Coase and Williamson explained why the firm swallows certain transactions, but they left a tempting picture in place: the firm as a thing, an island with a clear inside and outside, a realm of authority set against the market's realm of exchange. A powerful line of thought, beginning with Jensen and Meckling, denies that the picture is quite right — and in denying it, exposes both what the firm is made of and the conflicts that haunt it.
The firm, on this view, is not a thing at all but a nexus — a single point at which a great many contracts meet and are tied together. The corporation we name as one entity is, looked at closely, a knot of agreements: the employment contracts with its workers, the loan contracts with its creditors, the supply contracts with its vendors, the sale contracts with its customers, and the residual arrangement with its owners, who are promised whatever is left when the others have been paid. There is no firm over and above these contracts; the firm is just the name we give to the place where they intersect, a legal fiction that serves as the common counterpart to them all. And this dissolves the bright line between firm and market that Coase's island suggested. The relation between a company and its salaried manager is, in law, no different in kind from the relation between the company and its outside supplier: both are contracts, both voluntary, both terminable. The firm does not abolish contract and replace it with authority; it is contract — a particularly dense bundle of it, gathered at one node.1
If the firm is a web of contracts among parties with their own interests, then its central trouble is that those interests diverge — and this is the agency problem, the friction the nexus view brings to the fore. Wherever one party, a principal, engages another, an agent, to act on his behalf, the agent has interests of his own and information the principal lacks, and so will not always act as the principal would wish: the manager hired to maximize the owners' wealth may instead maximize his own salary, his empire, or his ease; the worker paid to labor may shirk when unwatched. The principal cannot simply command the right behavior, for he cannot observe all the agent does, and cannot write a contract foreseeing every situation — the same incompleteness that bedeviled the hold-up. So he is left with agency costs: the cost of monitoring the agent, the cost of bonding the agent to good behavior, and the residual loss from the misbehavior that no monitoring or bonding wholly prevents. Every contract in the nexus carries such a cost, for every one joins parties whose interests are not identical, and the firm is, in part, a structure for managing these frictions — for aligning, as best it can, the interests of agents with the principals they serve.2
Why, then, gather contracts into a firm at all, if each carries an agency cost — why not leave the parties to deal in the open market? One answer, from Alchian and Demsetz, is team production. Much of what firms do cannot be parceled out and bought piecemeal, because the output is joint: when a team lifts a load or builds a car together, the contribution of each cannot be cleanly separated from the rest, and so cannot be priced and rewarded individually by the market. But what cannot be measured invites shirking — each team member, knowing his slack will be hidden in the joint product, is tempted to give less than his share. The solution is to set someone to watch: a central monitor who observes the team, disciplines the shirkers, and, to be sure he monitors diligently rather than shirking himself, is given the residual — the profit left after all are paid — as his reward and his spur. The firm, on this telling, is the team plus its monitor-owner: an arrangement for capturing the gains of joint production while holding its besetting shirking in check, with ownership of the residual the device that makes the monitor watch.3
The nexus view stands in productive tension with the authority view that preceded it, and the tension is illuminating rather than embarrassing. Coase and Williamson saw the firm as the domain of authority, where command replaces the market; Alchian and Demsetz, and Jensen and Meckling, retort that there is no real authority in a firm — the employer can no more command the employee than a customer can command his grocer, for the employee, like the grocer, can simply refuse and walk away; the relation is voluntary, contractual, terminable, and the appearance of command is only the working-out of a contract the employee entered for his own reasons. Who is right? Something of both, the volume will hold. The nexus theorists are right that the firm rests on contract, that its authority is bounded by the freedom of its members to exit, that it is no little tyranny but a voluntary association. Yet the authority theorists are right that within those contractual bounds, something real and distinctive happens — that the employee, having signed on, does accept direction across a range of tasks he did not individually negotiate, and that this open-ended submission to be directed is exactly what distinguishes the employment contract from the purchase of a good. The firm is contract, yes — but a special kind, in which one party agrees to be told what to do.4
What the nexus view leaves unresolved, and what the next plate must supply, is the question of what ties the knot — what, if the firm is merely a meeting of contracts, distinguishes the parties who are inside it from those merely contracting with it. Why do we say the shareholders own the firm, but the bondholders and suppliers, who also have contracts with it, do not? The answer cannot be that the owners have a contract and the others do not, for all have contracts; it must be that the owners' contract is of a different kind — that they hold something the others lack. That something, the next plate will argue, is the residual: not only the residual profit, the leftover after all fixed claims are paid, but the residual right of control, the authority to decide everything the other contracts did not specify. To own a firm, it will turn out, is to hold the rights that no one else's contract claimed — and that, in a world where no contract can specify everything, is to hold a great deal.5
The nexus is the firm seen as what it is made of: not a thing with a wall around it, but a knot of contracts — with workers, lenders, suppliers, owners — tied at a single point, each contract joining parties whose interests diverge, and each therefore carrying its agency cost, the price of trusting an agent who is not oneself. The view dissolves the easy line between firm and market, reminding us that the firm rests on voluntary agreement and that its authority is bounded by the exit of those who may always leave; and it locates the firm's central trouble in the friction between principals and agents, the same hidden-action problem the asymmetry family knew. Yet it leaves a question it cannot answer — what distinguishes the owner from the other parties to the knot — and the answer carries the volume to the heart of the matter. The next plate takes up ownership: what it is to own a firm, when a firm is only a meeting of contracts. The next plate is the owner.