• Is the Theory of the Firm a Missing Chapter in Austrian Economics?

    pdficon2Glenn Fox
    University of Guelph
    Email: gfox@uoguelph.ca



    “The problem of entrepreneurship for economists is that the best-developed and best-understood part of economic theory – neoclassical economics – is really mathematics.  Business firms in that system are merely formulas, “production function[s].”  There are no people, no institutions; it is a timeless paradigm of resources shifting back and forth according to changes in relative prices and costs.  This has meant that entrepreneurship, the most forceful, dramatic, and obvious phenomena of economic life, has perforce been ignored by theoretical economists in their story of how economic events happen.” — Jonathan Hughes (1986)


    “The entrepreneur is at once one of the most intriguing and . . the most elusive  . . . characters that constitutes the subject of economic analysis.” — William Baumol (1993)



    Hayek’s (1945) justifiably famous characterization of the price system does not make specific reference to the roles of firms in the mobilization of distributed knowledge.  The price system transforms personal, subjective, conflicted knowledge of the particulars of time and place into objective price knowledge.  What roles do firms play in this process of transformation?  Major treatises in the Austrian tradition do not generally contain specific sections devoted to the examination of the economic functions of firms as social institutions.  This has prompted some writers to suggest that Austrian economics has a missing chapter, that it has some catching up to do compared to literature in the Walrasian/Jevonsian and the neo-institutionalist traditions in neoclassical economics. The thesis of this paper is that the theory of the firm is not a missing chapter in Austrian economics.  The impression that it is a missing chapter rests on a failure to recognize that the treatment of the firm as a social institution in the Austrian neoclassical tradition is thematic rather than topical.  Many elements of the Austrian approach to social theory devote considerable attention to the functions of firms in the price system and the insights obtained from this considerable attention anticipate many contemporary rediscoveries in the economic theory of the firm.

    Why Do We Need an Economic Theory of the Firm?

    It is useful to consider why economics needs a theory of the firm, and perhaps why Austrian economics needs a theory of the firm, apart from the need to understand the roles of firms in the price system.  Firms exist (and persist) as social institutions, generally as the product of intentional human action, so it is reasonable to ask why people bother to form firms, in light of the human action axiom.  If all human action is an attempt to move from a less desired state to a more desired state, then what is it that makes the formation of something recognizable as a firm a desirable outcome?  In addition to being the initial product of intentional human action, firms evolve over time, sometimes in ways not anticipated by their founders, so that firms exhibit aspects of spontaneous as well as planned orders.  Some contemporary writers, including Coase, who himself seems to have been inspired by Robertson, characterize the existence of the firm as a paradox.  According to this view, firms represent situations where the price system is suspended. Coase uses Robertson’s metaphor that firms are like lumps of butter in a pail of buttermilk.  The buttermilk, in this context, is the price system.  Within the firm, resources are directed by managers without minute by minute regard to market prices, in the interest, according to Coase, of economizing on transaction costs.  If we regard firms as systems of cooperation among owners of goods of higher order, then the nature of that cooperation would seem to be centrally related to the subjectivist perspective on capital theory.  Ethical and empirical questions about the nature, significance and function of profits would appear to require a theory of the firm as one element in their resolution.  What is profit?  What function does it serve? And is it a legitimate form of income? As I will argue later, the Austrian tradition, more than any other branch of economics, has devoted more attention the relationships among entrepreneurs and providers of capital, relationships that are typically embodied in firms.

    We also need a theory of the firm in order to understand the nature of competition, especially with respect to concerns about apparent forms of anti-competitive behavior of businesses that give rise to various government policies intended to promote competition.  Here, Hayek’s “Competition as a Discovery Procedure” contains rich insights that have been generally overlooked in this field.  There are important questions about the role of entrepreneurship in the formation and ongoing existence of firms that continue to attract attention as does the theoretical question of whether entrepreneurship occurs within firms.  Austrian business cycle theory maintains that clusters of entrepreneurial errors occur in response to changes in money market conditions.  We need a theory of the firm to understand how so many decisions made by so many firms could be in error.  As a matter of intellectual curiosity, we need a theory of the firm to understand industry structure. In most industries, firms of different sizes, types and ages coexist.  New firms emerge, existing firms grow, contract, change their internal organization and some disappear.  Why? In addition to satisfying intellectual curiosity, there are important implications for business policy arising from these questions.  Ronald Coase (1960) has suggested that we can think about an entire economy as one big firm.  If he is correct, then there is a paradox about planning.  We need a theory of the firm to explain why planning is functional in a firm, even in a complex firm, but is not functional for an entire economy.

