by on October 25, 2017 in Economics

Robert Locke’s excellent discussion of the different perspective presented by a tacit-knowledge rather than explicit-driven driven enquiry into economic matters prompts me to reprise my understanding of the purpose of a business firm.

Put briefly: a business firm exists to translate what is often called tacit knowledge in to what is called explicit knowledge. An alternative wording would be that firms take the ad hoc and various and make them into the codified and uniform. In my own thought I use the words “secondary knowledge” to refer to the kind of knowledge that tackles ad hoc or unexpected circumstances. I use the words “primary knowledge” to refer to the codified knowledge that allows us to tackle the usual and/or repetitive circumstances. It is phraseology I borrowed from evolutionary psychology.

Why do firms do this?

Because that’s how they extract value.

Firms succeed when they control a process in order to produce something. Such processes are constructed from a variety of roles and routines whereby knowledge is combined with energy and physical resources, with the outcome being something for sale. Since establishing a process is a risky proposition — it takes up both space and time and so is susceptible to uncertainty on two fronts — control becomes the key component. And, in order to make the process most profitable, firms want to establish maximum control over the outcome: products must be both qualitatively and quantitatively predictable. How best to do that? By eliminating the ad hoc and various and limiting production to the codified and uniform.

However, as all students of evolutionary theory will recognize, being too specific, too codified, and too uniform renders something highly risky in the face of uncertainty. An unpredicted event may make the output of even the most efficient process useless or obsolete. In biology such uncertainty might arrive in the form of environmental turmoil. In business it might arrive in the form of a new technology. Either way excessive specialization and excessive efficiency makes a process vulnerable to change.

So firms need to absorb novelty. They need to be able to adapt. This implies that there is survival value in the ad hoc and the various, since they are the source of the novelty and adaptation. But to wring out the efficiencies upon which profitability best thrives the new ideas and discoveries within the ad hoc and various must be reduced to code: reliable replication is the key to effective production.

The profit cycle then begins again: knowledge gleaned from confrontation with uncertainty is carefully reduced to code. The specific discovery is made general production. And along the way value is added because quality controlled production becomes possible in quantity.

Being able to deploy both primary and secondary knowledge is the only long term source of survival. In my view the goal of a firm is to survive, it is not to maximize profit since uncertainty rules out the ability to maximize. But to thrive a firm needs to generate sufficient profit to locate and benefit from novelty so it can then reduce that novelty to codified and thus controlled production.

And so on …

The advantages of primary knowledge are that it allows consistent and reliable replication; it is objective inasmuch as it exists outside of any one person [it is coded]; and it is cheap to maintain [it has low/no error rate]. It is thus the most efficient basis for process construction. As noted: these advantages come at the cost of potential failure in the face of change.

In contrast, secondary knowledge is highly variable; subjective inasmuch as it is unique to an individual; and it is expensive because it is both relatively scarce and inscrutable. It is also highly likely to involve redundancy since its components might have no application to any particular problem, but are, rather, available to be called upon to deal with change.

So the getting balance between highly efficient but vulnerable to change, and less efficient yet adaptable, processes is the goal of good management. Survival depends upon the latter. The former is the source of profit. Translation from one to the other is the purpose of the firm.


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