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.Since the allocation of resources in equilibrium is optimal, any regulatory or otherinterference would lead to inefficiency.Neoclassicism is therefore antithetical tothe regulation of corporate activity by the state or any other regulator in favour ofa laissez-faire approach.64 Perfect competition describes a market where there are a large number of smallfirms who produce an identical (homogenous) product, where there are no entry-barriers fornew competing firms and where all firms face the same costs.65 Alchian, A.(1950) Uncertainty, Evolution and Economic Theory , Journal ofPolitical Economy, vol.58, 211. 22 The Globalization of Corporate GovernanceDespite its undisputed influence, at least until the global financial crisis thatbegan in 2008, in modern economic thinking, neoclassical theory has someobvious flaws.Particularly, the over-abstraction of global rationality, certainty andperfect market assumptions which constitute the basis of the theory.The problemsstem from the fact that the neoclassical theory is based on optimal equilibriumconditions.This means that if its preconditions are relaxed with the introductionof elements of uncertainty or deviations from the perfect market models, thenthe price-theoretic assumptions begin to lose their predictive power and theneoclassical theory its normative significance.While in a utopian world marketscan be perfectly competitive and economic agents (individuals and firms) canmake their decisions having perfect knowledge about all current and potentialeventualities, in reality these conditions cannot be met.As already mentioned, traditional neoclassical theory probably fits bestthe pre-managerial era when markets resembled to a large extent the modelsof competition it assumes.It is in that era that the theoretical consensus aboutneoclassicism arose, after all, despite the fact that even then global rationalitywas far from a real circumstance.66 However, in an economy dominated bymanagerial firms the neoclassical theory loses much of its relevance.The size ofmanagerial firms indicates that markets are imperfectly competitive (oligopolistic)and that Alchian s evolutionary argument cannot apply.In addition, the separationof ownership from control appears to be in odds with the owner-entrepreneurassumption and reveals the gap left by traditional theory s failure to deal with thestructure of the firm.So it is not a coincidence that it was in the 1930s, the heydayof managerial capitalism, that an intense debate arose on whether neoclassicaltheory was satisfactory or a new more realistic approach should be developed todeal with the firm as an organization that differs from markets or individuals.The pioneering attempt to provide theoretical insights into the nature of thefirm as a coordinator of resources was made by Coase.67 In his famous article TheNature of the Firm he sought to explain the firm s nature and existence by lookingat the reasons for intra-firm as opposed to market coordination.68 If as neoclassicaltheory assumes there is no difference between the two, he asked, then why is itthat firm coordination sometimes supersedes price-mechanism coordination in themarket?In order to deal with this question Coase focused on the single exchangetransaction or more simply the contract between two economic agents.69 What he66 Kirzner, I.(1997) How Markets Work: Disequilibrium, Entrepreneurship andDiscovery, Hobart Paper No.133, Institute of Economic Affairs.67 See Campbell, D.and Klaes, M.(2005) The Principle of Institutional Direction:Coase s Regulatory Critique of Intervention , Cambridge Journal of Economics, vol.29(2),263 288.68 Coase, R.(1937) The Nature of the Firm , Economica, vol.4(4), 386.69 In the economic literature the word contract has a less technical meaning than inlegal texts as it is used to broadly describe an economic transaction. Corporate Governance Convergence and Corporate Theory 23found was that the use of the price mechanism entails what he called transactioncosts.70 Such costs can arise from drafting, negotiating and enforcing contractsbecause natural prices of goods are not automatically known to the transactingparties.The real world is one of uncertainty where, contrary to the global rationalityassumption, economic agents do not and cannot have full knowledge about allrelevant contingencies.71 Thus, Coase argued, in order to economize on the costs ofusing the market and therefore of production or allocation, transacting parties allowan entrepreneur to coordinate the distribution of resources by command.Withinthe firm contracts are not eliminated but are considerably reduced because theyare replaced by cooperation.For the series of contracts between the entrepreneurand other agents required in market transacting one is substituted where the latteragrees to follow the directions of the former in return for some remuneration.So, Coase defined the firm s hierarchical structure as a system of relationshipswhich comes into existence when the direction of resources is dependent on anentrepreneur.72 Optimal firm-size is determined by balancing the costs arisingfrom market and entrepreneur coordination so the firm expands until the pointwhere both types of costs are equal.73Coase s insights gave a new spin to economic theories of the firm because hedemonstrated that firms do exist and they are different from markets or individuals.Although, as himself admitted fifty years after his seminal work, his intention wasto compare coordination by organizations with that by the market mechanism,his transaction cost approach provided the theoretical platform for an analysis ofthe firm as a governance structure.74 The Coasean theory, however, did not catchon until several decades later when theorists, like Williamson, rediscovered andexpanded it to form a new kind of economic analysis based on transaction costs.75As Zingales noted:[t]he link between theory of the firm and corporate governance is even morecompelling & The word governance implies the exercise of authority.But ina free-market economy, why do we need any form of authority? Isn t the marketresponsible for allocating all resources efficiently without the intervention ofany authority? In fact, Coase (1937) taught us that using the market has its costs,70 See Coase, R., above n68, 391.71 These circumstances are responsible for what Simon has termed boundedrationality.In rejecting the neoclassical hypothesis of global rationality he argues thatthe real world is one of uncertainty, where agents have incomplete knowledge.As such anagent s rationality is unavoidably bounded.See Simon, H.(1957) Models of Man: Socialand Rational, New York: Wiley.72 See Coase, R., above n68, 393.73 Ibid., 394.74 Coase, R.(1988) Lectures on The Nature of the Firm , Journal of Law, Economics,and Organization, vol.4(1), 33 at 47.75 We discuss Williamson s work later in this chapter
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