    Critical Austrian Conceptual Distinctions

    It is not possible in this brief introductory survey of issues to do justice to all of the critical distinctions between neoclassical economics in the Mengerian tradition and neoclassical economics in the Walrasian tradition.  But I would like to focus on a partial list of what I see as the more important distinctions.  First, it is impossible to comprehend the Austrian perspective on the theory of the firm without understanding the distinction made in that literature between risk and uncertainty.  Like Knight, writers in the Austrian tradition maintain that these are two distinct decision contexts.  The consensus view in the Walrasian neoclassical tradition seems to be that there risk and uncertainty are synonyms.  The Mengerian tradition maintains that there is a fundamental difference between uncertainty and risk, or what Mises called the distinction between case probability and class probability, or what more recently Langlois has described as parametric uncertainty vs structural uncertainty.  Israel Kirzner, in the development of his theory of entrepreneurial alertness, relies on the Knightian distinction.  According to Kirzner, in a context of uncertainty, “the decision maker [is] ignorant of the extent of his own ignorance.  He is subject to genuine surprise . . . he is . . . making a choice without knowing what he is selecting, or what he is giving up.”  The resolution of uncertainty involves surprise, learning, discovery and adaptation.  The resolution of risk does not (eg. flipping a coin).  I don’t think that it is possible to comprehend the Austrian perspective on the theory of the firm without an appreciation of the maintained distinction between risk and uncertainty.

    Space does not permit a detailed examination of other critical distinctions between the Mengerian and Walrasian perspectives.  Table 1 provides an admittedly cryptic summary of some of the elements of such an examination.  For the purposes of this paper, the implication of the summary offered in Table 1 is that there are paradigmatic differences between the Mengerian and the Walrasian traditions in neoclassical economics.  As Kuhn (1962) famously explained, inter-paradigmatic communication is at best difficult.  Even familiar concepts like equilibrium and rationality take on distinct meaning and significance in the two paradigms.


    Table 1: Critical Distinctions Between the Mengerian and Walrasian Neoclassical Traditions


    Alternative Economic Conceptualizations of the Firm

    There are at least five distinct conceptualizations of the firm in the economics literature.  Adam Smith saw the firm as an institution that facilitated specialization and the division of labour, allowing for fuller expression of individual comparative advantage in production.  Although he saw the division of labour as the central organization principle in economics, the discipline has not generally followed his early example.  The more common conceptualization in Walrasian neoclassical economics, at least until recently, views the firm as an optimizing organization.  Sometimes this perspective is characterized as seeing the firm as a production function, an organization that transforms inputs into outputs with a given technology, but the theory actually focusses on optimizing quantities of inputs and outputs.  There are many noteworthy contributions to the literature in this tradition, including Carlson (1939), Samuelson (1947), Ferguson (1969) and Fuss and Mcfadden (1978).  According to this perspective, firms either maximize profits, given a set of input prices, output prices and a production function, or minimize total cost for a pre-determined level of output given a set of input prices and a production function.  In the profit maximization approach, the optimization problem is represented as:

    Max PY – C(Y, W) subject to Y ≤ f(X),

    were P is a vector of output prices, Y is a vector of outputs, C(Y,W) is a cost function with a vector of input prices, W, and the vector of outputs as arguments.  Output is constrained by a production function, f(X), whose arguments are quantities of inputs.  The solution to this optimization problem yields a system of profit, product supply and factor or input demand functions.

    From the cost minimization perspective, if the quantity of output, Y, is predetermined, the problem is stated as:

    Min WX subject to f(X) ≥ Y,

    where the notation is as defined above.  In this case, the solution to the optimization problem yields a system of cost and conditional factor demand functions.

    Work in this tradition typically adopts the logical positivist methodological position (See Blaug, 1980, for a representative treatment).  Validation of this conceptualization of the firm is based on Samuelson`s (1947) exposition of the testable hypotheses implied by the second order conditions required for optimization.   The falsifiable hypotheses for profit, supply and factor demand functions involve tests for monotonicity, symmetry, concavity and linear homogeneity.  The parallel hypotheses for cost and conditional factor demand functions involved tests for monotonicity, symmetry, convexity and linear homogeneity.  The empirical track record for this paradigm is abysmal, however (Blaug, 1980, Applebaum, 1978, Fox and Kivanda, 1994).

