Companies such as those at Abu Dhabi's Khalifa Industrial Zone, and around the world, exist in order to ensure efficient markets but they shouldn't get too big. Courtesy Abu Dhabi Ports Company
Companies such as those at Abu Dhabi's Khalifa Industrial Zone, and around the world, exist in order to ensure efficient markets but they shouldn't get too big. Courtesy Abu Dhabi Ports Company

Why the firm underpins a modern economy



Markets versus firms

The whole point of free market capitalism is that actions are directed by market prices and that this in turn ensures an efficient economy. But consider this: when a business firm instructs an employee to transfer from one department to another the employee is not obeying market prices, he transfers because he is told to. This is not free market capitalism. So why does it happen?

This question was asked by the British economist Ronald Coase who won the Nobel prize in economics in 1991 based on his research on the matter. I first read about this fascinating idea in last week's The Economist magazine. I found it fascinating, not least because it gave me some insights into the perennial question of whether large state owned enterprises (SOEs) and government related entities (GREs) should exist, at least at their current sizes, in an efficient economy. Here I am talking simply about the economics and efficiency of the market and not about any other policy matters. These ideas are based on Mr Coase's work but do not necessarily reflect his thinking.

The idea of an efficient market was introduced by Adam Smith, the Scottish philosopher considered to be the father of modern economics. Smith used the phrase “invisible hand” to describe the theory that if each consumer is allowed to buy whatever they want and each producer is allowed to sell whatever they want then this would result in an optimal allocation of resources and setting of prices that would benefit the economy as a whole. This optimality is what is now known as Pareto optimal, ie any reallocation of resources that makes one market participant better off would necessarily make at least one other participant worse off.

From this definition we see that for each consumer to buy what they want and each producer to sell what they want it would imply that each person works as an individual contractor and that they would contract with other market participants whenever they needed a good or service. This leads to Mr Coase’s question: why, then, do firms exist?

His answer is that firms exist when there are high costs to using the market. For example, in many countries it is legal and common for taxi drivers to be self-employed. The quality of the service is clear before a client gets in the car, indeed most markets require standardised cars. The fares are standardised and clear, visible on a meter. Client acquisition is simple, drive around until someone hails you. There might be benefits from collective bargaining, say on insurance, but there is no reason to believe that if there are enough self-employed taxi drivers then there won’t be competition amongst insurers to provide for this client segment. The costs of using this market are therefore low.

But what happens if we remove standardisation? At its most basic level, what happens if instead of employing people full time we employ them for specific jobs? If you’ve ever had to hire a consultant, individual or firm, you will understand the concept of the scope of work which outlines in detail what is required from the contractor. This has to be developed and negotiated on a case by case basis. There is also a listing of legal rights and responsibilities, with remedies and indemnification if anyone’s rights are breached. This also has to be negotiated on a case by case basis.

These costs would simply take up all of a person’s time. They would not be able to actually do productive work. This is why employment contracts do not specify in full detail all of these points, it would be exhausting to renegotiate every time an employee’s job changes. This is where markets fail, when there is no standardisation or there is uncertainty. An employment contract has to therefore be relatively vague if it is to be efficient and both employee and employer have to trust the contract. This is why a firm exists, to regulate non market compliant but nevertheless efficient transactions.

Consider a large endowment, fictional for this exercise. This endowment is managed by a sophisticated investment office (IO) and overseen by a board of trustees (BoT). The IO has previously submitted a plan to the BoT which was to develop a multi-strategy multi-asset class portfolio via allocations to investment managers (IMs) globally. Over the years the portfolio has done well, but the IO realises that they are paying away large amounts of fees, often 2 per cent of assets and 20 per cent of profits. These are high transaction costs. So why not expand the firm to internalise the investment managers and therefore reduce these high transaction costs?

The IO submits a plan to the BoT, who approve, and the IO starts to hire in IM teams to directly invest in the global markets. As the years pass, the performance of the portfolio starts to deteriorate. There are more and more internal portfolio blowups. What is happening?

Well, although the firm can reduce transaction costs, remember that it is the market that imposes efficiency. When an IM is external, they have to compete with other IMs for allocation. This incentivises them to keep innovating and to remain efficient. Once the IMs are internalised then they no longer have an incentive to innovate, the money is locked in. So the portfolio performance deteriorates. Perhaps one way to motivate the internal IMs is to pay them 2/20 again. It invariably always happens.

The more frightening issue is why are there portfolio blowups in which large amounts of money are lost in a short amount of time. An internal audit and review highlights something that was completely missed by the IO’s plan: governance. When the IMs where external then the IO acted in a governance capacity, performing regular due diligence on the IMs and holding them accountable. In addition, other investors are performing due diligence on the external IMs so there is an even higher probability of negative issues being highlighted.

