Corporate governance and business ethics: The challenges of institutional reform

Why do firms exist at all? This was the question posed in Ronald Coase's seminal 1937 paper [2]. Why, in other words, does the price system not extend all the way down to the level of the individual transaction? The answer Coase gave was that there are costs associated with using the price system. There is the cost of obtaining information such as what goods and services are available and what their prices are. There are the negotiation costs associated with the process of drawing up contracts. These features of transactions give rise to costs and benefits of using the price system. Coase argues that firms form in a market economy when, at the margin, the benefits of avoiding the price system just offsets the costs. Thus one important outcome of a market economy is the balancing of advantages and disadvantages of using the market through the formation, merger, or dissolution of firms leading automatically to their efficient sizing. Economic theory also asserts that when firms maximize their total market value - that is the sum of the market values of the equity, debt and any other contingent claims outstanding - it will also lead to the maximization of social welfare. In brief, when a company acquires an additional unit of any input(s) to produce an additional unit of any output, it increases social welfare by at least the difference between the value of the output and the cost of the input(s) required in producing it. When inter-temporal tradeoffs and risk are added into the equation, nothing of major importance is changed in this proposition as long as there are markets in which the individual can buy and sell risk at a given price. The risk-adjusted interest rate is then used in calculating the market value and the corporate objective function that maximizes social welfare then becomes "maximize present market value of the firm"; it tells firms to expand output and investment to the point where the long-term market value of all claims on the firm (not only equity but also debt and other instruments) of the firm is at a maximum.