    One immunizing strategy that has been adopted in this paradigm is to suggest that firms aren`t really profit maximizers or cost minimizers after all, but rather expected utility maximizers.  As Just and Pope (1979), however, have demonstrated, the expected utility model does not generate any falsifiable hypotheses.  So its use is inconsistent with the empiricist logical positivist methodology.  In any case, the econometric evidence seems clear, that firms are not optimizing organizations.  A moment’s reflection might suggest why this is the case.  The traditional abstract conceptualization of firms as optimizing organizations limits the dimensions of optimization to a relatively small number:  the quantity of output, the quantities of typically 5 or less inputs, and a scalar profit or cost metric.  Actual firms face many more dimensions for optimization.  Is the parking lot the optimal size?  Is the sign over the door in the optimal font?  Is the number of phone jacks in the office optimal?  It is inconceivable that actual firms would possess the cognitive capacity to optimize on every dimension of their operations.

    More recently, the economic literature on the firm has been dominated by transaction costs economics.  Transaction costs were introduced to the economics literature in 1937 by Ronald Coase in what has come to be an influential essay entitled “The Nature of the Firm.”  Coase’s premise is that there is cost to undertaking a market exchange.[1]   Coase originally defined transaction costs as the value of resources used up in making, or attempting to make, a market exchange.  There are three constituent elements of transaction costs.  Search costs are incurred in looking for a potential exchange partner.  Negotiation costs are incurred in trying to establish the terms of an exchange, once a potential exchange partner has been located.  Verification or concluding costs[2] are incurred after the exchange of items of property has taken place when the parties to the exchange make sure that they got what they bargained for.

    The transaction cost explanation for the existence of the firm is that people form firms in order to avoid transaction costs.  This explanation is usually couched in terms of a counterfactual situation in which a manager hires all of the inputs required for production at the start of every business day at the prevailing market price.  At the end of each day, in this counterfactual, all of the input providers are paid and terminated.  At the beginning of the next day, the process is repeated.  The manager and the input owners incur daily transaction costs.  The creation of a firm, which in this view is an ongoing hierarchical relationship among owners of factors of production under the direction of a manager[3] avoids these daily[4] transaction costs.  This benefit, however, precipitates other costs.  The primary cost acknowledged by Coase in his original paper, and this is consistent with his use of Robertson’s metaphor that firms are like lumps of butter in a pail of buttermilk[5], is that by directing the employment of inputs without regard to momentary changes in prices in the external markets for inputs, managers of firms may misallocate resources.  Additional cost categories identified in subsequent literature by Coase, Williamson and others include opportunistic behavior, such as shirking or hold-up problems.  The growing list of incentive problems that have been identified in the transaction cost theory of the firm actually make the ongoing existence of firms out to be something of a miracle.

    Although the transaction cost perspective is generally offered as an alternative to the view that the firm is an optimizing organization, a vestigial influence of the firm as an optimizing organization is evident in the transaction cost literature on the boundaries of the firm.  Here, the marginal costs of expanding the firm, which means replacing a market exchange relationship with a current factor owner with a contract with that factor owner, equal to marginal benefits, accruing in the form of reduced transaction costs[6].   The transaction cost theory of the firm includes a role for a manager, but there is no theory of entrepreneurial discovery and there is at best an incomplete theory of capital commitment and allocation.  Like the optimizing view of the firm, capital is just another input in the transaction cost theory of the firm.

    A fourth perspective on the theory of the firm in the economics literature is called the resource based theory of the firm.  Penrose (1959) suggested that the firm should be viewed as a collection of resources or capabilities.  Owners of these resources earn rents by cooperating in a firm, which is an organization that that facilitates the maintenance of rents.  While the definition of resource rents in this theory is conventional, that is rents represent payments to owners of resources that are higher than what those resource owners could earn in their next most attractive employment, the theory does not provide a clear explanation of how cooperation in a firm facilitates the creation or the maintenance of rents.  In this theory, the entrepreneur is an optimal searcher, a resource allocator, but not an opportunity discoverer, so what is called an entrepreneur in the theory is really a manager.  The resource based theory of the firm lacks a full development of the economic theory of the entrepreneur and therefore cannot explain fully how firms develop and maintain capabilities.

