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Economic Theories of the Modern Company (1)

Contractarian approach considers the firm as a nexus of contract[1], around which the market players conduct their activities. The firm acts as a central common party to a set complex contracts[2].

Imagine a scenario where you try to gather capital, supply and labour in a market. This would be costly[3] as you would have to determine the relevant prices, to conclude separate contracts for each transaction between each player. Also you would be required to foresee the risks and to stipulate various clauses in these long-term contracts in order to protect yourself from remoter risks.

The firm replaces the price mechanism and reduces these transactional costs by replacing the market. Thus production is organised more efficiently through firms, rather than exchanges in the market.

Can we say that the firm is then only quantitatively different than ordinary contracts? This counter-intuitive description of the firm would not show the whole picture. Since it has a separate legal personality different than shareholders, managers, creditors and employees we cannot say that the modern company can be replicated by ordinary contracts. Thus it is more accurately described as a nexus for contract, since it serves as the common counterparty to all these contracts and it has it’s own assets.

The agency theory complements this contractarian approach by focusing on the problem of monitoring all these stakeholders. According to the theory, in each case where there is an agent and a principal, the agent may tend to act for her own interests, rather than for that of the principal. This leads to agency costs. Thus, corporate law should deal with these ‘negative externalities’ arising from the agency relationship i) among shareholders, ii) between shareholders and managers and iii) between the company and other stakeholders[4].

What is the corporate law according to contractarian approach then? It is seen as a special branch of contract law supplying default rules in order to fill the gaps of the corporate contract. Hence, it is no different than standard-form contracts readily available to parties.

In the next article, I will try to explain the proprietary foundations of the modern company.

[1] Easterbrook & Fischel (1991), p. 15.

[2] Jensen & Meckling (1976), p. 315.

[3] Coase (1937), p. 390-391

[4] Kraakman et. al. (2009), p. 6.


Image source:

Cem Veziroğlu

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