutiny of testing), creating an environment where everyone can innovate, and debate turns into doing.⁴⁰ (italics added)

The above quote captures the spirit of a high-performing firm. Figure 1.1 describes who really benefits from such high performance.

Figure 1.1 illustrates the core economic principle that society benefits from resources allocated to value-creating investments that at least earn the cost of capital. A firm's output, less the costs (including the cost of capital) of all resources used, provides a net benefit (surplus) to society. Meanwhile, a firm generates cash flows that drive its market valuation. So, a successful firm directly benefits both shareholders and society, but not equally.

The⁴¹ societal benefits from Henry Ford manufacturing an affordable automobile surely exceeded the investment returns achieved by the capital owners of Ford Motor Company. Also, consider the new HIV/AIDS drugs that entered the market after the late 1980s. The estimated benefit to the firms that developed these drugs was about 5% of the overall benefit to society from improved patient health.⁴² This is why in Figure 1.1 there are many more dollar signs in the box for societal benefits versus the box for shareholder returns.⁴³

THE PRAGMATIC THEORY OF THE FIRM

As noted earlier, the pragmatic theory of the firm specifies that a firm's knowledge-building proficiency is the fundamental cause of a firm's survival and prosperity as well as a pathway to significant improvements across a firm's typically siloed activities. This theory is about connectedness among the firm's purpose, its major activities, and its long-term overall performance, with particular attention to long-term financial performance.

Employees improve their knowledge-building proficiency with experience in traversing the knowledge-building loop which is explained in Chapter 2. Success in understanding cause and effect reveals faulty or obsolete assumptions and leads to new assumptions whose reliability is then verified. Language matters and employees' knowledge-building proficiency improves with a habitual concern for questioning assumptions underpinning words describing the firm's activities. Attention to language can help guide experiments (similar to Intuit's experimentation culture) having the potential to negate “knowledge” which is now obsolete possibly due to a changed environment.

Figure 1.2 summarizes the key components of the pragmatic theory of the firm. The firm's purpose has been discussed. The remaining components of Figure 1.2 will be reviewed in the chapters to follow.

The pragmatic theory of the firm offers a more insightful template compared to existing theories of the firm. It reflects the following tenets about knowledge building and firm performance:

• The fundamental cause of a firm's long-term performance is its knowledge-building proficiency versus that of its competitors.

  

• Although competitive advantage is typically ascribed to a firm's capabilities, intangible assets, and the like, the source of these advantages is the firm's knowledge-building proficiency.
• A firm's performance—distilled into long-term, life-cycle track records of economic returns and reinvestment rates—offers insights about firm performance helpful to investors and other stakeholders and, in particular, can improve management's resource allocation decisions.
• Job satisfaction and retention of key employees improves as knowledge-building is made an integral part of employees' jobs.
• Innovation, whether in products, processes, or strategy, improves as more employees (including management) are engaged in knowledge-building experiences with the potential to discover faulty assumptions and generate insights.
• Firm risk (see Chapter 4) is best conceptualized as impediments to achieving a firm's purpose.
• Sustained shortfalls in profitability are typically assigned to changes in the external environment. But the real cause is a combination of management's inferior knowledge-building proficiency (lack of effective feedback and failure to question core business assumptions) and reliance on a business-as-usual culture of complacency.
• A comprehensive understanding of a firm's life-cycle performance (e.g., how a firm's economic returns fade over time) yields a conceptual roadmap for handling intangibles (see Chapter 5).
• A pragmatic theory promotes new thinking as to testable hypotheses. A section, “Excess Shareholder Returns and Three Levels of Cause-and-Effect Logic,” in Chapter 5 highlights empirical tests for better linking a firm's performance to shareholder returns.

Since the pragmatic theory of the firm is rooted in a firm's knowledge-building proficiency, the next chapter includes practical insights about one's worldview, perceptions, and language that strongly influence how we build knowledge.