    The fifth economic perspective on the theory of the firm is the thematic treatment of firms in the work of Menger, Mises, Hayek, Kirzner, Sautet, Rothbard and others in the Austrian tradition.  This perspective could be called the entrepreneurial/capitalistic theory of the firm.  Important contributions include Menger’s theories of property and production and his economic analysis of goods of higher and lower order.  Also included are Mises’ and Kirzner’s theories of entrepreneurial discovery and property rights, Fetter’s and Kirzner’s theories of time preference, interest and capital, Hayek’s theory of knowledge, entrepreneurial action in a context of disequilibrium, Buchanan’s analysis of the subjectivity of opportunity costs and, therefore, profits, Menger’s and Hayek’s distinctions between planned and spontaneous orders and Mises contributions to the theory of bureaucratic vs profit organizations.

    Israel Kirzner (1997) has suggested that the emphasis on entrepreneurial alertness is the key differentiating feature in the Austrian tradition, and that would imply that it is also the centerpiece of the Austrian theory of the firm.  Following Mises, entrepreneurial alertness is involved in all human action.  The entrepreneurial function is a type of arbitrage, but it is a richer conceptualization of arbitrage than is normally recognized.  Arbitrage is usually understood as the recognition that existing prices that are somehow inconsistent over space or time, and then acting on that inconsistency.  Misesian and Kirznerian entrepreneurship, in the context of a business enterprise, is the entrepreneurial perception that imagined future prices are too high, relative to current factor prices, or that the imagined future prices for a good which does not currently exist are high, relative to current and expected factor prices.  These entrepreneurial perceptions are tested experientially in undertaking production activities with a view toward future product prices.  Entrepreneurial error occurs when these perceptions turn out to be incorrect.  It is the working out of these experiential tests that Hayek emphasized in his “Competition as a Process of Discovery.” Firms, in this theoretical context, facilitate the testing of entrepreneurial perceptions under pervasive uncertainty.  Hayek’s inference, in “Competition” is that the outcome of such testing cannot be known in advance.  So firms are knowledge production organizations.

    There are several unique and at times controversial elements of the economic theory of entrepreneurship in this theoretical tradition.  Several authors, for different reasons, maintain that entrepreneurship is not a resource, that it is not a productive factor and that it cannot be bought or sold.  Kirzner argues that entrepreneurial alertness has no opportunity cost.  Properly understood, entrepreneurial action is the expression of human creativity, will, initiative, vision, imagination and even leadership.

    There are three specific characterizations of entrepreneurial action in the Austrian tradition.  There is a general recognition in the Austrian tradition that that entrepreneurial alertness is an element of all human action. But there are three specific formulations of entrepreneurial alertness and action that rest on this general foundation.  The first of these is Kirzner’s exposition of the pure entrepreneur.  The pure entrepreneur perceives opportunities but owns no resources.  The pure entrepreneur is literally a disembodied spirit, since owning no resources rules out even self-ownership.  Self-ownership implies owning labour, which Kirzner rules out.  The pure entrepreneur, to Kirzner, is an ideal type, useful for theoretical examination of the nature of entrepreneurial perception.

    A second conceptualization of entrepreneurship is Mises’ theory of the entrepreneur-promoter.  This individual possesses entrepreneurial imagination but lacks sufficient resources for the realization of that imagination.  He or she needs to persuade owners of factors of production, particularly owners of capital, to commit their resources to the realization of the imagined outcomes.  The testing of entrepreneurial perceptions in the process of Hayekian competition cannot take place unless the entrepreneur-promoter can persuade particularly the owner of capital to commit that capital to the perceived opportunity.  Mises devotes considerable attention to the energetic organizational leadership required to sustain the commitment of resources to the realization of the entrepreneurial vision.

    The third conceptualization is Rothbard’s theory of the entrepreneur-capitalist.  Here, the entrepreneur possesses imagination as well as the means of realization of that imagination.  The entrepreneur-capitalist uses owned capital to hire factors of production to realize entrepreneurial vision.  Here, the entrepreneur does not have to promote the venture to the capitalist, since the two functions are combined in the same person.  The entrepreneur-capitalist commits capital to the hiring of goods of higher  order and assigns those goods to the needed processes of production.

