Economic and Legal Aspects of the Firm
A. Some Basic Concepts and Terminology
a. What is a “Firm”
i. The “firm” is what we call the set of relations that arise when resources are allocated by the entrepreneur via commands to her employees rather than the set of relations that arise when an entrepreneur allocates resources via contract with outsiders.
ii. The firm as a nexus of contracts
b. What Is the Difference Between a Sole Proprietorship and a Business Association?
i. The jointly owned firm is a “business association” and can be organized as either a partnership, corporation, or LLC.
B. Organizing the Firm: Selecting a Value-Maximizing Governance Structure
a. Business Planning: The Role of the Corporate Lawyer in Organizing a Firm
i. Goal is to avoid litigation
b. The Goal of Informed Rational Choice Between Competing Investment Options
i. Comparative Search for Best Investment
1. The search for maximum value requires rational investors to take both a comparative and an ex ante perspective
ii. Risk and Return
1. Expected Return = (Possible return X Probability) + (Possible return X Probability) =
2. “Risk” is the degree to which the various possible outcomes will differ from the “expected return.”
a. 0 = “risk free”
b. “Risk averse,” “risk neutral,” and “risk preferring”
c. Only the “Risk averse” will diversify
d. A partnership has greater risk than a corporation
3. Transaction Costs and Choice of Organizational Form
i. Can choose to embody understanding in a long-term contract.
ii. Can also choose to structure their relationship as sole proprietor and agent, a partnership, a limited liability company, or a corporation.
b. Transaction Cost Factors
i. Bounded rationality
1. Judgments are not perfect
2. Adapt quickly to changed circumstances
iii. Potential disadvantage
1. Surrendering autonomous control over her own business as she becomes subject to opportunism
4. State-Provided Governance Structures
a. Entity and Employment Law as Standard Form Contracts
i. Parties organizing as a corp., partnership, or LLC get the protection of state-provided rules and dispute resolution processes.
b. Default Versus Immutable Rules
i. Most off-the-rack rules found in each state-provided standard form are “enabling” in the sense that they provide the parties with default rules
1. Default rules are either enabling, meaning you can opt in or out, or immutable, meaning they must be adopted