When the IMs are internalised the IO becomes the IM. The IO attempted to create a risk function, but you know how it is. The IMs kept complaining that the risk function is holding them back. You see, the chief executive does not control the investment portfolio, the chief investment officer (CIO) does. I should know, I’ve been CIO three times in my life.

The BoT, who are supposed to only be responsible for the corporate governance of the IO, are now also responsible for the investment governance since the IO forgot that its responsibility was to protect the portfolio and not enrich themselves.

Thankfully this is an account of a completely fictional endowment.

The lesson here is that as the size of a firm increases, its transaction costs increase but its innovation and efficiency decrease. There is a happy equilibrium at some point. For an economy of our size, I’d be guessing wildly if I said that this equilibrium is probably well south of US$10 billion for a directly managed balance sheet, although the amounts managed externally can be unlimited.

Importantly, a firm should either be a manager of managers or a single, direct operator. The corporate governance and risk management can otherwise be weakened, severely.

Vidaamuyarchi

Director: Magizh Thirumeni

Stars: Ajith Kumar, Arjun Sarja, Trisha Krishnan, Regina Cassandra

Rating: 4/5

 

Company%20profile
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Hales' batting career

Tests 11; Runs 573; 100s 0; 50s 5; Avg 27.38; Best 94

ODIs 58; Runs 1,957; 100s 5; 50s 11; Avg 36.24; Best 171

T20s 52; Runs 1,456; 100s 1; 50s 7; Avg 31.65; Best 116 not out

If you go
Where to stay: Courtyard by Marriott Titusville Kennedy Space Centre has unparalleled views of the Indian River. Alligators can be spotted from hotel room balconies, as can several rocket launch sites. The hotel also boasts cool space-themed decor.

When to go: Florida is best experienced during the winter months, from November to May, before the humidity kicks in.

How to get there: Emirates currently flies from Dubai to Orlando five times a week.
Cryopreservation: A timeline
  1. Keyhole surgery under general anaesthetic
  2. Ovarian tissue surgically removed
  3. Tissue processed in a high-tech facility
  4. Tissue re-implanted at a time of the patient’s choosing
  5. Full hormone production regained within 4-6 months
Game Changer

Director: Shankar 

Stars: Ram Charan, Kiara Advani, Anjali, S J Suryah, Jayaram

Rating: 2/5

if you go
MATCH INFO

Manchester United 1 (Fernandes pen 2') Tottenham Hotspur 6 (Ndombele 4', Son 7' & 37' Kane (30' & pen 79, Aurier 51')

Man of the match Son Heung-min (Tottenham)

How to protect yourself when air quality drops

Install an air filter in your home.

Close your windows and turn on the AC.

Shower or bath after being outside.

Wear a face mask.

Stay indoors when conditions are particularly poor.

If driving, turn your engine off when stationary.

COMPANY PROFILE
Name: HyperSpace
 
Started: 2020
 
Founders: Alexander Heller, Rama Allen and Desi Gonzalez
 
Based: Dubai, UAE
 
Sector: Entertainment 
 
Number of staff: 210 
 
Investment raised: $75 million from investors including Galaxy Interactive, Riyadh Season, Sega Ventures and Apis Venture Partners
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The biog

Place of birth: Kalba

Family: Mother of eight children and has 10 grandchildren

Favourite traditional dish: Al Harees, a slow cooked porridge-like dish made from boiled cracked or coarsely ground wheat mixed with meat or chicken

Favourite book: My early life by Sheikh Dr Sultan bin Muhammad Al Qasimi, the Ruler of Sharjah

Favourite quote: By Sheikh Zayed, the UAE's Founding Father, “Those who have no past will have no present or future.”

PROFILE OF STARZPLAY

Date started: 2014

Founders: Maaz Sheikh, Danny Bates

Based: Dubai, UAE

Sector: Entertainment/Streaming Video On Demand

Number of employees: 125

Investors/Investment amount: $125 million. Major investors include Starz/Lionsgate, State Street, SEQ and Delta Partners

'HIJRAH%3A%20IN%20THE%20FOOTSTEPS%20OF%20THE%20PROPHET'
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Match info

Premier League

Manchester United 2 (Martial 30', Lingard 69')
Arsenal 2 (Mustafi 26', Rojo 68' OG)

THE SPECS

Engine: 6.75-litre twin-turbocharged V12 petrol engine 

Power: 420kW

Torque: 780Nm

Transmission: 8-speed automatic

Price: From Dh1,350,000

On sale: Available for preorder now