    The Entrepreneur-Promoter and Market Based Management®

    Mises conceptualization of the entrepreneur-promoter is developed and applied in particular detail in Charles Koch’s (2007) The Science of Success.  Koch (2007, p. 25) describes Market Based Management® as an “holistic approach to management that integrates theory and practice and prepares organizations to deal successfully with the challenges of growth and change.” Previously, Koch acknowledged the critical role that his study of the ideas of Mises and Hayek played in the development of the theoretical aspects of this integration.  The practice came from the adaptive experimental application of this theory to Koch Industries.  The characterization of the firm presented by Koch emphasizes the integration of the function and organization of the firm with the price system.  Firms that achieve and maintain this integration thrive, while those that do not, eventually, disappear.  Hayekian experimentation is a critical element of this integration.  This experimentation is undertaken with a clear expectation that some experiments will fail.  Failure is not the goal, and firms must have exit strategies when failures occur, but management which strives to eliminate failures undermines the viability of the firm in the longer term.  Koch’s exposition of the entrepreneur-promoter emphasizes attributes which have attracted limited attention in the business literature and have been ignored, generally, in the economics literature.  For example, he maintains that the realization of entrepreneurial imagination requires the development of trust within the organization.  He also proposes that a low rate of time preference is necessary for the firm to be effective.  Market Based Management® rests on an Austrian understanding of the subjective theory of value, the principle of comparative advantage, the importance of spontaneous order, marginal costs and benefits and knowledge of the particulars of time and place.  This is combined with principled leadership[7] of the organization, which is the basis for the development of trust among owners of goods of higher order cooperating within the firm.  The entrepreneur-promoter, as might be expected, is responsible for shaping the vision of and culture of the organization.  But, in addition to this function, the entrepreneur-promotor also contributes to organizational design, in the form of shaping processes for the delegation of authority and property rights, the development of systems of accountability and establishment of incentives within the firm.  Ultimately, the goal of organizational design is “to provide incentives that harmonize the interests of the individual with those of the company” (Koch, 2007, p. 150).

    Is the Theory of the Firm a Missing Chapter in Austrian Economics?

    The thesis of this paper is that the answer to this question is no.  Austrian economics, going back to Menger, has developed a substantial body of thought that anticipated and even surpassed the insights of the modern business and economic literature.  The Austrian perspective has not, however, until relatively recently, been presented topically as a theory of the firm.  The Austrian theory of the firm is imbedded in the Austrian theory of institutions, including markets, capital and entrepreneurial alertness.

    In the Austrian neoclassical tradition, firms are an integral part of the price system.  Price proposing and product introduction are expressions of entrepreneurial action.  Among other things, firms propose and adjust prices, as well as production plans.  This is an experimental process of discovery that takes place in a context of uncertainty and competition.  These critical functions, however, are often viewed with suspicion from the vantage point of the Walrasian equilibrium paradigm.    From the perspective of the entrepreneurial theory of  the firm, they both would appear to be normal and even necessary adaptive actions.  In the Austrian tradition, firms are not like “Lumps of butter in a pail of buttermilk.”  Successful firms find ways of internalizing the market process within the organization.

    I am not suggesting, however, that the treatment of the firm in the Austrian tradition is a closed subject. Important controversies remain to be resolved.  A prominent example is a debate about the relative importance of the entrepreneur and the capitalist.  Rothbard argues that the capitalist is more important.  In his view, there are lots of entrepreneurial ideas lying around, but only a few get exploited because capital is scarce.  Kirzner, on the other hand, argues that entrepreneurial alertness is more important.  Entrepreneurs, if necessary, can borrow capital from savers to pay for the services of goods of higher order.  Let me conclude by stating an hypothesis:  that this debate cannot be resolved in the terms in which it is currently expressed.  If the firm is a necessary institutional context to facilitate the cooperation of entrepreneurs, capitalists and owners of goods of higher order, perhaps joint necessity of the contributions entrepreneurs and capitalists is a more fruitful perspective.



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    [1] Menger (1871) was aware of this phenomenon.  He explained it in terms of the differential marketability of commodities.  This differential marketability was the basis for his theory of the origin of money.

    [2] Later, Coase seems to have accepted the term monitoring or enforcement costs for this third subcategory of transaction costs.  This migration of terms, however, creates conceptual muddle, since the terms monitoring and enforcement are often associated with contracting costs, and the transaction cost theory of the firm makes a distinction between a market exchange (outside the firm) and a contract (inside the firm).

    [3] Alternative ways of expressing this relationship are that the firm is a nexus of contracts or that firms embody team production.

    [4] Of course, the choice of a daily exchange is arbitrary.  Why not consider hiring factors twice a day, or hourly, or at one second intervals?  Shortening the unit of time increases the transaction costs incurred to search for new inputs.

    [5] In this metaphor, the buttermilk is the price system or the market.  The firm, that is the lump of butter, is suspended in the market, but it is differentiated from the market.  Market exchange is suspended in the firm.

    [6] This is sometimes referred to as the “make or  buy” decision in this literature.

    [7] Koch’s treatment of principled leadership within the Hayekian firm is similar, in some respects, to Havard’s Virtuous Leadership (2007)